Stock markets have been on a wild ride in recent years, as central bankers decided they had become “Masters of the Universe”. But now markets are starting to relearn their key role of price discovery. This is already proving very painful for those who believed “stocks can only go up”.
As Bloomberg senior editor John Authers has noted:
“For a quarter of a century now, investors have worked on the assumption that the Fed (and other central banks) lack the nerve to press ahead with tight policy if it hurt asset prices. It’s not an unreasonable belief, as the central bank has caved to market pressures at every time of asking since its epochal decision to rescue Long-Term Capital Management in 1998, and then cut rates to help the market regain its feet. It was the one time when Paul Volcker ever publicly criticized his successor, Alan Greenspan.”
CENTRAL BANKS WRECKED MARKET’S ROLE OF PRICE DISCOVERY
He chose to argue – contrary to logic and to JK Galbraith’s conclusion to his classic “The Great Crash”– that the cause of the post-1929 Crash was not wild speculation. Instead, he blamed the Fed’s decision to reduce money supply after the Crash.
Wall Street, of course, loved the Theory as Powell argued that:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
The chart shows the results of his Theory, as it was adopted by all the major central banks. One would have hoped that the dotcom and subprime bubbles in 2000 and 2008 would have been a warning.
But instead, they doubled down – taking debt to record levels along with prices for stocks, crypto, housing etc.
BEN GRAHAM IS THE BEST GUIDE WE HAVE TO WHAT HAPPENS NEXT
Ben Graham is known as the ‘father of security analysis’ and was Warren Buffett’s mentor. His valuation metric accurately predicted the 1987 Crash:
- Its simple but effective formula requires a forecast of annual earnings growth over the next 10 years.
- A company with zero growth over this period has a Price/Earnings ratio of 8.5
- Each expected 1% of growth above this adds 2 to the P/E ratio
The chart tells the story. We first posted it a year ago, suggesting that The Stock Market Bubble Starts to Burst. As we warned then:
“Unsurprisingly, stocks have begun to sell off as traders realise they can no longer rely on the central banks to support the market. By the end of last year (2021), it was really just 7 NASDAQ stocks keeping the bubble aloft:
- Using Ben Graham’s long-time valuation formula, Tesla was the most over-valued by 3419%
- Amazon was next at 760%, Netflix at 580%, Microsoft at 419%
- Then there was Apple at 368%, Google (Alphabet) 320%, and Facebook at 280%
“These were clearly bubble valuations, and already they are starting to reduce.”
Today, his real-world analysis is starting to pay off again, as the bubbles continue to burst.
It is highly unlikely that any of these companies can grow earnings over the next 10 years, given the competition that is already emerging in their core markets. Being generous, and assuming they can in fact maintain current earnings:
- Graham’s formula suggested Facebook (now Meta) should only be worth $120. Today, it is $130 compared to $335 a year ago
- Amazon was $167 (adjusted for its 20:1 split) versus Graham’s $22 value. It has halved since then, but is still over-priced at $79
- Apple was $176, with a Graham value of $48. So it is also still over-priced at today’s $130
- Netflix was $544 versus its Graham value of $94. It has collapsed to $290, but is still over-priced
- Google (now Alphabet) was $141 (adjusted for its 20:1 split), versus its Graham value $44, and is still over-priced at $87
- Microsoft was $318 versus its Graham value of $76, and is still over-priced at $240
- Tesla was $359 versus its Graham value of $11, and is still overpriced at $113
Now, we are all starting to suffer for the central banks mistake in adopting Bernanke Theory. The bubbles they created are finally starting to burst as interest rates start to return to more normal levels. This will be very painful for all those who trusted them to manage the economy.