Month: April 2015

How To Know If Markets Are Over-Valued Or Not? (Part 1)


With record highs in stock markets being reached recently, the question that dawns any intelligent investor is this: is the stock market over-valued or not? The other question is, does it matter?

These are difficult questions to answer.

And it’s made harder to answer when investing legends seem to contradict with each other. People like Seth Klarman thinks markets are bubbly. News that valuation indicators such as Shiller P/E and Buffett Indicator (Total US Market Cap / US GNP) indicate over-valuation keeps showing up. Yet the person who “invested” the Buffett Indicator” seems to think we’re not at bubble territory, which is also agreed by index fund legend John Bogle.

And ultimately the reason why these questions are so difficult to answer is because the perceived truth involves so many moving parts, so you need to understand the relationship between all moving parts and also come up with your own assumptions to come to a conclusion.

To begin to understand how people get their sense of valuation from, we need to understand absolute valuation and relative valuation.

Let’s start with absolute valuation.

Absolute valuation means you value if something is over-valued based on a predetermined investment hurdle rate. It could be 10% (which Warren Buffett uses), or it could be 6% (Joel Greenblatt’s minimum hurdle rate when 10 year US treasury yields less than 6%).

The rationale for a predetermined investment hurdle rate is that when compared to the essentially risk-free interest rate of 10-30 year US treasury bonds, what return should I get from non-US treasury bonds in order to justify and compensate for the risk I’m taking?

So in this sense, the US stock market isn’t over-valued since according to Stanley Druckenmiller, the US stock market’s current valuation is supposed to be where it is relative to a near zero interest rate. And this conclusion is very straightforward if we look at the following graphs using today (Apr 25th 19:43 HK Time) as an example.

S&P 500 PE Apr 24(Screenshot from

S&P 500 Shiller PE Apr 24(Screenshot from

10 Yr Treasury Yield Apr 24(Screenshot from

30 Yr Treasury Yield Apr 24(Screenshot from

First let’s look at the P/E ratios of S&P 500.

The current P/E is 20.70 and the Shiller P/E (10 Yr inflation adjusted average earnings) is 27.38 [1]. If we were to treat stocks as bonds, then the yield or interest rate of the S&P 500 would be roughly between 3.65% – 4.83% (100 divided by P/E gives you Earnings Yield), which is higher than the 10-30 Year Treasury Rates [2] of 1.93% – 2.62%.

So from a theoretical point of view, if stocks were risk-free, then the maximum value we should be willing to pay for stocks should be all the way up to 38.17 – 51.81 P/E.

The question that dawns from this exercise is, how much excess return (or minimum hurdle rate) is appropriate to compensate for the risk in investing in non-risk free investments such as stocks?

If you have the perspective that as long as stock returns can be higher than the risk-free interest rate by a certain percentage (eg. higher by 50% – 100%), then we are probably entering slightly under-valued to fair value territory [3].

If you have the perspective that once the risk-free interest rate’s 50% premium is below 6% (eg. if 10-30 Year Treasury Rate was 3.5%, it’s 50% premium would be 5.25%) you demand a minimum of 6% return as your minimum hurdle rate, then the stock market is at over-valued territory.

But frankly speaking, this is an over-simplified way of seeing whether the stock market is over-valued or not, and I’m not even done with talking about absolute valuation nor begun to talk about relative valuation.

There are two more considerations that require our attention, namely taxes and method of return.

Firstly, taxes are not levied against US treasury bonds, so not only does non-risky investments have to compensate the risk with excess returns compared to a risk-free interest rate, it also has to compensate for the tax effect.

Secondly, if stocks don’t return money to shareholders in the form of dividends, then the only way a shareholder can generate a return is either through earnings growth and/or positive sentiment (eg. higher P/E multiple).

If shareholders are to make most of their money through earnings growth and/or positive sentiment, then further excess return needs to be demanded to compensate for potential of negative sentiment destroying market value faster than earnings growth can grow against.

So the more complete way of seeing whether the stock market is over-valued or not is to determine how much excess return (or minimum hurdle rate) is appropriate to compensate for the risks and costs in investing in non-risk free investments such as stocks? After all, the risks are many and costs of tax cannot be ignored.


[1] The reason why current P/E and Shiller P/E is both used is because criticism of P/E as valuation tool is that it is extremely easy to manipulate earnings through accounting shenanigans while at the same time earnings can also be volatile from a year to year basis. The criticism of Shiller P/E on the other hand is that 10 years as a period to average out earnings is too long since serious earnings recessions that happened over a short period of time were captured, thus distorting the output value. A range would give a better picture.

[2] Similar reason to the point above in that interest rates maybe overly high or low if looking at only one class (eg. 10 Year only or 30 Year only) of long term US treasury bonds. Also everyone has different definition of how long constitutes long term.

[3] If 10-30 Year Treasury Rates is 1.93% – 2.62%, then stock returns need to be 2.90% – 3.93% if you demand 50% excess of risk-free interest rate or 3.86% – 5.24% if you demand 100% excess of risk-free interest rate.


Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)


Catalysts and Greater Fool Theory


Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors’ dependence on market forces for investment profits. By precipitating the realization of underlying value, moreover, such an event considerably enhances investors’ margin of safety. I refer to such events as catalysts. – Seth Klarman

Feedback loops can be either negative or positive… a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. – George Soros

If you are not sure who the fool is in a trade or complicated investment, there is likely a fool and that fool is likely to be you. – Terrence Yang

Once in a while you stumble upon a crazed frenzy of people suddenly bidding the shit out of stocks within an extremely short period of time.

We’re witnessing it right now with the Hong Kong stock market.

Usually I don’t pay attention to such crazed frenzy since a bubble that’s been growing in size rapidly is still a bubble. I simply hate over-paying for things.

But what if the crazed frenzy is targeting under-valued stocks or stock markets? I’ve always thought the Hang Seng Index was under-valued before this crazed frenzy, either from an absolute valuation perspective [1][2] or a relative valuation perspective [3]. What stopped me from buying it was because I didn’t really like the quality of companies in the Hang Seng Index [4].

But when a catalyst like the crazed frenzy we’re now experiencing appears, it really piqued my interest since as Seth Klarman mentions, a catalyst that quickens a stock or stock market to rise to full value reduces risk for investors.

The risk with going into a bubble is momentum begets momentum, since people’s belief (we’re in a bull market) drives action (invest) that drives reality (bull market rises even more), which leads to a game of Greater Fool Theory. According to Investopedia’s definition of Greater Fool Theory, “it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” So if I don’t have a game plan of when to go in and when to go out, I could become the fool in this game.

To prevent myself from being the fool, I needed to do fundamental analysis to make sure that: 1) My entry point is under-valued and 2) My exit point is full value. The reason being that if I entered at an under-value point, if I find myself still holding onto the stocks after the bubble bursts, it will still generate a decent return. The reason for exiting at full value instead of continuing to hold on until over-valuation is because the whole point of going in a bubble is to take advantage of a catalyst that realizes under-valuation to full valuation at a short period of time, so there’s no point to linger on after missions is accomplished.

Either way, as Mohnish Pabrai always says, “Heads, I win; Tails, I don’t lose much“.

Having decided I was going to play this game of Greater Fool Theory, three questions had to be asked. What do I invest in? What is the entry point? What is the exit point?

So what do I invest in?

I decided to forego individual securities. I have 7 Hong Kong stocks on my watchlist, but they were either over-valued or not in great financial health before this crazed frenzy even began.

Which left me with the Hang Seng index since I don’t touch individual stocks that I don’t follow myself, so a basket of stocks to protect myself against ignorance seemed like a good idea even though potential returns would diminish.

What is the entry and exit point?

My calculation of fair value of the Hang Seng index using 2015 March data was a range between $30.33 to $39.74. So my entry point was essentially any price below $30.33 and I would fully exit by $39.74.

And that is what happened. I’ve entered a position in Hang Seng Index at $27.70. I don’t foresee myself adding upon the position any further during this crazed frenzy. Let’s see how this turns out.


[1] eg. ~11 P/E as of today translates to 9% Earnings Yield. Even if you cut it in half into 4.5% Earnings Yield, it’s extremely likely that Hang Seng Index can grow 1.5% annually until perpetuity, ensuring at least a theoretical 6% return until perpetuity (Note that the Earnings of P/E is extremely easy to manipulate and volatile, so don’t 100% rely on P/E ratios. But for explanation purposes it is used as it’s easy to understand)

[2] A 6% discount rate is used if the risk-free US 10 Year Treasury Yield is yielding less than 6%. Right now it is at 1.96%. This benchmark is recommended by Joel Greenblatt.

[3] ~11 P/E compared to a mean of ~14.5 P/E. Historical P/E can be found here:

[4] Don’t get me wrong, Hang Seng Index companies are profitable and good. I just don’t think they are world class calibre (eg. Google, Visa, Mastercard).

[Disclaimer] Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Currently holds stocks in Tracker Fund of Hong Kong (SEHK: 2800)

Understanding Qualcomm Annual Report’s Technology Concepts

I’ve been compiling a list of companies that produce products / services which I can’t live without (you can read here why that’s important:

One of these companies is Qualcomm, the world’s largest smartphone semi-conductor.

But going through the 2014 annual report was not an easy read, causing intense confusion for a non-Electrical Engineering background reader like me within the first few paragraphs.

So here are my notes of what I learned about the encountered technology concepts I didn’t understand. The objective is to know enough about the concepts to understand the annual report, so any extreme technical specifics I will link to other websites to explain.

All the technology concepts you need to grasp before fully understanding the 2014 Qualcomm annual report is concentrated in “Item 1. Business”

“Item 1. Business” Technology Concepts

Understanding the following sentence makes the “Overview” of “Item 1. Business” much easier to understand:

“Based on wireless connections, CDMA and TDMA (Time Division Multiple Access), of which GSM (Global System for Mobile Communications) is the primary commercial form, are the primary digital technologies currently used to transmit a wireless device user’s voice or data over radio waves using a public cellular wireless network. “

The key to understanding this sentence are the three terms I’ve highlighted, namely CDMA, TDMA and GSM.

In this sentence, Qualcomm is saying that the key technologies used for what we understand conventionally as our 2G and 3G capabilities for our smartphones are CDMA and TDMA.

For 2G technology, the dominant standard is GSM with over 90% market share. GSM is based on the TDMA technology. This explains why Qualcomm says “TDMA… of which GSM… is the primary commercial form”.

For the remaining <10% market share, another technology that is used is CDMA (Code Division Multiple Access), which Qualcomm has “significant patents, patent applications and trade secrets” on. Qualcomm invented CDMA, so anyone who uses CDMA has to pay Qualcomm patent license.

The reason why CDMA and TDMA “are the primary digital technologies currently used to transmit a wireless device user’s voice or data over radio waves using a public cellular wireless network” is because despite advances in 3G and 4G technologies, most of the world is still using 2G technology: screen-shot-2014-02-05-at-5-37-00-pm(Clicking the image will bring you to the source I borrowed the picture from)

So if Qualcomm literally owns CDMA technology, and it makes up <10% of 2G market share compared to GSM, doesn’t that make Qualcomm not great? Well fortunately for Qualcomm, the dominant standard for 3G technology is the UMTS (Universal Mobile Telecommunications System), which is based on the W-CDMA technology (another extension of CDMA technology). And as you can see from the graph above, many people are using 3G and the numbers will keep picking up.

Another key part of Qualcomm’s strength is in the following sentence:

We also continue our significant role in the development and commercialization of OFDMA (Orthogonal Frequency Division Multiple Access) technology for which we own substantial intellectual property.

OFDMA is the technology used for LTE technology, which is always marketed as 4G LTE technology. Technically speaking 4G and LTE are not the same, as a smartphone that uses LTE technology just means it is significantly better than 3G technology but not quite up to 4G technology standards yet. What’s important to note is that Qualcomm is also the dominant player for LTE technology as well, with a whopping 94% market share in 2013 alone. Mobile-LTE-baseband-market-shares(Clicking the image will bring you to the source I borrowed the picture from)

The rest of the “Overview” of “Item 1. Business” is straightforward, basically stating that Qualcomm also has products in the following areas:

[Disclaimer] Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

If you find any of the technology concepts to be explained incorrectly, please feel free to point out so that I can rectify it. Thanks!

Ratios That Give Staying Power AND Profitability

I mentioned in my previous post that “I’ve tied up significant capital already in HSBC stocks [in]… 2 months… I might not be able to get even cheaper bargains if HSBC stock prices continue to slide”.

And that was exactly what happened.

But it wasn’t because I didn’t have enough cash to spare. It was simply because I wasn’t willing to tie in even more capital into stocks, let alone a stock that isn’t even a great company that’s worth holding until perpetuity.

And that’s because I want to maintain staying power.

Staying power is the ability to keep all operations in your life going on regardless of optimistic or pessimistic external conditions, eg. I can continue to hold onto my investments for the full duration required for the investment’s price to rise and match fair value regardless if I lose my job, get a pay cut, or a bear market happens

That is something I really treasure, as I want to dictate how I live my life on my own terms as much as possible.

As such, there are two financial ratios (in descending order of importance) that I think is really important to follow very strictly to ensure I continue to maintain staying power:

  • Current Ratio (a.k.a. How long can you survive without any income?): Just like in any company where high Current Ratios are favorable, it is favorable for individuals to have high current ratios too to prevent being forced to engage in activities that solves short term survival by sacrificing long term profits.
    • Preston Pysh mentions that Warren Buffett invests in companies with Current Ratio of >=1.5. I believe a Current Ratio of >=1.5 should be the golden standard that every individual should aim for as well
    • My formula for Current Ratio is different than conventional definitions, namely I believe Current Ratio should = Cash + 50% of Debit + 50% of Investment. Cash retains its nominal value practically all the time, but debit (what people owe you) and investments could lose up to 50% value at any given moment
    • I think Current Ratio can be split into 3 stages, namely (Surviving – 0.5 Current Ratio, Good – 1.0 Current Ratio, Excellent – >=1.5 Current Ratio). If Current Ratio is below 0.5, all financial activities should be focused on making sure it rises above 0.5 before focusing on other aspects (eg. debt repayment, investing or luxury spending)
  • Debt to Equity Ratio (a.k.a. Ratio of how much of your assets are funded by debt or personal net worth): A low Debt to Equity ratio is favorable to ensuring a company doesn’t go bankrupt due to having too much debt, the same is true for individuals:
    • Preston Pysh mentions that Warren Buffett invests in companies with Debt to Equity Ratio of <=0.5. I believe a Debt to Equity Ratio of <=0.5 should be the golden standard that every individual should aim for as well
    • I think Debt to Equity Ratio can be split into 3 stages as well, namely (Surviving – 1.5 Debt to Equity Ratio, Good – 1.0 Debt to Equity Ratio, Excellent – <=-0.5 Debt to Equity Ratio). If Debt to Equity Ratio is above 1.5, and Current Ratio is above 0.5, then all financial activities should be focused on making sure Debt to Equity Ratio drop below 1.5 before focusing on other aspects (eg. investing or luxury spending)

It’s important to have staying power, but it’s also important not to be obsessed with squeaky clean financial health and forego the ability to maximize long term profitability from investing.

According to Ray Dalio, debt is good if you can increase income faster than debt (eg. post-tax investment returns > post-tax debt interest). But everyone knows that debt is dangerous as well, since the positive magnified effects of leveraged return can only be reaped if you have stable income or liquid assets that can meet short term debt repayments while you hold onto investments for the full duration it needs to have prices rise to fair value.

So how to balance between staying power and potential profitability from leverage? I believe long term market timing is required.

As opposed to short term market timing that provides guidance to specific investment decisions (eg. shorting S&P 500), long term market timing reaps the benefits of hedging against falls and profiting against rises by providing guidance to asset allocation decisions while avoiding the need for 100% accuracy on predicting when the market falls or rises.

The idea is to hedge the portfolio with cash during bull markets and to leverage the portfolio with debt during bear markets.

It combines the idea of Mohnish Pabrai’s lesson that “the correct lesson to learn from 2008-2009 was to hold cash. And I didn’t have cash at the time…” instead of always being fully invested just in case a bear market comes along, and the idea that Warren Buffett’s great Berkshire Hathaway returns was contributed by using debt to invest in the form of float.

So going back to my comment on using long term market timing, the indicator that I use is an average of Shiller P/E and Total Market Index (Total US Market Cap / US GNP). The reason why I use US stock market indicators is because 1) If the US stock market crashes, most if not all other global markets crash. No other stock market in the world holds equivalent amount of influence 2) I’m primarily interested in investing in US stocks. The reason why I use an average of both indicators is because reliance on only one indicator alone may provide excess optimism or pessimism for guidance to my asset allocation decision.

In practice, two financial ratios come to play depending on whether the average of Shiller P/E and Total Market Index is over-valued or under-valued:

  • If Shiller P/E and Total Market Index is over-valued, I will rely on the Cash to Asset Ratio. The Cash to Asset Ratio will be equivalent to what % the Shiller P/E and Total Market Index is over-valued (eg. If average of both indicators is 40% over-valued, then my Cash to Asset Ratio will be 40%).
  • If Shiller P/E and Total Market Index is under-valued, I will rely on the Debt to Asset Ratio. The Debt to Asset Ratio will be equivalent to what % Shiller P/E and Total Market Index is under-valued (eg. If average of both indicators is 40% under-valued, then my Debt to Asset Ratio will be 40%).

There are however two important things to consider when doing long term market timing:

  • NEVER EVER let Debt to Asset Ratio increase above 1. The purpose of using debt is to magnify your returns through leverage, but never use it to the extent that you could get realistically get bankrupt with it. A Debt to Asset Ratio implies that if all hell breaks loose, you can still manage to have positive net worth after liquidating all assets to pay debt. Thankfully, since you’re using an average of two indicators, the probability that the average results of both indicators telling you to go above 1 in Debt to Asset Ratio is almost impossible.
  • Allow plus or minus 5% wiggle room with your portfolio allocation. The average of both indicators will constantly shift, so to buy or sell constantly to perfectly match your asset allocation to the average of both indicators will kill your returns due to all the taxes and commissions incurred. Learn from passive index fund investors when it comes to re-balancing as they always have to balance following an asset allocation plan and minimizing costs in doing so.

As for what investments should be made when using debt… that’s a completely different blog post in itself. I’ll write about it in the future.


Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)