Do you like Optical Illusions?

Here are a few popular optical illusions that you might have seen before.

 

The Infamous Elephant Drawing

The Infamous Elephant Drawing

 

and this,

 

See a young woman with her head turned or an old hag?

See a young woman with her head turned or an old hag?

 

 

Want to see another one?

 

S&P 500 Index from 1997 to Present

S&P 500 Index from 1997 to Present

 

 

Sometimes I do pop my head ‘up and about’ and try to see what others in the world of finance are seeing.

 

This chart has been making the rounds, seemingly produced by J.P. Morgan Asset Management (Can you believe anything on the internet these days?) and I have seen it numerous times on predominantly bearish websites and used by individuals who say there is a crash coming in US equities.

 

I have to admit I did stare at this chart for quite some time. Then I cracked a smile, shake my head and say “gotcha”.

 

This S&P 500 Index chart is an optical illusion like the other two! So please don’t be fooled. This stuff embarrassingly is passed off as serious research however it is anything but.

 

For comparison purposes have a look at our long-term model price chart of the S&P 500 Index over a slightly longer but an inconsequential two years. (Our S&P chart starts in 1995 instead of 1997.)

 

S&P 500 Index with monthly price bars and EBV Lines (colored lines).

S&P 500 Index with monthly price bars and EBV Lines (colored lines).

 

 

As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.

 

Our model price chart does look different in some very important ways.

 

Logarithmic versus Linear Charts? The best is …

 

We do all our chart work on a logarithmic or a semi-log scale instead of linear charts. This is a very important distinction. Why? When viewing a price graph or chart on a linear basis, you are observing a chart numerically based on a standard measure of the y-axis – the numerical value of the S&P 500. I would recommend that you view a price chart on a semi-log basis so you can easily observe the percentage change of the stock or index in question. Compare where the S&P 500 bottomed in 2009 on both charts. The market bottom on the linear chart looks relatively calm compared to our semi-log model price chart where the downward price spike looks longer and more hazardous to your financial health, which it was. In general, distortions can appear in the market or equity bottoms or tops, for that matter, on linear price charts that can fool the observer in the actual price volatility that actually did occur.

 

 

How to disclose meaningful financial data in chart form?

 

In the history of finance we have yet to formally discover or thought about how best to display fundamental information on a price chart. You can observe the preparer of this S&P 500 Index chart – assuming it was J.P. Morgan Asset Management – tried their best to insert on what they thought were key pieces of information for your consideration. Was this financial information disclosure meaningful? Should investors make important investment decisions on relative measures like dividend yields, bond yields and the simplistic price/earnings ratios? How about something more concrete? Wouldn’t it be better to try and find another financial fundamental independent variable to chart so users make more informed investment decisions?

 

Re-Thinking the Use of Corporate Balance Sheets

 

Nobody it seems think about public companies balance sheets in terms of financial price analysis. Firstly, all corporate balance sheets by definition have to balance numerically, which is a good thing. And secondly, management and auditors spend an inordinate amount of time to ensure valuations on key asset and liabilities are properly recorded and reflect economic reality. Whether you have thought about a company’s balance sheet in terms of company analysis you may have to agree with me though, as an independent price variable to be charted over time this variable would be very strong.

 

 

Accounting Book Value per share + our ‘Secret Sauce’

 

The accountants call it ‘book value’ – simply divide the net book value or net worth of the company with its shares outstanding. To this number we add our ‘Theoretical Earnings’ value on a per share basis. (Remember our calculation of Theoretical Earnings is the net income a company needs in order for its balance sheet to stay of constant value or state over a period of time. See Theoretical Earnings under ‘Key Concepts’ tab above.) This result gives us our ‘Economic Book Value’ – to distinguish and differentiate from accounting book value – that graphically we chart on a semi-log scale as the green line, which we call EBV. The constants above this green line we number EBV+1, EBV+2 and so on to EBV+10. There are only three EBV lines below our calculated EBV or our charted Green Line that we number EBV-1, EBV-2 and EBV-3. See below

 

 

By calculating and charting these EBV levels or zones over time observers can observe how the balance sheet of any company or companies grouped together in an index have grown or compounded their net worth over time – especially on a semi-log price chart.

 

Combining together both EBV levels and the S&P 500 Index Value

 

Thinking of these two variables separately – EBV levels and Index pricing – they are both independent of each other and readily verifiable. So combining them together on one chart provides what I believe is a fundamental financial analysis first. Two independent variables on one financial analysis chart interacting together and giving an observer valuable fundamental information not only on valuation levels but also positive and negative transits alerting investors of a possible change in fundamentals.

 

 

Analyzing Both Charts – J.P. Morgan Asset Management and our Model Price chart – at the Same Time

 

Look at the first market high in 2000, on the JP Morgan produced chart. Now look at our long-term model Price chart. The S&P market high, in 2000, almost put the Index value up to EBV+6 – amazing in hindsight. Now trace the second high, in 2007, on the JP Morgan produced chart – with an Index high of 1565 versus 1527 in 2000. Again, referencing our Model Price chart this market high was at EBV+4. Same index price level, however a big difference in terms of valuation in the market.

 

Now look at the third and last high on this chart produced by JP Morgan, an index level of 1872, after a heroic and seemingly Everest climb from the market bottom of March 2009. Again consulting our model price chart, this same index level, 1872, places the S&P 500 in a valuation zone just above EBV+3.

 

Huh?

 

Is the valuation on the S&P 500, something to worry about when the past previous tops in the market were at (almost) EBV+6 and EBV+4? Phrased another way, the market – as defined by the S&P 500 – traded over EBV+3 from 1993 (not on chart) to 2007, (14 years) probably without fear of excessive valuation. But now in 2014 investors should now be worried of excessive valuation?

 

Conclusion

 

Grazers of financial information on the internet must be on guard. Information can be displayed in such a way that can lead users to the wrong conclusions or worse support the originators narrative or agenda. I have essentially proven that two price charts, each displaying essentially the same piece of information – the price series of the S&P 500 Index over a certain period of time – of having two different meanings. Depending how the price series and the information around the price series are displayed.

Optical illusions can be fun for you and the whole family.  Unfortunately and often optical illusions do appear in the financial news media and get spread around the Internet like a wild fire.  Take great care when viewing and assessing this information.  As the colloquialism goes, this free piece of information and 50 cents won’t buy you anything at Starbucks or worse may put a dent into your financial future.

 

2 responses to “Do you like Optical Illusions?

  1. cobbiangrant April 9, 2014 at 2:33 pm

    Thanks Brian, I think I digested and comprehended about 60%, not to shabby for this old fella. But I’m gaining both in my portfolio and comprehension level!!

  2. dOUG cOWDREY April 16, 2014 at 12:12 pm

    Like the educational post Brian thanks.

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