Stock Market Crash Needed to Bring Back Value into the Market
The markets are expansive. Retail investors know it, as does the Wall Street spin machine. The widely-followed cyclically adjusted price-to-earnings (CAPE) ratio flashes at its second-highest level ever; news that’s widely disseminated through the financial media. Although CAPE gets all the headlines, market “expensiveness” really hits home when viewed through the value prism. A stock market crash might be the only way to correct the imbalances at this stage.
According to investment management firm GMO LLC., when they ran legendary value investor Benjamin Graham’s “deep value screen,” not a single stock came back positive. Not one. This is a far cry from 2008, when five percent of U.S. stocks were affirming deep-value status—including companies like Microsoft Corporation (NASDAQ: MSFT). (Source: “The S&P 500: Just Say No,” GMO LLC., August 2017.)
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The criteria used follows Benjamin Graham’s (aka “the father of value investing”) methodology regarding deep value companies:
- The stock’s earnings yield should be at least twice the AAA bond yield
- The stock’s dividend yield should be at least two-thirds of the AAA bond yield
- Stocks should have total debt of less than two-thirds the tangible book value
- A Graham and Dodd P/E (10-year earnings) of less than 16-times. (Source: Ibid.)
Keep in mind, five percent of stocks classified as “deep value” in 2008 is a significant amount. Almost 4,000 common stocks trade on the NASDAQ and the S&P 500 alone. Throw in the Russell 2000 and the Dow Jones Industrial Average, and we’re talking about perhaps 300 “deep value” stocks versus zero today.
But the bigger question pertains to market valuations. It’s one thing to have stocks trade at nosebleed levels, with “deep value” stocks sprinkled in. It’s quite another to literally have no “deep value” stocks present at all. It eerily highlights how broadly the Fed’s liquidity tide has raised all boats. And that’s a scary thing.
It’s the type of misallocation that can only be corrected through sharp price reversals. When nothing’s cheap anymore, capital becomes discriminate.
