Is the market cheap?

Dear Reader and Fellow Investors,

In the previous blog we have shown how long term pricing data for the standard and poor index suggests that equity investment returns oscillate around an average compounded annual growth rate (CAGR) of approximately 6.5 - 7%. However, this does not give us an intuitive feel of whether the index is cheap or expensive at the moment. We can use the data to do this.

Below you can see how the standard and poor index has evolved since 1927 by discounting past data with a rate of 6.53%. We use this number as we assume this to be the average CAGR of the index. Should we use a larger number, past values will be larger (i.e. the 1929 peak would have been even higher). Please note the data is up to January 2010.



At first glance the data would suggest that the index in January 2010 was not expensive, as the average seems to be approximately 1,250. This can go a long way to explaining why the markets have rallied so strongly in the last 12 months. Indeed, at first glance, the chart could be interpreted as suggesting the rally could still have sufficient steam to rise another 10-15% with a suitable probability of success. However, we could also note that when the S&P falls below 1,000, it usually hangs around for quite some time. The only other time that did not occur was in the great "bear market rally" of the early thirties. However, that rally was eventually totally liquidated. However, the rally lasted for 3/4 years.

Though we continue to buy the equity of companies that meet our strict criteria, we remain deeply sceptical and only buy opportunities we feel offer deep value and hence sufficient protection to reduce the possibility of a permanent loss of capital should an aggressive market decline occur.

As always, please feel free to post us any questions should you have any.


Yours sincerely,

Alessandro Sajwani