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Clarium’s Q1 2009 quarterly letter, The Wonderful Wizard of Oz, argues that the “Goldilocks” era of low inflation and stable credit creation likely ended in 2008 for the foreseeable future. Suppose this thesis is true. How could investors use this assessment to value an asset class such as equities? Stock markets have depreciated substantially since the financial crisis began in August 2007. Stocks were objectively expensive then. Have stocks now priced in all the bad news and reached fair value? Are stocks now cheap? Could stocks still be overvalued?

We present a framework for valuing the S&P 500 by combining two analyses. The first analysis is based on a process proposed by Benjamin Graham and David Dodd in their classic 1934 book, Security Analysis and subsequently developed further by Robert Shiller in his 2000 book, Irrational Exuberance. We calculate the 10-year trailing inflation adjusted P/E ratio1 for the index on a monthly basis from 1916 through 2008 and compute its average value over that 92 year history. The second analysis determines whether a given year is classified as “positive liquidity” or “negative liquidity.” Positive liquidity years are characterized by stable prices coupled with meaningful credit expansion and/or money supply growth, while negative liquidity years are characterized by severe inflation, deflation or substantial credit contraction2.

Conceptually, one would expect the stock market to receive a higher valuation in an era of positive liquidity than in an era of negative liquidity. And indeed, this is exactly what we see.

1This P/E ratio is computed as fol lows. The price (P) is the inf lat ion-adjusted average price of the S&P 500 for a given month. The earnings (E) is the simple average of the inf lat ion-adjusted earnings over the previous 10 years. The data is from Robert Shi l ler: http://www.econ.yale.edu/~shil ler/data.htm. Al l adjustments for inf lat ion are based on the level of the CPI in March 2009.

2 The precise quantitative definit ion is as fol lows. In a posit ive l iquidity year the average of the growth over the prior year of the money supply and private debt is greater than 2%, and the CPI is between -2% and 5%. A negative l iquidity year is one that is not a posit ive l iquidity year. Money supply is defined as M2 from 1960 – 2008; from 1916 – 1959 the definit ion fol lows Milton Friedman and Anna Schwartz, A Monetary History of the United States, table A-1, column 9. Private debt is taken from the Fed Flow of Funds from 1946 – 2008; from 1916 – 1945 the source is the US Department of Commerce.

Appendix

A mAcro frAmework for vAluing theS&P 500

Fig. A1 S&P 500 – 10 year Trai l ing P/E Ratio

1928 1948 1968 20081988

0

10

20

30

40

50S&P 500 – 10yr Trai l ing P/E

Posit ive l iquidity cycles ( lasting more than 2 years)

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The average valuation overall is a P/E ratio of 16.3. Applying this valuation to the calculated •earnings of the S&P 500 for December 2008 implies a value of about 945.The average valuation in a positive liquidity regime is a P/E ratio of 19.1. Applying this •valuation to the calculated earnings of the S&P 500 for December 2008 implies a value of about 1,105.The average valuation in a negative liquidity regime is a P/E ratio of 11.1. Applying this •valuation to the calculated earnings of the S&P 500 for December 2008 implies a value of about 640.

A more detailed look shows that stock market valuations vary quite a lot around the average in both positive and negative liquidity cycles3.

Note how stock market valuations tend to overshoot on both the upside and downside. Valuations start a negative liquidity cycle significantly higher and trough significantly lower than the average throughout; the same is true in reverse for positive liquidity cycles. If one applies a typical trough valuation to the calculated earnings of the S&P 500 for December 2008, it implies a value of roughly 370. No doubt the eternal struggle between fear and greed partly explains this pattern, and of course by definition one does best to buy at the cheapest price. But there are also fundamental reasons for this behavior. The rate of credit growth or contraction and the degree of price stability profoundly affect profit growth and the cost of capital. Determining whether one is in a positive or negative liquidity cycle and estimating the length of that cycle are critical valuation inputs, and the change in valuation throughout the cycle reflects the evolution of those estimates.

One should note that a deflationary negative liquidity cycle is even more dangerous than an inflationary negative liquidity cycle. In a deflationary cycle, falling prices cause (both real and nominal) earnings to fall, and this happens in conjunction with compressing valuations. Cash is therefore a superior asset to stocks. In an inflationary cycle, rising prices cause (nominal) earnings to rise, which partially offsets the effect of compressing valuations. Here one may still do better to own stocks than to hold cash, particularly if one avoids the initial valuation compression.

3 Only major l iquidity cycles are shown in the table and the graph. A t ime period is classif ied as a major l iquidity cycle based on more than two years of either posit ive or negative l iquidity as quantitatively defined. There are several shorter t ime periods where the quantitative definit ion of the l iquidity cycle contradicts the classif ication used for major l iquidity cycles (1939-1940, 1944-1945, 1949-1950, 1971-1972 are shown as negative l iquidity in the table and the graph, but are quantitatively classif ied as posit ive l iquidity, while 1990 is shown as posit ive l iquidity in the table and the graph, but is quantitatively classif ied as negative l iquidity).

Fig. A2

PERIOD

7.4

14.7

14.0

15.7

12.2

18.2

12.3

22.8

12.5

32.6

25.8

22.2

16.8

24.1

22.3

44.2

4.8

7.3

5.6

10.4

8.5

11.1

6.6

8.5

8.0

22.0

12.3

13.0

12.1

22.3

8.5

15.3

12.5

8.0

22.0

12.3

13.0

12.1

22.3

8.5

NEGATIVE

POSITIVE

NEGATIVE

POSTIVE

NEGATIVE

POSITIVE

NEGATIVE

POSITIVE

1916-1922

1923-1929

1930-1933

1934-1937

1938-1951

1952-1968

1969-1982

1983-2008

PE STARTOF CYCLE

PE ENDOF CYCLE

TROUGH PE PEAK PE AVERAGE PETYPE OF

LIQUIDITY CYCLE

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Finally, it is important to stress that this framework is only descriptive and not predictive. One has to make an independent prediction about whether the next several years will be a positive or negative liquidity cycle to know which historical P/E ratios to use. Nevertheless, this framework may be a powerful way to supplement traditional valuation metrics in making an asset allocation decision. After twenty-five years of a positive liquidity cycle, investors who have been lulled into believing that the macro makes no difference to valuation may pay a high price.

PAtrick wolff, cfA

managing Director

clarium capital management llc

richArD SchliPf

Associate

clarium capital management llc