Market Valuation, Deus Ex Machina, and Volatility

We have written several times to say that the market in general is overvalued based on earnings (the CAPE) and book value (Tobin’s Q). Even after the recent selloff, the market is still well above long-term averages. However, astute market watchers know that although there is a tendency for the market to move toward fundamental averages, there are never guarantees about when they will move and being too early can often look as if one was simply wrong.

Still, for the market to avoid moving downward toward its fundamental averages, one would have to expect significant positive economic developments in the near term such as skyrocketing productivity, job growth, and earnings growth. Is there anything on the horizon that makes you feel that these positive developments are just around the corner?

Media explanations for daily market price movements are usually vague guesses, but it seems there are plenty who are willing to bet their clients’ money on it. It seems there are many people holding out hope for some kind of deus ex machina so that just about any rumor helps the market temporarily avoid its fate.

Here is an explanation from today’s Dow Jones Newswire’s Market Talk Column for today’s late swing in the market:

4:05 (Dow Jones) US stocks pull a fast one – a very fast one – in the last hour, rallying almost maniacally in the last 10 minutes of trading to finish higher after falling sharply in the morning. DJIA jumps 69 (0.6%) to 11061, after sliding as much as 168 earlier; S&P 500 gains 8 (0.7%) to 1162, Nasdaq Comp rises 27 (1.1%) to 2495. Fears of Greek default drove morning’s sell-off. Rumors in the afternoon that – wait for it – the Chinese would buy (or are buying) Italian debt seems to have driven the rally.

A rumor that the Chinese may buy Italian debt is the deus ex machina for the world economy?

The problem in Europe and the rest of the developed world is a decades-long lack of productivity combined with a population that expected much. We all wanted something for nothing. Up until now, politicians in the developed world made many promises to their constituents and only asked for office in return. Those promises resulted in policies that helped accelerate our resource consumption from the future to the past and present.

For example, in the US think of long-term policies such as Social Security; Medicare; subsidized housing in the tax code; tax policies that favor debt over equity; etc.; and short-term policies such as cash-for-clunkers. Each allowed individuals or corporations to:

  • avoid saving for retirement;
  • avoid saving for medical care that will surely be needed one day;
  • avoid saving for a large down payment on a house or car; or
  • encouraged the use of debt to expand or buy a business

In each case, more wealth could be exhausted earlier in one’s life than it could without such policies. In each case, a larger amount of resources are guaranteed to be exhausted in the future to pay for present consumption, which of course means less will be available for future consumption of anything.

Those promises also created incentives for people to shun the productive work that leads to real wealth creation and created incentives to simply seek handouts. But, that can only go on for so long and now it is time to pay the bills.

I need to understand how that translates into the optimism that is keeping the market floating above its long-term fundamental averages. How does receiving a large bill for prior consumption make one optimistic about the economy and the market in the near future? How is that bill going to be paid, if not with long-deferred gratification? Do you think dumb-money, say from the Chinese, will pay the bill free of negative conditions? I do not. What exactly can Italy offer the Chinese? And then, which trap door will the deus ex machina come from for Greece, Ireland, Spain, the US, Japan…

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