Best of the Week
Most Popular
1.Stock Market Crash and Recession Indicator Warning: Extreme Danger Ahead - Harry_Dent
2. Is This How World War III Begins, In Almost Complete Silence? - Jeff_Berwick
3.Trump Wins 2nd Presidential Debate, Betfair Betting Markets Odds Bounce - Nadeem_Walayat
4.Why Krugman, Roubini, Rogoff And Buffett Dislike Gold - GoldCore
5.End of SPX Stock Market Correction Nears - Tony_Caldaro
6.Get Ready for the Future - Exponential Machine Intelligence Mega-trend towards Singularity - Nadeem_Walayat
7.US Housing Market Bubble II – It’s Happening Again! - Andy_Sutton
8.FTSE BrExit Stock Market Panic Crash Resolves towards New All Time Highs - Nadeem_Walayat
9.Can Trump Still Win Despite Opinion Polls, Bookmakers and Pundits all Saying Hillary has Won? - Nadeem_Walayat
10.Gold’s, Miners’ Stops Run - Zeal_LLC
Last 7 days
Stock Market Investment Success Through the “Investment Rule of 72” - 21st Oct 16
The Final Bottom in Gold - WHEN - 21st Oct 16
Gold Green Lights Upleg - 21st Oct 16
Demand for US Mints Silver Eagles has ‘Returned with a Vengeance’ - 21st Oct 16
Central Bankers Can't Stop The Death Blow Of The Post US Election Recession - 21st Oct 16
The Fortune at the Bottom of the Pyramid: Golden Opportunity for Frontier Asia - 21st Oct 16
Have You Taken These 4 Simple Steps to Improve Your Trading? - 21st Oct 16
The Stock Market is an Accident Waiting to Happen - 20th Oct 16
It's Rally Time for Gold and Silver Equities - 20th Oct 16
Cashless Society – Risks Posed By The War On Cash - 20th Oct 16
China's Insanely Leveraged Housing Market Will Enter Its Secular Bull Market In 2017 - 20th Oct 16
Donald Trump Bounces Going into 3rd and Final US Presidential Election Debate - 20th Oct 16
Attention Please: Phase Two of the Gold and Silver Train Now leaving the Station. All Aboard? - 19th Oct 16
How to Successfully Trade a Stock Market Crash - Black Monday October 19th 1987 - 19th Oct 16
Tesla, Apple and Uber Push Lithium Prices Even Higher - 18th Oct 16
Silver, Debt, and Deficits – From an Election Year Perspective - 18th Oct 16
UK Property Market: Slow Growth Does Not Equate To Decline - 18th Oct 16
Trump Election Victory is in Your Power - 18th Oct 16
Stock Market More to Come! - 18th Oct 16
This Past Week in Gold and Silver - 17th Oct 16
A Falling Stock Market Cannot Be Allowed - Financial Repression Is Now “In-Play”! - 17th Oct 16
Commodities, Forex and Stock Market Trend Forecasts - 17th Oct 16
Stock Market Crash..or No Crash? - 17th Oct 16
A perspective on risk rally – Risks abound but Stock Market is Confident - 17th Oct 16
Bank of England Blames Brexit for Sterling Drop Inflation, Masks QE Money Printing Cause - 17th Oct 16
From Piety to Pride to Pity, America's Racial Divide - 17th Oct 16
Is Obama Juicing US Government Spending To Get Hillary Clinton Elected? - 16th Oct 16
Seek Your Independence: Anything Else Will Destroy You - 16th Oct 16
SNL - US Presidential Debates, 1st, 2nd, VP - Like You've Never Seen them Before! - 16th Oct 16
End of Economic Growth Sparks Wide Discontent - 16th Oct 16
Donald Trump on Life Support, May Abandon Election Campaign and War on Republican Party - 15th Oct 16
The Gold Manipulators Not Only Will Be Punished, They Have Been Punished - 15th Oct 16
Black Votes Matter - Is the US on the Verge of Mass Race Riots? - 15th Oct 16
Gold Stocks Screaming Buy - 14th Oct 16
Brace Yourself for the Quadrillion-Dollar Reckoning - 14th Oct 16
The Next Recession Will Blow Out the Budget - 14th Oct 16
John Mauldin: My Infrastructure Plan to Save the US Economy - 14th Oct 16
World War III On The Brink: War Will Continue Until It Triggers Economic Collapse - 14th Oct 16
US T-Bill Rejection At Ports In Progress - 14th Oct 16
These 2 Debt Instruments Pose Peril to Millions of Investors - 14th Oct 16
China’s Rocketing Housing Market Real Estate Bubble - 14th Oct 16
DIY Winter Home Maintenance Money Saving 22 Point Checklist to Get Ready for Winter/Fall - 14th Oct 16
US Stock Market, Big Picture View - 13th Oct 16
Stock Buybacks Main Force Driving Bull Market; Rewards Investors and Starves Innovation - 13th Oct 16
SPX Gapping Down... - 13th Oct 16
Syria - Obama Stepped Back From Brink, Will Hillary? - 13th Oct 16
The Structure and Future of Gold in the Investment and Monetary World - 13th Oct 16
Can Trump Still Win Despite Opinion Polls, Bookmakers and Pundits all Saying Hillary has Won? - 12th Oct 16
Gold and Crude Oil - General Stock Market Links - 12th Oct 16
Samsung's Galaxy Battery Just The Tip Of The Iceberg - 12th Oct 16
Hillary: Deceit, Debt, Delusions (Part Two) - 12th Oct 16
Gold and Silver Metals Show Strength Relative to the USD Index - 12th Oct 16
Announcing Trader Education Week -- a Free Event to Help You Learn to Spot Trading Opportunities - 12th Oct 16
Confirmed Stock Market Sell Signals - 11th Oct 16
Hillary Deceit, Debt, Delusions - 11th Oct 16
Trump Support Crashes to New Low of 6.4 on Betfair Odds Betting Market - 11th Oct 16
The World Is Turning Dangerously Insular - 11th Oct 16
An American Tragedy: Trump Won Big - 11th Oct 16

Free Instant Analysis

Free Instant Technical Analysis

Market Oracle FREE Newsletter

LEARN to Trade

Farrell's Rule #2 U.S. Stocks Won't Bottom Before 2011, 25% Below End 2008

Stock-Markets / Stocks Bear Market Jan 16, 2009 - 03:46 PM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleFarrell's Rule # 2: "Excesses of stock prices above the long-term average are invariably followed by excesses of an equal magnitude below".

So what is the long-term average?

Here's a notion, how about valuing stocks in USA using International Valuation Standards (IVS) instead of using the "Dumb-Ass BIG Surprise Valuation Standards" (DABSVS) which are so much in vogue these days?

By definition a valuation of stocks done over 50 years, if it was done properly, would deliver the long-term average, because also by definition, over a long period of time, everything is valued properly, on average, by the market.

By way of explanation, International Valuation Standards were devised by a group of valuation institutes led by the US and UK valuation institutes, so that the stupidity and SURPRISE of the Asian Crisis would not be repeated. The first edition was published in 2000 and these standards are accepted by practically every valuation institute in the world (including the one in France ...imagine!!).

Of course IVS have never been implemented or recognized by governments, bean counters, economists, or banking regulators, because it would not be politically expedient for investors to actually know what the real value of assets actually is. And it would certainly not be expedient for taxpayers and voters to know what the real value of the liabilities that their chosen representatives have run up on their behalf!

Imagine...such blasphemy might expose highly respected public figures to the suggestion that they are Dumb-Asses!! One can't have that, after-all what is most important to a politician, (a) appearances, or (b) the economic viability of the country they represent?

No contest there - appearances wins hands down every day.

What's the difference between IVS and DABSVS?

The difference is that DABSVS say that there are only two ways to value an asset (1) Book Value (based on what some Dumb Ass (allegedly) paid for an asset a long time ago (that of course includes any "commissions" that were paid)) and (2) Mark-to-Market which is the price that some random Dumb-Ass might have paid yesterday (also includes "commissions").

IVS considers the possibility that in the real world there are a lot of Dumb Asses, and says that whenever there is an epidemic of Dumb Asses (or the evidence of that in the form of manure), then, it's a good idea to do an income capitalization valuation, just as a check.

And in cases where there is a big discrepancy between IVS and DABSVS a prudent investor would be well advised to consider using the income capitalization value rather than the DABS value (if he doesn't like surprises of the trillion dollar variety).

Income capitalization Valuation of S&P 500

The total stock market capitalization is a measure of the profit margin made on the total economic value-adding capacity in the country, multiplied by a market-derived yield. If over a long time this margin is constant, then it follows that market capitalization would reflects the sum of economic activity (GDP in nominal prices) multiplied by a yield, which reflects the cost of money (long-term interest rates (LTIR)).

So, over a long time, one would expect a plot of GDP x 1/LTIR would correlate with the total market cap of a country, which for expediency (since no one, neither the government, nor the NYSE nor the NASDAQ publishes a time series of market cap), I used the average stock market they say "good enough for government work".

Here is a "BIG SURPRISE" does!!!

Well at least for the data from 1950 to 1995, which is before the Dumb-Asses really managed to get a corner on the "market" (I use apostrophes because if a market is being manipulated by Dumb Asses then until they run out of money, it's really NOT a market in the true sense of the word).

The Regression coefficient of the line is 95.9% which means that over a long period of time (45 years is a long period of time), 95.9% of changes in the S&P 500 can be explained by changes in GDP x 1/LTIR.

By the way, the Standard Deviation of the "model for the S&P 500 Index" compared to actual for this period is 26% so that means that for 10% of the time the difference between the model, and the "actual" could be 50% (two standard deviations). What that says in plain English is that Dumb Asses weren't invented yesterday. I suspect that if I had compared actual market cap of USA the Standard Deviation would have been less.

(Also by the way I used the end of year high for the S&P 500 and the previous one year's GDP in the model).

Anyway, good enough for government work!

Dumb Ass Cycles

If this analysis is valid (hard to argue against a 96% R-Squared of two simple timelines and International Valuation Standards), then the deviation between the "valuation" (i.e. the model) and the actual is a measure of the influence that (collectively) Dumb Asses have on the market, which I shall call the "Dumb Ass Index"; where:

The Dumb Ass Index = 1- (S&P 500 /(GDP (nominal)/(1/LTIR)))

Plotting the Dumb Ass Index over time allows a review of Farrell's Rule since by definition the model delivers the "Long Term Average":

Just a note, looking at the chart I reckon that if the market cap of US stocks had been used then from 1950 to 1980 or so the line would have shifted a bit, because the amount of economic activity represented by stocks increased over this period. Perhaps some 24 year-old economics PhD student can spend the next twenty years studying that point?

Anyway, to NOW:

My take on the chart is that what happened starting in about 1995 there was a "bubble" in the stock market (caused mainly by Dumb Asses doing what they do best), which peaked in 1999, at which point stocks were 80% over priced.

Then there was a fall down to the equilibrium line, but this was arrested by the "brave efforts" of Dr. Greenspan, so things just bumbled along for a while. But at a cost, because in the real world a dose of "irrational exuberance" must inevitably be followed by a hangover, with the pain of the hangover being exactly equal to the amount of the previous exuberance (Farrell's Rule).

Well OK we had the "hair of the dog" thanks to Dr. Greenspan, that got us through most of the day, but then our liver blew up and WOW!!!


The Good News is that right now by this analysis the S&P 500 is 49% under-priced compared to the long-term average.


If Farrell's Rule holds the market won't turn until the S&P 500 is about 80% below the long-term average, and it could take a year, perhaps two for that to happen.

The VERY BAD NEWS is that according to Nouriel Roubini 2009 will deliver a -5.4% rate of nominal economic growth.

In which case there is at least 25% more to be shaved off the S&P 500 (and presumably other stocks) before the market turns back.

Aghh...!!...Goodness Gracious, what to do, what to DO?

As my friend Ambrish says in perfect and beautifully modulated Hinglish whenever he gets it caught in his fly.

Well for a start, it might be a good idea to dump DABSVS and mandate that everyone (yes governments, bean counters and economists too) start using International Valuation Standards.

Then at least we would know where we are for a change. A valuation is like a reference grid on a map, get those wrong and you can end up going around in circles. LIKE NOW!

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

Copyright © 2009 Andrew Butter

Andrew Butter Archive

© 2005-2016 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife