Gross Investment Outlook

One of the consistent arguments amongst the loudest of the bulls for calling a bottom and dipping our toes back into the market (made time and time again over the past 8 months) has undoubtedly referenced a perceived undervaluation, or "cheapness", in the equity markets. Technical analysis screams both individual securities and the marketplace(s) are oversold, and perhaps more convincingly, accepted fundamental valuation methodologies often paint the same picture. Certainly fear, volatility, a global recessionary environment and the ever-evolving uncertainties plaguing the credit markets offer explanations for a DOW shedding value and, at times, struggling to find support, but PIMCO's Bill Gross offers an additional take: the fallacy of undervaluation.

Gross first visits the two strongest culprits influencing the undervaluation notion; the Q-Ratio and the P/E ratio. Essentially, the Q-Ratio, which is mean reverting in the long-run, compares the stock market valuation relative to replacement cost of net assets (with a value of 1.0 representing perfect valuation). When Q is above 1.0, market valuations exceed reproduction costs, indicative of overvaluation. When Q is below 1.0, the opposite is true. As Gross notes, "Today's Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation."

P/E, as it turns out, paints the same picture (valuations below historical average):Clearly undervaluation given the above is difficult to dismiss entirely, but Gross points out that such valuations may not account for recent changes that have serious potential to be "not only non-cyclical, but non-secular...[and] likely to be transgenerational."

"My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don’t have to
go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks..."