I was asked today why I am a philosophical bear. Well the fact is that I am not. I am a bear because the market is still extremely overvalued. The following chart, from Smithers & Co., illustrates this fact. This chart superimposes two valuation methods. The first is a version of Tobin’s q ratio, which is defined as the ratio of market value of a company to the total replacement cost of company assets. In other words, would it be cheaper to buy a company’s stock (q < 1) or just start from scratch and buy/build all the assets (q > 1)? Just to confuse matters, this chart is actually plotting log q, so that the fair value for q, where q=1, is the zero line on the chart. At 1 on the chart, q is 2.7 times fair value.

The second is Shiller’s cyclically adjusted price/earnings (P/E) ratio, also plotted on a logarithmic basis. This averages the market P/E over a ten year period and gives similar results to John Hussman’s price/peak earnings ratio. As can easily be seen, q and the P/E track one another quite well.

It is clear from the chart that extreme overvaluation is followed by extreme undervaluation. It takes nine to fourteen years to proceed from one to the other. Since peak valuation last occurred in 2000, an bottom of extreme under-valuation can be expected in three to eight years. It does not mean that nominal prices will be lower at that point - extreme inflation could mean that the next bottom in valuation would be at Dow 36,000. Of course, at that point, a Big Mac would probably cost about $50. My view is that this is an unlikely outcome, that the forces of globalization and a collapsing credit bubble will be powerfully deflationary, disabling the financial system for years so that even Bernanke’s helicopters will be unable to reflate the credit bubble - as happened in Japan. But it is not impossible that Ben will succeed, and it is essential to respond to the actual outcome, regardless of one’s opinions of what it should be.

The chart shows the major bottoms of valuation, which have marked the beginnings of the four most recent great bull markets - 1921, 1932, 1949 and 1982. We look forward to being able to invest at the next bottom, which I expect will be before 2010. Then I will not be a bear anymore, philosophical or otherwise.