Sneaky Street Conspiracy?

Tucked inside this recent post joining the debate on who is the bigger contrarian, is an assertion that Wall Street is tricking us into thinking the market is attractive when it is really almost 30% overvalued.  Barry Ritholtz invokes a big name, Cliff Asness,  and states that he has researched the forward earnings comparison.  This is not what Asness and his colleagues did, as they make clear in a footnote.  The problem is that most people’s eyes glaze over while reading complex research like this, despite some entertaining zingers from Asness.

Most people are not going to read the paper, so they take it on faith that people like Barry (and Mark Hulbert in his piece) are getting it right.

There are three things wrong with this interpretation of the Asness study:

  1. He did not look at forward earnings from 1871 onward because the data do not exist.  One would expect people to know this, even without reading the footnotes!  Looking at the time period where forward earnings data are available gives a dramatically different conclusion — but then it is a more bullish era.
  2. We should not care about what happened to the market or what the relationships were in 1871.  Or 1926.  Or 1956.  Or maybe even 1976.  Start with the question of whether any market relationships before the era of derivatives should still be expected to hold true.  The desire to use data that are not relevant, just because you have it, is one of the big problems in forecasting.
  3. Most importantly, prediction is, after all, about looking forward.  It seems obvious, but many forecasters miss the point.  Using trailing earnings is especially bad at a time when there is rapid growth (as we have seen for the last three years) or a sudden decline.

Those interested in this sensible notion might want to read my paper, "Should Experts Look Forward to Predict?" 

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  • Barry Ritholtz December 23, 2005  

    Note that I did not say it was 30% overvalued — that was Marl Hulbert’s description.
    I wrote that based on Asness’s study, the market was trading at 30% over its median P/E: “With SPX 29% over its median P/E, it is hardly cheap.”
    There’s an enormous difference between overvalued and hardly cheap . . .

  • Jeff Miller December 26, 2005  

    Thanks for the clarification. I guess I put this comment together with your DOW 7000 forecast, as did some of your viewers (my investors) who asked what I thought about it. These folks are thinking about selling positions — some might even go short — based upon your call, so they want to make sure they understand. Even my dad watches you:)

  • Barry Ritholtz December 27, 2005  

    One last thought on this: I beleive compared historical TRAILING EARNINGS with present trailing earnings.
    This was then compared with the present forward looking earnings. Note — Wall Street Analysts have tended towards being over optimistic . . .