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Using International Valuation Standards to Determine the S&P-500 Fundamental Value

Stock-Markets / Stock Market Valuations Dec 28, 2010 - 12:57 PM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleOf late, there has been a lively debate about the “fundamental” value of all sorts of things…stock markets, real estate, gold, oil, toxic assets, and even Treasuries. Often as mot the debate is a manifestation of a newly discovered psychological disorder called “Bubble-Phobia”, which is an irrational fear that prices are disconnected from the “fundamental”.

As with the early psychological breakthroughs of Jung and Freud, for the S&P-500 there has been no shortage of theories, all the way from P/E ratios to Tobin’s “Q’s” and everything in-between.

 Some valuation experts said that the rally in the S&P 500 after 666 was a dead-cat-bounce and that sooner-or later that index would go down to it’s “fundamental” which might be as low as 450. Although eighteen months later with the index almost double the low; anyone who is still holding on to that particular theory is starting to look a mite ridiculous; but perhaps their day may come?

Sadly no consensus has been reached. About the only thing that they have in common is that very few of the aficionados of valuation who periodically strut their stuff on Prime-Time are confident enough in their convictions or their abilities to actually put numbers on the table.

That’s the difference between a valuation and grandstanding hot-air. When you do a valuation you put a number on the table, you say “this is the value”; which is kind-of different from making ambiguous pronouncements like “cover-your-shorts” or “the-train-left-the-station”.

So what is Value?
Part of the problem is that there is no consensus about what “value” actually is. For example the Basel II Guidelines mention the word 164 times, but nowhere is there any explanation about what the word was supposed to mean or how anyone is supposed to figure out what it is.

That was the core problem with the credit crunch, what happened there was all the bankers and the central bankers and the regulators and the experts on television thought that the “assets” of the world’s banking system were worth a lot more (value) that they actually turned out to be worth.

The valuations of those assets were done mainly using US GAAP (in USA) and using IFRS (in Europe), and for example, in July 2008 the valuations written down for assets of all the banks, quasi banks, and shadow banks in USA showed that everything was gee-wiz-wonderful. Which is why Hank Paulson, having received copies of all those glowing valuations, felt confident enough to stand up on Primetime Television and declare…”The US Banking System is a Safe and Sound One”, or in other words that the “fundamental” value of the “assets” was much more than the liabilities.

What happened next; was that sadly it started to become increasingly obvious that the valuations had been…Err…completely wrong.

That was a big surprise for a lot of people. But it wasn’t a big surprise for the International Valuation Standards Committee, who in 2003 (five years before) had written to the Bank of International Settlements to point out that the valuations (done using US GAAP and IFRS and relied on by all the bankers in the world to figure out the “value” of “assets”), were, quote…”fundamentally flawed and bound to be misleading”.

Or in other words, in plain English, they were completely wrong.

Of course no one was interested in what the proponents of some “New-Fangled” valuation theory had to say; but in retrospect it would appear that there may be grounds for suspecting that the wonderful valuation theories that were relied on by the banking glitterati prior to the credit crunch (and are incidentally still relied on), might not be very, let’s say…”robust”; like in they tend to give completely the wrong answer at critical junctures, which can be a mite embarrassing.

So how about this “New Fangled” idea of doing valuation?
International Valuation Standards (IVS) was first published in 2000; it considers two types of value:

1:  “Market Value” which is based on sales comparisons (in the past), and is exactly equal to what accountants and central bankers call “Fair Value”, except, and this is the thing, except when the market is in disequilibrium.

That is a very big exception; IVS says (if you are doing a proper valuation) in such cases, you should “consider” reporting Other Than Market Value as well as, or instead of, Market Value; depending on the purpose of the valuation.

By contrast, “Fair Value” is always defined (in Wall Street lingo), as the price you can reasonably expect to sell something for, to someone dumber than you, as in “Fair-Play” or “TALF”. That’s a great strategy, until, one day, you can’t find anyone dumber than you are.

2: “Other Than Market Value” is an opinion of value based on an estimate of the price that transactions in the past would have occurred at, if the market had not been in disequilibrium due for example to the chaos created from time to time by dumb-donkeys, (sometimes “donkeys” are called “asses”), flash-traders, “God’s Workers”, international terrorists, and other unsavoury characters. That is sometimes called the “fundamental” by the popular press, hence the “shorthand” in the title.

In other words, Other Than Market Value is the price you can reasonably expect to sell something for, to someone smarter than you.

So how about an example of how that works?
If the New-Fangled valuation approach is so darned good, then it ought to be able to be used to value anything. And if you follow the instructions, you ought to be able to end up with a valuation (like a number you can write down on a piece of paper), that will at a very minimum ensure that you don’t make of a complete fool of yourself, like standing up in front of the whole world and declaring, “The US Banking System is a Safe and Sound One”.

This is how it works in the “New-Fangled” system, which is by-the-way what’s called a “principle-based” valuation approach (as opposed to a “rules” based approach).

1: To start with, you are supposed to explain what the purpose of the valuation is, for example it might be to give an opinion on what is the minimum price you can reasonably expect to be able to sell a synthetic collateralised debt obligation lovingly crafted by Goldman Sachs and rated AAA by Moody’s, at some indeterminate time in the future (by-the-way the right answer to that one is “A Big Fat Zero”). The purpose of the valuation in this example; is simply to demonstrate that the “New Fangled” valuation standard, actually works.

2: You are supposed to explain, in language that a person of “normal” intelligence, without any specialist knowledge can understand, how you do the valuation. So in this case, if you, dear long-suffering reader can’t understand how this valuation is done, please feel free to write to the editor and ask for your money back. Putting that another way, if a “normal person” can’t understand how a valuation is done, it’s a lousy valuation. And sorry folks, just because you are a Nobel Prizewinning economist and you made a good call five years ago, doesn’t get you off the hook.

3: You are supposed to come up with a theory on how to do the valuation based on “sufficient market-derived data” from the past. It doesn’t matter what the theory is, because the test is not how smart you or your theory is, it’s whether you can demonstrate that it works (in the past), and optimally, that it works in the future; like you can tell someone “you will be able to sell that piece of toxic garbage you bought for $100 million for at least $10 within the next five years”, and that “opinion” turns out to have been correct.

4: You are supposed to review whether the market is in disequilibrium, and if you think it is, (a) say so and (b) consider reporting Other Than Market Value as well as or instead of Market Value.

So here we go:

The Theory
1: The value of the S&P 500 can be accurately determined, at any point in time, by applying the principles of International Valuation Standards.

2: If fundamental value is known, long-term price gyrations of the index are predictable.

The “Model”: Two parts:

1: The “fundamental” for the S&P-500 is equal to a constant multiplied by the nominal GDP of USA divided by the yield on the 30-Year.

Although it’s not actually necessary to explain how you came up with your theory (you could have a theory that the fundamental value of the S&P 500 was determined by the number of ducks in the pond in your local park, the issue is not the theory, the issue is showing that it works). But by way of explanation, if nominal GDP is a proxy for the fundamental earning power of the companies in the S&P 500, then that’s a rough & ready income capitalization valuation.

2: Deviations from the fundamental; defined as periods of “disequilibrium”, are symmetrical around the fundamental over time, thus the dynamics “post-bubble” are predicated by the dynamics of a preceding bubble; in other words:

The mispricing above the “fundamental” in a bubble is reflected, after the “pop”; in the mispricing under the fundamental both in terms of magnitude, and timescale.

That’s not a particularly new idea, at least in principle; it is to some extent a re-statement of Efficient Market Hypothesis, except that says mispricing is instantly recognised by the market, and I think it also says that the world is flat, although I’m not 100% sure about that?  It’s also the same idea for the idea of “reversion to the mean”, and Bob Farrell’s 2nd Law:

Excesses of stock prices above the long-term average
are invariably followed by excesses of an equal magnitude below.

What’s new is that it is precise, and on top of that one thing it does (if it’s right) is allow the “fundamental” to be estimated from the square root of the “top” of a bubble multiplied by the “bottom” of the trough that follows.

Figuring out the “fundamental” (what Farrell calls the long-term average), is not easy.

If it were, central bankers could do it and there wouldn’t be bubbles, but being able to have at least one point of reference, (or if you go back in time two or three), helps to navigate, and more important, to provide a check on whether or not the way you estimate the fundamental is any good.

Putting that all together, and “tweaking” the model to get the tops and the bottoms to line up, gets to this:

That says today (29th December 2010) that the S&P 500 is going through a “post-bubble” and that it is mispriced (low) relative to the “fundamental” today by 28%, and that the “fundamental” today is 1,739.

Testing the theory:
By the way, this type of analysis is not “economics” it is “science”.

I haven’t worked out if economics is an “art” like abstract expressionism where the main challenge for the “victim” is working out which way up to hang the picture, or a philosophy like existentialism, or a process of endlessly assembling tedious data and boring people to death, like “conceptual-art”, which is a melange of “art” and “philosophy”.

Whatever it is, it’s not science.  In science you observe, you build a theory based on observation, you check to see if the theory explains the past, then you design an experiment to test it, in real-life and in real-time.

Test #1: Cycle to cycle, a plot of that “model” against actual, explains 97% of changes in the S&P-500 since it started; a similar model explains 96% for the DJIA since 1900. So far so good; certainly I have never seen any of the television valuation pundits or star-economists even suggest that they “back-checked” their grand theories, and I sincerely doubt that if they did, they would get to a 97% R-Squared to explain the subject of their pontifications.

Test #2:  The real test of any theory is whether or not it is useful for prediction, in real-time.

A valuation is an estimate or an “opinion” about what you will be able to do in the future, that’s the whole point; the past is well…past.

If the theory works then prediction should be possible. Just as for example, if you have a theory that the world spins round, you ought to be able to predict where the sun will come up in the morning with a reasonable degree of accuracy. If you can’t well that is proof the theory is wrong, although if you can, it’s not 100% proof that the theory is right.

So how did this “New Fangled” valuation approach work in terms of predicting the price of the S&P 500?

Correct predictions
Jan      2009:              The index will turn when 675          is breached              
Feb      2009:              Then there will be a strong rally                            
May    2009:              Until 1,200
Jan      2010:              Then there will be a 15% reversal which will be short lived

Incorrect Predictions:
Jan      2009:              The bottom won’t be before 2011 (retracted in Feb 2009)


Either (a), the “timing” prediction was wrong and the bottom in March 2009 was the bottom, or (b) the prediction that the day 675 was breached was wrong, (on that day it fell to 666.7 intraday), in which case we can expect the index will fall below 675 at some point of time in the future.

With regard to (b),most people would agree that a reversal to below 675 is highly improbable, but  both (a) and (b) can’t be right, so perhaps the four correct predictions were “flukes” and the incorrect prediction on timing proves the “theory” wrong?

If so it needs to be put on the trash along with all the other clever economic and financial theories that failed to predict the credit crunch, i.e. practically all of mainstream “art”.

Or perhaps the “theory” is half-right? “

It would be nice if all the predictions had been “perfect”, there are two explanations for why the “timing” prediction was wrong, either (a) the theory and the model is wrong or (b) the genius who was applying the theory was not half as smart as he thought he was.

My opinion is that (b) is probably the correct answer, although in my defence I would like to say that “When” is always more difficult to predict than “What”.

You can predict, with a reasonable degree of certainty, that if someone drinks a bottle of vodka every night and then goes for a drive, they will have a crash. What’s hard to predict is when.

In that analogy the “drunk” is the OEDC economies (and their governments and central bankers), the “vodka” is debt, and the current debate is about how much vodka is “safe”.

But perhaps that analogy is unfair (to vodka); certainly Churchill was drunk most of the time, and he did a pretty good job. By contrast, many self-styled “maestros” who suffer from periodic delusions that end up causing a lot of damage to other people, are clean-living types, for example Hitler was fastidious about his food (and his “regularity”), he exercised daily, and he did not smoke or drink.

So perhaps, if elected government officials could be persuaded to chain-smoke and drink vodka all-day, instead of committing their constituents (and their constituent’s children) to crushing debt (whilst personally profiting hugely from the deal), the world would be a better place?

That’s another theory, which I personally have selflessly taken upon myself to develop, and which may perhaps, in time, make a significant contribution to global prosperity and world peace, (work in progress).

 The Paradox of “When”

The story so far (according to the “theory”):

1: The bubble in the S&P 500 started in about November 1994
2: At its peak the market was 100% over-priced (i.e. the S&P 500 was selling for double the “fundamental”).
3: The bubble popped in late 2000 and the fundamental was breached in mid-2002; that was the end of the bubble (highlighted in pink).

This is new:

4: For some reason Allan Greenspan loosened more than he should have, starting in 2002, which among other things helped transfer the bubble to the housing market, and also stopped what the Austrians call the “mal-investments” that only made sense in the bubble, starting to get liquidated.

Liquidation of “mal-investments” can be painful, it’s a bit like going Cold-Turkey and there is always the temptation to have “just one-more shot” to ease the pain. In that regard Greenspan was like Elvis Presley’s doctor, handing out pain-killers, until his patient had a heart-attack.

Greenspan says (in “The Age of Turbulence”), that he did that to protect the American economy from the effects of 9/11.

With the benefit of hindsight, he probably couldn’t have done a better job at trashing the American economy if he had been an ardent supporter of the elusive “master-terrorist” who (allegedly) lives in a cave; because what that did was compound the problem by “kicking the can down the road”, making it much worse.

But that is all conjecture, and who cares about “should-have; could-have”?

With regard to this “theory” the explanation proposed here for why (a) is right and (b) is wrong, and why International Valuation Standards provide a valid methodology for estimating the “fundamental”, is that thanks to the heroic efforts of Alan Greenspan working in perfect harmony with the “Workers-Sent-by-God”, the inevitable was delayed, for five years.

So for those five years America lived in a fantasy world, getting high on “happy-drugs” paid for with $17 trillion of securitized debt, which has now gone bad; compounding a relatively small problem (in 2002) into a massive problem in 2007.

Blame it all on Allan Greenspan!

There you go, everything can be blamed on Allan Greenspan and no one else should take any blame for the Charlie Foxtrot. That’s a popular line, and it’s smart too, after all he is eighty-four and although he is fastidious about his food, exercises daily, and doesn’t drink or smoke, he won’t live forever. So he probably won’t be around to defend himself for as long as the young-bucks who were also implicated in the disaster; which is always a good thing to consider when you are choosing a scapegoat.

Actually it wasn’t particularly Alan Greenspan’s “fault”, he was after all a simple government employee answerable to Congress and the President. If they thought he was doing a lousy job, they should have sacked him.

His big-crime was that he thought (as many other people did), that when Moody’s & Co stamped AAA on something, it was “safe as houses”, and that his job (as he saw it) was to make sure the vodka was flowing to keep the party going, so long as it was “safe”, as in the uniquely 20th Century Invention “Safe-Sex”.  

And boy did the liquidity and the easy-money, create the divine ingredients for one hell-of-a-party, and as day follows night; one hell-of-a-hangover.

QUESTION: Did Greenspan or any of the two-thousand PhD economists employed directly or indirectly by the Federal Reserve and the US Government to “manage” the complexities of the world’s greatest fiat currency, know how to do a valuation?

ANSWER: Obviously not.

Here’s an idea for Ron Paul and any other proponents of “change”.
Perhaps it would be a good idea if the central bankers, regulators, and other “experts” that are employed to keep the bicycle of the fiat currencies of the OEDC countries from falling over; are required, under the law, to demonstrate that they know how to do a valuation?

Certainly, that does appear to be a useful core competence for anyone in that job, particularly since most if not all of the recent drama can be traced to an astonishing ignorance of what is the fundamental value of, housing, commercial real estate, stock markets, and all the other “assets” used to collateralize the inherently risky business of fractional reserve banking, which manifestly turned out to be worth a lot less when the keys got sent back, than had been expected.

That was a “Big Surprise”. Making sure there are no surprises is the whole point of doing valuation.

That’s why in 2003 the International Valuation Standards Committee sent that note to the Bank of International Settlements. The supreme irony is that no one did anything, probably because the “functionaries” were so incompetent that none of them understood why valuation is important, or how to do one.

Although I suppose the alternative is always to go back to using gold, cowry shells, or cattle, as a means of exchange?

I digress; it is proposed that this analysis demonstrates that International Valuation Standards work. They were first published in 2000 to challenge the idiocy of the Voodoo Valuation Standards mandated by FASB, IFRS and all the other incompetents who helped create the credit crunch.

Here’s an idea, why not use them?

The Future

To figure out the future first you have to work out where you are now, a good way (in all matters financial) is to do a valuation.

Based on this analysis my “Opinion of Value” of the S&P 500 is presented as follows:

1: Valuation Standard Applied:         International Valuation Standards (IVS)
2: Purpose                                       So as to demonstrate IVS works
3: Type of Valuation:                       Other Than Market Value
4: Date of Valuation                        27th December 2010
5: Valuation basis                            Sales comparison based on 100 years of data
6: Value Opinion for Index:              1,739

So if that’s right the S&P 500 today at 1,250 is 38% undervalued; that doesn’t mean it’s going to “bounce” to 1,739.

If the theory is right, the real “damage” to the S&P-500 happened from 1994 to 2002 (seven years), so according to the theory, the “hangover” should last seven years. The updated “theory” is that regardless of when it started, there has to be seven years to flush out the mal-investment of the 1994 to 2002 bubble, starting November 2007.

So everything ought to be getting back to “normal” by November 2014, where “normal” is defined as the point in time where “Market Value” equals “Other-Than-Market-Value”.  At that point in time the slate is wiped clean, and the option to create another bubble, or not, will be…an option.

That means, even if the “fundamental” is unchanged (i.e. if nominal GDP growth is zero and the yield on the 30-Year stays the same as it is today), the index will rise by about 40% over the next four years. That’s an average of 8% per year, and that’s not counting dividends (standing at about 2% these days).

If, for example, US nominal GDP growth is 5% over that period (3% real + 2% inflation, say), and the yield on the 30 Year averages about 4.5% (that’s the hard thing to predict and is another story (, then the index will reach 2,100 on Christmas Day in  2014.

That’s 14% a year (plus dividend) which is better than bonds, if you believe the planning assumptions, and the “valuation”. But beware, some sectors will be better than others, and there will be pullbacks, although very unlikely to be more than 20%, and generally short-lived, as is explained here:

The caveat of course is that the game has changed. Historically most of the companies on the S&P-500 made their money in USA or in businesses directly affected by the economy of USA; now 50% of earnings come from outside USA from countries that are more and more disconnected from the US economy.

Seeing as the economies outside USA are likely to grow more than USA, it’s quite possible that the S&P 500 will go up to more than 2,100.

 And in which case, the “valuation model” will become more complicated.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. 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.

© 2010 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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