The question repeatedly asked of us last week is how much more can the stock market fall? We don’t have a crystal ball and we cannot predict the future but we can take steps to prepare for it. Our analysis and understanding of history allow us to use many different fundamental and technical models to create a broad range of possible answers to the question. With that range of potential outcomes we adjust our risk tolerance as appropriate.
For example, in our daily series of RIA Pro charts and the weekly Newsletter, we lay out key technical, sentiment, and momentum measures for many markets, sectors, and stocks. In doing so, we provide a range of potential shorter-term outcomes. We also depend on feedback from other reliable independent services such as Brett Freeze at Global Technical Analysis. His work is exclusively and routinely featured every month in Cartography Corner on RIA Pro.
In this article, we move beyond technical analysis and share a simple fundamental valuation analysis to help provide more guidance as to where the market may trade in the coming months and even years. This analysis can be viewed as bullish or bearish. Our goal is not to persuade you towards one direction or the other, but to open your eyes to the wide range of possibilities.
The data employed in this analysis is as of the market close on March 13, 2020.
Shiller’s Cyclically Adjusted Price to Earnings (CAPE 10) is one of our preferred valuation measures. Robert Shiller developed the CAPE 10 model to help investors assess valuations based on dependable, longer-term earnings trends. The most common CAPE analysis uses ten years of earnings data. The period is not too sensitive to transitory gyrations in earnings and it frequently includes a full economic cycle.
As shown below, monthly readings of CAPE fluctuate around the historical average (dotted line). The variance of valuations around the mean is put into further context with the right side y-axis, which shows how many sigma’s (standard deviations) each reading is from the average. The current CAPE of 25.36, or +1.10 sigma’s from the mean.
Data Courtesy Robert Shiller
The average CAPE over the 120+ years is 17.06, the maximum was 44.20, and the minimum was 4.78.
If we use more recent data, say from 1980 to current, the average CAPE is 22.29. Due to the higher average over the period, which includes the late 90s dot com bubble and the housing bubble, the current reading is only .36 sigma’s above its average.
The following tables, using both time frames, provide price guidance based on where the S&P 500 would need to be if CAPE were to move to its average, maximum, and minimum, as well as plus or minus one sigma from the mean.
The graph below shows the S&P 500 price in relation to that which would occur if the CAPE ratio went to its average, maximum, minimum, and plus or minus one sigma from the last 120 years.
It is important to stress that the denominator, earnings, includes data from March 2010 to February 2020. That ten years did not include a recession, which, over the 120+ years in this analysis, only happened briefly one other time, the late 1990’s.
The Corona Virus will no doubt hurt earnings for at least a few quarters and could push the economy into a recession. Accordingly, the denominator in CAPE will likely be declining. Whether or not CAPE rises for falls depends on the price action of the index.
Stocks are not cheap. As shown, a reversion to the average of the last 120 years, would result in an additional 33% decline from current levels. While the massive range of outcomes may appear daunting, this analysis is designed to help better understand the bounds of the market.
The S&P 500 certainly has room to trade much lower. It can also double in price and stay within the bounds of history. Lastly, given the unprecedented nature of current circumstances, it may be different this time and write new history.
Market Bubbles: It’s Not The Price, It’s The Mentality.
“Actually, one of the dangers is that people could be throwing risk to the wind and this [market] could be a runaway. We sometimes call that a melt-up and produces prices too high and then if there’s a shock, you come down to Earth and that could impact sentiment. I think this market is fully valued and not undervalued, but I don’t think it’s overvalued,” – Jeremy Siegel
Here is an interesting thing.
“Market bubbles have NOTHING to do with valuations or fundamentals.”
Hold on…don’t start screaming “heretic,” and building gallows just yet.
Let me explain.
I can’t entirely agree with Siegel on the market being “fairly valued.” As shown in the chart below, the S&P 500 is currently trading nearly 90% above its long-term median, which is expensive from a historical perspective.
However, since stock market “bubbles” are a reflection of speculation, greed, emotional biases; valuations are only a reflection of those emotions.
In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.
Notice that with the exception of only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently.
Secondly, all market crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.
For Every Buyer
You will commonly hear that “for every buyer, there must be a seller.”
This is a true statement. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.
Market crashes are an “emotionally” driven imbalance in supply and demand.
In a market crash, the number of people wanting to “sell” vastly overwhelms the number of people willing to “buy.” It is at these moments that prices drop precipitously as “sellers” drop the levels at which they are willing to dump their shares in a desperate attempt to find a “buyer.” This has nothing to do with fundamentals. It is strictly an emotional panic, which is ultimately reflected by a sharp devaluation in market fundamentals.
Bob Bronson once penned:
“It can be most reasonably assumed that markets are sufficient enough that every bubble is significantly different than the previous one, and even all earlier bubbles. In fact, it’s to be expected that a new bubble will always be different than the previous one(s) since investors will only bid up prices to extreme overvaluation levels if they are sure it is not repeating what led to the last, or previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.
I would argue that when comparisons to previous bubbles become most popular – like now – it’s a reliable timing marker of the top in a current bubble. As an analogy, no matter how thoroughly a fatal car crash is studied, there will still be other fatal car crashes in the future, even if the previous accident-causing mistakes are avoided.”
Comparing the current market to any previous period in the market is rather pointless. The current market is not like 1995, 1999, or 2007? Valuations, economics, drivers, etc. are all different from cycle to the next. Most importantly, however, the financial markets adapt to the cause of the previous “fatal crashes,” but that adaptation won’t prevent the next one.
“Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.
Every bubble has two components:
An underlying trend that prevails in reality, and;
A misconception relating to that trend.
When positive feedback develops between the trend and the misconception, a boom-bust process is set into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia.
As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”
Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.
The chart below is an example of asymmetric bubbles.
The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market, which can create a feedback loop between the markets and fundamentals.
This pattern of bubbles can be seen at every bull market peak in history. The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.
As Soro’s went on to state:
“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions.
In the passive or cognitive function, the fundamentals are supposed to determine market prices.
In the active or manipulative function market, prices find ways of influencing the fundamentals.
When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”
Currently, there is a strong belief the financial markets are not in a bubble, and the arguments supporting that belief are based on comparisons to past market bubbles.
It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested, and a continual drone of “bullish chatter;” the markets are poised for the unexpected, unanticipated, and inevitable event.
When thinking about excess, it is easy to see the reflections of excess in various places. Not just in asset prices but also in “stuff.” All financial assets are just claims on real wealth, not actual wealth itself. A pile of money has use and utility because you can buy stuff with it. But real wealth is the “stuff” — food, clothes, land, oil, and so forth. If you couldn’t buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they’re printed on (if you’re lucky enough to hold an actual certificate).
But trouble begins when the system gets seriously out of whack.
“GDP” is a measure of the number of goods and services available and financial asset prices represent the claims (it’s not a very accurate measure of real wealth, but it’s the best one we’ve got.) Notice the divergence of asset prices from GDP as excesses develop.
What we see is that the claims on the economy should, quite intuitively, track the economy itself. Excesses occur whenever the claims on the economy, the so-called financial assets (stocks, bonds, and derivatives), get too far ahead of the economy itself.
This is a very important point.
“The claims on the economy are just that: claims. They are not the economy itself!”
Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today.
The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction is the catalyst to bring “fear” into an overly complacent marketplace.
It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.”
This “time IS different.”
However, “this time” is only different from the standpoint the variables are not exactly the same as they have been previously. The variables never are, but the outcome is always the same.
The Next Decade: Valuations & The Destiny Of Low Returns
“As for what comes next, is this bull market tired? Is a crash long overdue? Not if you look at history. Stocks rallied for nearly 20 years between the early 1980s and the late 1990s. By that measure, we could easily see another decade of strong gains before the next “Big One”. Of course, the worst day in stock market history happened during that 20-year bull market in 1987, so we cannot be complacent. But the prognosis for the next 10 years is still good even if we run into a few 20% corrections along the way.”
After a decade of strong, liquidity-driven, post-crisis returns in the financial markets, investors are hopeful the next decade will deliver the same, or better. As Bob Farrell once quipped:
“Bull markets are more fun than bear markets.”
However, from an investment standpoint, the real question is:
“Can the next decade deliver above average returns, or not?”
Lower Returns Ahead?
Brian Livingston, via MarketWatch, previously wrote an article on the subject of valuation measures and forward returns.
“Stephen Jones, a financial and economic analyst who works in New York City, tracks the formulas that several market wizards have disclosed. He recently updated his numbers through Dec. 31, 2018, and shared them with me. Buffett, Shiller, and the other boldface names had nothing to do with Jones’s calculations. He crunched the financial celebrities’ formulas himself, based on their public statements.”
“The graph above doesn’t show the S&P 500’s price levels. Instead, it reveals how well the projection methods estimated the market’s 10-year rate of return in the past. The round markers on the right are the forecasts for the 10 years that lie ahead of us. All of the numbers for the S&P 500 include dividends but exclude the consumer-price index’s inflationary effect on stock prices.”
Shiller’s P/E10 predicts a +2.6% annualized real total return.
Buffett’s MV/GDP says -2.0%.
Tobin’s “q” ratio indicates -0.5%.
Jones’s Composite says -4.1%.
(Jones uses Buffett’s formula but adjusts for demographic changes.)
Here is the important point:
“The predictions might seem far apart, but they aren’t. The forecasts are all much lower than the S&P 500’s annualized real total return of about 6% from 1964 through 2018.”
While these are not guarantees, and should never be used to try and “time the market,” they are historically strong predictors of future returns.
As Jones notes:
“The market’s return over the past 10 years,” Jones explains, “has outperformed all major forecasts from 10 years prior by more than any other 10-year period.”
Of course, as noted above, this is due to the unprecedented stimulation the Federal Reserve pumped into the financial markets. Regardless, markets have a strong tendency to revert to their average performance over time, which is not nearly as much fun as it sounds.
The late Jack Bogle, founder of Vanguard, also noted some concern from high valuations:
“The valuations of stocks are, by my standards, rather high, butmy standards, however, are high.”
When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12-months of reported earnings by corporations, GAAP earnings, which includes “all of the bad stuff.”Wall Street analysts look at operating earnings, “earnings without all that bad stuff,” and come up with a price-to-earnings multiple of something in the range of 17 or 18, versus current real valuations which are pushing nearly 30x earnings.
“If you believe the way we look at it, much more realistically I think, the P/E is relatively high. I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.” – Jack Bogle
These views are vastly different than the optimistic views currently being bantered about for the next decade.
However, this is where an important distinction needs to be made.
Starting Valuations Matter Most
What Jani Ziedins missed in his observation was the starting level of valuations which preceded those 20-year “secular bull markets.” This was a point I made previously:
“The chart below shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. One thing you will notice is that secular bull markets tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend to end around 23-25x earnings or greater. (Over the long-term valuations do matter.)”
The two previous 20-year secular bull markets begin with valuations in single digits. At the end of the first decade of those secular advances, valuations were still trading below 20x.
The 1920-1929 secular advance most closely mimics the current 2010 cycle. While valuations started below 5x earnings in 1919, they eclipsed 30x earnings ten-years later in 1929. The rest, as they say, is history. Or rather, maybe “past is prologue” is more fitting.
Low Returns Mean High Volatility
When low future rates of return are discussed, it is not meant that each year will be low, but rather the return for the entire period will be low. The chart below shows 10-year rolling REAL, inflation-adjusted, returns in the markets. (Note: Spikes in 10-year returns, which occurred because the 50% decline in 2008 dropped out of the equation, has previously denoted peaks in forward annual returns.)
(Important note:Many advisers/analysts often pen that the market has never had a 10 or 20-year negative return. That is only on a nominal basis and should be disregarded as inflation must be included in the debate.)
There are two important points to take away from the data.
There are several periods throughout history where market returns were not only low, but negative.(Given that most people only have 20-30 functional years to save for retirement, a 20-year low return period can devastate those plans.)
“Importantly, it is worth noting that negative returns tend to cluster during periods of declining valuations. These ‘clusters’ of negative returns are what define ‘secular bear markets.’”
While valuations are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns and should never be used in any investment strategy which has such a focus. However, in the longer term, valuations are strong predictors of expected returns.
The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are, without question, expensive.
Furthermore, note that forward 10-year returns do NOT improve from historically expensive valuations, but decline rather sharply.
Warren Buffett’s favorite valuation measure is also screaming valuation concerns (which may explain why he is sitting on $128 billion in cash.). The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP. Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors.
Again, with this indicator at the highest valuation level in history, it is a bit presumptuous to assume that forward returns will continue to remain elevated,.
Bull Now, Pay Later
In the short-term, the bull market continues as the flood of liquidity, and accommodative actions, from global Central Banks, has lulled investors into a state of complacency rarely seen historically. As Richard Thaler, the famous University of Chicago professor who won the Nobel Prize in economics stated:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.
I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market.”
While market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.
Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
Job losses rise, wealth effect diminishes and real wealth is destroyed.
Middle class shrinks further.
Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption.
Wash, Rinse, Repeat.
If you don’t believe me, here is the evidence.
The stock market has returned more than 125% since 2007 peak, which is roughly 3x the growth in corporate sales and 5x more than GDP.
It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).
However, in the meantime, the promise of another decade of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”
“Our goal is to win a war, and to do that we may need to lose a few battles in the interim.
Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.
We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”
For long-term investors, the reality that a clearly overpriced market will eventually mean revert should be a clear warning sign. Given the exceptionally high probability the next decade will be disappointing, gambling your financial future on a 100% stock portfolio is likely not advisable.
Caution: Mean Reversion Ahead
If you watch
CNBC long enough, you are bound to hear an investment professional urging viewers
to buy stocks simply because of low yields in the bond markets. While the
advice may seem logical given historically low yields in the U.S. and negative
yields abroad, most of these professionals fail to provide viewers with a
mathematically grounded analysis of their expected returns for the equity
reversion is an extremely important financial concept and it is the “reversion”
part that is so powerful. The simple logic
behind mean reversion is that market returns over long periods will fluctuate
around their historical average. If you accept that a security or market tends
to revolve around its mean or a trend line over time, then periods of above
normal returns must be met with periods of below normal returns.
If the professionals on CNBC understood the power of mean reversion, they would likely be more enthusiastic about locking in a 2% bond yield for the next decade.
Expected Bond Returns
return analysis is easy to calculate for bonds if one assumes a bond stays
outstanding till its maturity (in other words it has no early redemption
features such as a call option) and that the issuer can pay off the bond at
thought a simple example. Investor A and B each buy a two-year bond today
priced at par with a 3% coupon and a yield to maturity of 3%. Investor A
intends to hold the bond to maturity and is therefore guaranteed a 3% return.
Investor B holds the bond for one year and decides to sell it because the
bond’s yield fell and thus the bond’s price rose. In this case, investor B sold
the bond to investor C at a price of 101. In doing so he earned a one year
total return of 4%, consisting of a 3% coupon and 1% price return. Investor B’s
outperformance versus the yield to maturity must be offset with investor C’s
underperformance versus the yield to maturity of an equal amount. This is
because investor C paid a 1% premium for the bond which must be deducted from
his or her total return. In total, the aggregate performance of B and C must
equal the original yield to maturity that investor A earned.
shows that periodic returns can exceed or fall short of the yield to maturity
expected based on the price paid by each investor, but in sum all of the
periodic returns will match the original yield to maturity to the penny.
Replace the term yield to maturity with expected returns and you have a better
understanding of mean reversion.
Equity Expected Returns
bonds, do not feature a set of contractual cash flows, defined maturity, or a
perfect method of calculating expected returns. However, the same logic that
dictates varying periodic returns versus forecasted returns described above for
bonds influences the return profile for equities as well.
The price of
a stock is, in theory, based on a series of expected cash flows. These cash
flows do not accrue directly to the shareholder, with the sole exception of
dividends. Regardless, valuations for equities are based on determining the
appropriate premium or discount that investors are willing to pay for a
company’s theoretical future cash flows, which ultimately hinge on net earnings
The earnings trend growth rate for U.S. equities has been remarkably consistent over time and well correlated to GDP growth. Because the basis for pricing stocks, earnings, is a relatively fixed constant, we can use trend analysis to understand when market returns have been over and under the long-term expected return rate.
The graph below does this for the S&P 500. The orange line is the real price (inflation adjusted) of the S&P 500, the dotted line is the polynomial trend line for the index, and the green and red bars show the difference between the index and the trend.
Data Courtesy Shiller/Bloomberg
and red bars point to a definitive pattern of over and under performance. Periods
of outperformance in green are met with periods of underperformance in red in a
highly cyclical pattern. Further, the red and green periods tend to mirror each
other in terms of duration and performance. We use black arrows to compare how
the duration of such periods and the amount of over/under performance are similar.
current period of outperformance is once again offset with a period of
underperformance, as we have seen over the last 80 years, than we should expect
a ten year period of underperformance. If this mean reversion were to begin
shortly, then expect the inflation adjusted S&P 500 to fall 600-700 points
below the trend over the next ten years, meaning the real price of the S&P
index could be anywhere from 1500-2300 depending on when the reversion occurs.
We now do similar mean reversion analysis based on valuations. The graph below compares monthly periods of Cyclically Adjusted Price to Earnings (CAPE) versus the following ten-year real returns. The yellow bar represents where valuations have been over the last year.
Data Courtesy Shiller/Bloomberg
CAPE is near 30, or close to double the average of the last 100 years. If returns
over the next ten years revert back to historic norms, than based on the green dotted
regression trend line, we should expect annual returns of -2% for each of the
next ten years. In other words, the analysis suggests the S&P 500 could be around
2300 in 2029. We caution however, valuations can slip well below historical
means, thus producing further losses.
John Hussman, of Hussman Funds, takes a similar but more analytically rigorous approach. Instead of using a scatter plot as we did above, he plots his profit margin adjusted CAPE alongside the following twelve-year returns. In the chart below, note how closely forward twelve-year returns track his adjusted CAPE. The red circle highlights Hussman’s expected twelve-year annualized return.
If we expect
this strong correlation to continue, his analysis suggests that annual returns
of about negative 2% should be expected for the next twelve years. Again, if
you discount the index by 2% a year for twelve years, you produce an estimate
similar to the prior two estimates formed by our own analysis.
None of these methods are perfect, but the story they tell is eerily similar. If mean reversion occurs in price and valuations, our expectations should be for losses over the coming ten years.
saying goes, you can’t predict the future, but you can prepare for it. As investors,
we can form expectations based on a number of factors and adjust our risk and investment
thesis as we learn more.
reversion promises a period of below average returns. Whether such an adjustment
happens over a few months as occurred in 1987 or takes years, is debatable. It
is also uncertain when that adjustment process will occur. What is not debatable
is that those aware of this inevitability can be on the lookout for signs mean
reversion is upon us and take appropriate action. The analysis above offers
some substantial clues, as does the recent equity market return profile. In the
20 months from May 2016 to January 2018, the S&P 500 delivered annualized
total returns of 21.9%. In the 20 months since January 2018, it has delivered
annualized total returns of 5.5% with significantly higher volatility. That
certainly does not inspire confidence in the outlook for equity market returns.
you that a bond yielding 2% for the next ten years will produce a 40%+
outperformance versus a stock losing 2% for the next ten years. Low yields may
be off-putting, but our expectations for returns should be greatly tempered
given the outperformance of both bonds and stocks over the years past. Said
differently, expect some lean years ahead.
Understanding The Bullish Case
“It is difficult to get a man to understand something when his salary depends on him not understanding it.” Upton Sinclair
Recently, we listened to Stephan Auth, an uber-bullish Chief Investment Officer from Federated Investors, waltz around a bearish argument. Specifically, the interviewer asked how he reconciled his optimism with Shiller’s CAPE10 price to earnings calculation, which currently portends a high valuation, ergo a significant drawdown.
His argument against using Shiller’s CAPE, which compares the current price to the average of earnings from the last ten years, is that the current ten year data set includes poor earnings from the Financial Crisis. His preference is to compare prices to expected future earnings.
While we would like to share in Auth’s optimism, the truth is that prior earnings are a very good predictor of the future earnings, and forward earnings expectations are quite often abused by Wall Street to make stocks appear cheaper. The incentive for this bias is obvious in that people who work on Wall Street make money by selling financial instruments and their analysis is directed toward advancing that purpose.
In this piece, we provide both qualitative and quantitative analysis to take the basis of his arguments to task — namely, his rationale for using unknown earnings expectations versus known historical earnings. Our opinion, as you may surmise by the opening quote, is that such a perspective on valuations is not only wrong but likely the “spin” of a spokesman that makes a much better living when markets are rising.
Before presenting quantitative analysis showing that excluding earnings data from the crisis period does not make stocks cheaper, let us first explain why using long term earnings is appropriate and why recessionary data should be included.
First and foremost, despite what any salesman says, recessions and stretches of declining earnings are commonplace and occur with regularity. Per Wikipedia and the NBER:
The National Bureau of Economic Research dates recessions on a monthly basis back to 1854; according to their chronology, from 1854 to 1919, there were 16 cycles. The average recession lasted 22 months, and the average expansion 27. From 1919 to 1945, there were six cycles; recessions lasted an average 18 months and expansions for 35. From 1945 to 2001, and 10 cycles, recessions lasted an average 10 months and expansions an average of 57 months.
As tracked by the National Bureau of Economic Research (NBER), the average period of economic expansion has increased since 1945 to 57 months or 4.75 years. In other words, in any ten-year period chosen at random, there are likely to be two recessionary periods. Recessions are a natural part of the economic cycle and should be expected. Given this fact, is it really analytically irresponsible to factor in recessions and periods of weaker earnings into equity analysis? On the contrary, it is irresponsible to diminish or ignore entirely such periods.
CAPE10 uses ten years of earnings and, in our opinion, provides a long enough period, containing full economic cycles, through which to evaluate future earnings and the premium paid for those earnings. The flaw of CAPE, as pointed out correctly by Auth, is that it is not forward-looking. Unfortunately, forward looking analysis that is not tethered to the past is likely the result of using crystal balls, tarot cards and a good measure of hope. Just ask yourself, how many professional investors and esteemed economists saw the 2008 financial crisis coming in advance? Indeed, former Fed Chairman Bernanke denied the likelihood of a recession four months after it had already begun!
If one thinks the pattern of earnings will change notably in the future, then the value of CAPE analysis is compromised. In Auth’s defense, if one thinks, for example, that earnings will grow at twice the rate seen historically, then valuations may be cheap.
The graph below shows the evolution of earnings growth over the past 100+ years. The upward trend in earnings growth peaked decades ago. Stephen Auth may have some special insight, but the economic and earnings trends of the past 50 years leave us little reason to suspect that tomorrow will be vastly different than yesterday. Taking it a step further, earnings growth, a record ten years into an economic expansion, is only peaking at the point where prior earnings growth troughed over the last 50 years. More concerning, this is occurring despite a decade of extraordinary monetary and fiscal stimulus.
Data Courtesy Robert Shiller/Yale
If you agree that earnings are likely to take their cue from the past, then we should explore the price-to-earnings ratio using various time frames and not just the “misleading” ten-year CAPE.
In the analysis below, we compare price to earnings from the trailing twelve months (TTM) as denoted in the charts below as well as for terms of three years, five years, seven years, ten years (CAPE), 15 years, and 20 years. The four shortest time frames are void of data from the 2008 crisis or any recessions. The three longest time frames include the crisis, and in the case of the 20-year period also include the recession of 2001.
The graph below shows the minimum and maximum range of the seven P/Es for every given month over the past 100+ years.
Data Courtesy Shiller/Yale
As shown by the horizontal dotted lines, the current lowest (TTM) and highest valuation (20-year) of the seven time-frames are more expensive than all prior valuations except those of the late ‘90s tech bubble. To emphasize, even the “friendliest” of the seven time frame P/Es deem the markets historically expensive.
The graphs below detail current P/E valuations for the seven periods using average and standard deviation from the norm.
Data Courtesy Robert Shiller/Yale
Investors are paying a high premium for earnings based on a wide spectrum of valuations. Eliminating data from the financial crisis does not better justify current valuations as we have shown. Rather, it argues for more caution especially given the record-length of the current economic expansion and statistical likelihood that it will end sooner rather than later.
As noted earlier, forward valuations are optically cheap only because hope, expectations, and sales tactics are behind those highly optimistic earnings forecasts, which diverge widely from expected economic growth.
Stocks can certainly go higher, but we must apply analytical rigor to assess the data. History tells us stocks are currently very expensive regardless of which time frame we use to make the comparison. Saying otherwise is shoddy analysis at best and intellectually dishonest at worst.
Time To Recycle Your Junk
“Invariably, investors who disregard where they stand in cycles are bound to suffer serious consequences” – Howard Marks
If you believe, as we do, that the current economic cycle is likely at a similar point as 2006/07, then you should consider heeding the warning of the charts we are about to show you.
The current economic
cycle stretching from the market peak of 2006/07 to today started with euphoria
in the housing markets and investors taking a general indifference towards risk-taking.
In 2008, reality caught up with the financial markets and desperation fueled
sharp drawdowns, punishing many risky assets. The recovery that began in 2009 has
been increasingly fueled by investor enthusiasm. While the stock market gets
the headlines, this fervor has been every bit as evident in the junk bond
sector of the corporate fixed- income markets.
This Cycle Reached Its Tail illustrated how investor sentiment and economic activity has
evolved, or cycled, over the last 12 years. We recommend reading it as
additional background for this article.
The Popularity of Junk
Junk debt or
non-investment grade securities also known as high yield debt will be referred
to as “junk” for the remainder of this article. They are defined as corporate debt with a credit rating below the
investment grade threshold (BBB-/Baa3), otherwise known as “triple B.”
buyers of junk debt were credit specialists due to the need for an in-depth
understanding of the accounting and financial statements of companies that bear
a larger risk of default. Extensive analysis was required to determine if the
higher yield offered by those securities was enough to cushion the elevated
risk of default. The following questions are just a small sample of those a
junk investor would want to answer:
the company’s cash flow be sufficient to make the payments on the debt?
not, what collateral does the company have to support bond holders?
is the total recovery value of plant,
property and other capital represented by the company?
the yield on the junk bond offer a reasonable margin of safety to justify an
financial crisis, the profile of the typical junk investor has changed
markedly. Gone are the days when the aforementioned specialized analysts, akin
to accountants, were the predominant
investors. New investors, many of whom lack the skills to properly evaluate such investments, have entered the high yield
debt arena to boost their returns. We believe that many such investors are ill-prepared
for the risk and volatility that tend to be
associated with non-investment grade bonds when the economic cycle turns.
of exchange-traded funds (ETF’s) has made investing in junk-rated debt much
easier and more popular. It has opened the asset class to a larger number of
investors that have traditionally avoided the sector or simply did not have
access due to investment restrictions. ETF’s have turned the junk market into
another passive tool for the masses.
combination of investors’ desperate need for yield along with the ease of
investing in junk has pushed spreads and yields to very low levels as shown
below. While a yield of 6.40% may seem appealing versus Treasury bonds yielding
little more than the rate of inflation, consider that junk yields do not factor
in losses due to default. Junk default rates reached double digits during each
of the last three recessions. A repeat of those default rates would easily wipe
out years of returns. Even in a best-case scenario, an annual 2.5-3.5% default
rate would significantly reduce the realized yield. The graph below charts
yields and option-adjusted spread (OAS).
OAS measures the spread, or additional yield,
one expects to receive versus investing in a
like maturity, “risk-free” U.S.
Treasury bond. It is important to note that spread is but one measure investors
must consider when evaluating prospective investments. For example, even if OAS
remains unchanged while Treasury yields increase 300bps, the yield on the junk
bond also increases 300bps and produces an approximate 15% price decline
assuming a 5-year duration.
Junk Debt Spreads (OAS) and Economic
activity and corporate profits are well -correlated. Given the tenuous nature
of companies in junk status, profits and
cash flows are typically extremely sensitive to economic activity. The
following graphs illustrate current valuations and guide where spreads may go
under certain economic environments. The
label R² in the graph is a statistical measure that calculates the
amount of variance of one factor based on the other factor. The R², of .58 in the graph below, means that 58% of the change in OAS
is due to changes in real GDP.
In the scatter
plot below, each dot represents the respective intersection of OAS and GDP for
each quarterly period. Currently, as indicated by the red triangle, OAS spreads
are approximately 175 basis points too low (expensive)
given the current level of GDP. More importantly, the general upward slope of
the curve denotes that weaker economic
activity tends to result in wider spreads. For instance, we should expect OAS
to widen to 10% if a recession with -2.00% growth were to occur.
following are scatter plots of OAS as contrasted with PMI (business
confidence/plans) and Jobless Claims (labor market). The current OAS versus the dotted trend line is
fair given the current level of PMI and Jobless Claims. However, if the economy
slows down resulting in weaker PMI and rising jobless claims, we should expect a
much higher OAS. Note both graphs have a significant R².
As discussed earlier, frothy equity markets and junk spreads have rewarded investors since the financial crisis. The scatter plot below compares OAS to CAPE10 valuations. A return to an average CAPE (16) should result in an OAS of nearly 10. Assuming that such an event was to occur, an investor with a five-year junk bond could lose almost 30% in the price of the bond assuming no default. Default would harm the investor much more.
We finish up with a similar graph as we presented in Has This Cycle Reached Its Tail. A special thank you to Neil Howe for the idea behind the graph below.
using two year averages compares the U.S. Treasury yield curve and junk OAS.
The yield curve serves as a proxy for the economic cycle. The cycle started
with the blue triangle which is the average yield curve and OAS for 2006 and
2007. As the cycle peaked and the financial crisis occurred, the yield curve
widened, and junk OAS increased significantly. Starting in 2009, recovery took
hold resulting in a flattening yield curve and lower junk OAS. The current one month point denoted by the red dot
shows that we have come full circle to where the cycle began over ten years
Given the unrewarding risk-return profile of junk bonds, we recommend investors consider
reallocating from junk to investment grade corporates, mortgages or U.S.
Treasuries. For those more aggressive investors,
we recommend a paired trade whereby one shorts
the liquid ETF’s (HYG/JNK) and purchases an
equal combination of investment grade corporates (LQD) and U.S.
Had one put on the paired trade mentioned above in 2014, when
junk yields were at similar levels, and
held the trade for two years, the total
return over the holding period was 16.75%.
Similarly, such a trade established in
January of 2007 and held for two years would have resulted in an approximate total return of nearly 38.85%.
Investment return data
used in pair trade analysis courtesy of BofA Merrill Lynch US high yield and
Corporate Master Total Return Indexes. Treasury data from Barclays.
Junk debt is highly correlated
with economic activity and stock market returns. When potential default rates are considered with signs that the economic
cycle is turning, and extreme equity valuations, investors should be highly attuned to risks. This is not to say junk bond holders will suffer,
but it should raise concern about the amount of risk being taken for a marginal
return at best.
If you have owned junk debt for the last few years,
congratulations. You earned a return greater than those provided by more
conservative fixed-income investments. That said, we strongly recommend a critical assessment of the trade. Math and
historical precedence argue that the upside to holding junk debt is quite
limited, especially when compared to
investment grade corporate bonds that offer similar returns and expose the
investor to much less credit risk.
At RIA Advisors, we have sold the vast majority of our junk bond holdings over the last month. We are concerned that the minimal spread over Treasuries does not nearly compensate our clients enough for the real risk that the current economic cycle is coming to an end.
DIY Market Forecast II – Our Forecast
A week ago we published DIY Market Forecast. This article was unique for us as we did not offer you our opinions and forecasts. Instead, the article provided data and trends but left it to the reader to create their own five-year S&P 500 forecast. This approach appears popular based on the many favorable comments we have received. Of the reader comments, quite a few have asked us what our DIY forecast is.
In a nutshell here is our forecast:
We selected to use the 3% GDP growth table. While we could have easily opted for the 1% table, we give stronger economic growth the benefit of the doubt. Keep in mind, however, if a recession occurs and growth is minus two or three percent for a year or two, a one percent average growth rate will be the better bet for the next five years. Given the probability of that scenario as this economic cycle ages, consider our range of estimates as a top end of possible outcomes.
We then chose a range of profit margins and CAPE valuations that we think are reasonable. In both instances, we believe they will slip from current levels towards longer-term averages. We do consider the possibility that profit margins and CAPE go below average but think the most likely scenario as highlighted in red, is between average and slightly below current levels. We remind that you that current levels in both instances are extreme and unlikely to continue, let alone rise from here.
The table below highlights our DIY forecast. The red shaded area is our “probable” forecast and averages to an S&P 500 forecast of 1707, with a range of 2420 to 1164. The yellow shaded area allows for the two factors to drop slightly below average which historically has been common during market corrections. The average S&P forecast in this scenario is 1172 with a range between 864 and 1512.
In prior articles, we have estimated what fair value for the S&P 500 index would be. In general, our estimates tend to converge around 50% of the current level, which would be approximately 1350.
Accordingly, the forecast detailed above is in the ballpark and further supports our conviction that investors should not take the possibility of a 50% decline lightly. These are startling estimates, but considering the extent to which current S&P 500 levels are the product of manufactured liquidity-induced speculation as opposed to healthy organic growth, investors should keep an open mind. If we recall prior occasions in March 2000 and October 2007 when market levels were similarly over-extended, the reaction to a 50% decline projection then was met with equal skepticism.
Quite often, our articles follow a similar format. We start with a “hook” to grab your interest and then offer a summary of what’s to come. Next comes the meat of the article, with data, graphs and a discussion that supports our view on the subject matter. Our closing summary typically encapsulates the main takeaways along with investment implications if applicable. A quote or two along the way never hurts.
In this article, we take a different tack. We present and analyze the factors that drove the bull market to record highs over the last nine years. It is these same factors that will also determine where the market will head in the coming years. However, instead of stating our opinions and giving a market forecast, we leave that to you. This approach will not only allow you to estimate the future price of the S&P 500, but importantly prove valuable in helping you understand the forces that drive market prices.
Foundations of the Bull
Valuing a stock or an index may seem complex, but there are only two factors that account for the price and its performance – estimates of a corporation’s future cash flows and the factor, or multiple, investors are willing to pay for those cash flows. While this does not occur neatly in a program or spreadsheet as the description might imply, the performance of every stock and index can be decomposed into those simple pieces.
With that in mind, we turn to the current U.S. equity bull market which started in the shadow of the financial crisis of 2008/09. The 315% rally, which might celebrate its tenth anniversary in March of 2019, is the longest uninterrupted equity expansion in modern U.S. history. Given the extended duration of this rally, it is more important than ever to look forward and not assume yesterday gains will continue tomorrow.
The following two sections look at corporate cash flows and valuation multiple trends on the S&P 500. This historical attribution analysis offers context and perspective about how those trends may or may not change going forward and ultimately what that means for the price of the index.
Corporate cash flows that accrue to investors should be dissected into two components, revenues (sales) and profit margins.
Not surprisingly, corporate revenues are highly correlated with economic growth. Since 2010, aggregate revenues of the S&P 500 grew by 35.7%, while GDP grew by a similar 38.6%. The graph below shows the tight correlation. Historical observations going back decades further support this data.
Data Courtesy Bloomberg
Given the recent and longer-term correlation, it is sensible to assume that expectations for future economic growth, or GDP, are a solid proxy for future revenue growth.
The following graph of the long-term trend of GDP provides guidance for future revenue expectations. As we have written all too often, demographics, the increasing debt burden, and declining productivity growth will continue to impose a heavy and growing toll on economic growth. That does not mean there will not be periods of stronger than average growth, but we believe the 30-year trend lower is intact.
Data Courtesy Bloomberg
Revenue is only half of the cash flow story. Net earnings, which is what investors are ultimately paying for, account for all of the expenses required to produce revenue. Net earnings as a percent of revenues, better known as profit margin, is the common metric used to express this.
Aggregate profit margins historically vacillate above and below the historical average, but they have always been mean reverting. To wit, here is the wisdom of an investing legend:
The following graphs provide historical context on profit margins over the last two and seven decades respectively.
Data Courtesy Bloomberg and St. Louis Federal Reserve
In both graphs, the profit margin post-financial crisis is at or near all-time highs and has failed to regress to the mean despite the wisdom of Jeremy Grantham.
While not an extensive list, consider the following chief factors responsible for elevated profit margins:
Lowest interest rates in recorded history
Minimal wage growth
Low input costs
Unchanged shipping, trucking, and freight costs
Review the following table of major corporate expenses to understand current margins and formulate expectations for future ones. The table compares some key proxies for expenses over the last year versus the prior three years.
Data Courtesy Bloomberg
Two aspects of corporate expenses omitted from the table are taxes and tariffs. Recent tax reform boosted margins and helped more than offset the negative effects of the rise in costs shown above. The consequences of the on-going “trade war” are yet to be seen, but they are likely negative.
Since 1877 there are 1654 monthly measurements of Cyclically Adjusted Price -to- Earnings (CAPE 10). Of these 82, only about 5%, have been the same or greater than current CAPE levels (30.5). Other than a few instances over the last two years and two others which occurred in 1929, the rest occurred during the late 1990’s tech boom. The graph below charts the percentage of time the market has traded at various ranges of CAPE levels.
Data Courtesy Shiller
Valuations are a function of investor sentiment. When sentiment is exuberant, as it has been recently, investors are willing to pay more for a series of cash flows in expectations that revenue and earnings will rise at a heady rate in the future. Conversely, when investors are concerned about future earnings and economic growth, valuations tend to decline.
Looking back, there are many factors that drove investors to pay a higher multiple for cash flows over the last ten years. Consider a few:
Historically Low-interest rates
Lower discounting rates made the value of future earnings higher.
Resulted in a push towards higher returning, riskier, longer duration securities like equities and long maturity bonds.
Heavy Monetary Stimulus
Record low-interest rates and burgeoning central bank holdings of financial assets here and abroad.
Corporate Share Repurchases
Since 2013, S&P 500 companies have annually bought back 3% of their outstanding shares in aggregate.
Since 2012, net credit balances have been larger than those seen before the market drawdowns of 2000 and 2008.
Currently, balances are 3x larger than any peak seen in at least the last 36 years.
The proliferation of passive investment strategies which tend to ignore valuations
The expansion of corporate leverage to record highs nominally and as a percent of GDP
To that list we submit one important factor – inflation. The following graph demonstrates that valuations have only been well above the norm during periods when annual inflation is running between one and four percent. Outside of the “sweet spot,” CAPE valuations tend to peak about 25-30% lower than current levels.
Data Courtesy Shiller
How The Market Got Here
With an understanding of the factors that account for price performance since 2010, we now turn to the graphs below which decompose the gains of the last eight years into the components: revenue growth, profit margin expansion, and valuation expansion.
As shown, durable organic growth only accounted for 26.96% of the gains in the S&P 500 index since 2010. In other words, without multiple and margin expansion, the S&P 500 would stand at 1587, a far cry from the current 2790.
DIY- Forecasting the S&P 500
Now we let you forecast where the S&P 500 might be headed over the next five years based on your expectations for revenue, profit margins, and valuations. To formulate a personalized forecast, you will need to complete a two-step process. First, answer the three questions below. Next, feed your answers into one of three tables provided below. The result will be your forecast. To help with answering questions two and three below, we provide current levels along with minimum, average, and maximum historical levels. We also urge you to go back and consider the graphs and factors that drove recent trends.
How much will GDP, and therefore corporate revenues grow over the next five years?
Will margins stay at current levels, expand further or contract back to or below historical norms?
Will valuations stay at current levels, expand further or contract back to or below historical norms?
Once the questions are answered, the data can be used to generate a forecast. The example below offers a guide to the process. In the example shown, the question responses are that GDP growth will average 1% a year for the next five years, and that profit margins and valuations will stay the same for five years. The resulting output of 2838, as highlighted, is the expected value of the S&P 500 in five years.
Choosing among the three tables below is based on your forecast for future economic growth: low 1%, average 3% or high 5%. Once you select the appropriate table, find your expected profit margin for five years from now on the horizontal axis at the top and your estimate for CAPE valuations on the vertical axis on the left. The estimate for the future level of the S&P 500 lies at the intersection of the two forecasts.
The framework described above can be used for something as simple as finding one answer as we did in the example, but it also allows an investor to conduct scenario analysis to arrive at a range of possibilities. By assigning various probabilities to one, two or all variables, one can calculate a weighted average outcome. For example, hold CAPE and Profit Margin constant and assign a 30% probability to 1% GDP growth, 60% probability to 3% growth and 10% probability to 5% growth. Repeating that process produces a range of answers which could effectively be used to gauge risk versus return.
Although relatively simple in its construction, the ability to customize your forecast and apply multiple scenarios is a powerful risk management tool.
Jeremy Grantham’s Best Long-Term Advice For Investors
Over the weekend, I was reviewing some old commentary and stumbled across a piece from 2012 which contained an excerpt from Jeremy Grantham who is the famed investor at GMO.
I have spoken, and written many times in the past, that the media and Wall Street alike promotes the bullish and optimistic views not because it is correct – but because it sells product. There is no value in telling the retail investor the truth about the risks in the market because investors would pull money out of the market which would reduce Wall Street’s profitability. In other words, the bullish and optimistic marketing machines are good for their bottom line – just not necessarily yours. This is one of the primary points that Jeremy Grantham brought out in his commentary.
This is a read which is well worth your time and consideration. It speaks to the very issues that we address most often about understanding the long-term risks to your portfolio, investment rules, and the legacy that we are leaving to our children.
It was refreshing and enlightening in 2012. It is just as important and educational today. I have added illustrations to support his points.
Advice From Uncle Polonius
by Jeremy Grantham, GMO
For individual investors setting out on dangerous investment voyages.
Believe in history. In investing Santayana is right: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away. You absolutely must ignore the vested interests of the industry and the inevitable cheerleaders who will assure you that this time it’s a new high plateau or a permanently higher level of productivity, even if that view comes from the Federal Reserve itself. No. Make that, especially if it comes from there. The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens. Here’s how.
“Neither a lender nor a borrower be.” If you borrow to invest, it will interfere with your survivability. Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor’s critical asset: patience. (To digress, excessive borrowing has turned out to be an even bigger curse than Polonius could have known. It encourages financial aggressiveness, recklessness, and greed. It increases your returns over and over until, suddenly, it ruins you. For individuals, it allows you to have today what you really can’t afford until tomorrow. It has proven to be so seductive that individuals en masse have shown themselves incapable of resisting it, as if it were a drug. Governments also, from the Middle Ages onwards and especially now, it seems, have proven themselves equally incapable of resistance. Any sane society must recognize the lure of debt and pass laws accordingly. Interest payments must absolutely not be tax deductible or preferred in any way. Governments must apparently be treated like Polonius’s children and given limits. By law, cumulative government debt should be given a sensible limit of, say, 50% of GDP, with current transgressions given 10 or 20 years to be corrected.) But, back to investing …
Don’t put all of your treasure in one boat.This is about as obvious as any investment advice could be. It was learned by merchants literally thousands of years ago. Several different investments, the more the merrier, will give your portfolio resilience, the ability to withstand shocks. Clearly, the more investments you have and the more different they are, the more likely you are to survive those critical periods when your big bets move against you.
Be patient and focus on the long term.Wait for the good cards. If you’ve waited, and waited some more, until finally a very cheap market appears, this will be your margin of safety. Now all you have to do is withstand the pain as the very good investment becomes exceptional. Individual stocks usually recover, entire markets always do. If you’ve followed the previous rules, you will outlast the bad news.
Try to contain natural optimism. Optimism has probably been a positive survival characteristic. Our species is optimistic, and successful people are probably more optimistic than average. Some societies are also more optimistic than others: the U.S. and Australia are my two picks. I’m sure (but I’m glad I don’t have to prove it) that it has a lot to do with their economic success. The U.S. in particular encourages risk-taking: failed entrepreneurs are valued, not shunned. But optimism comes with a downside, especially for investors: optimists don’t like to hear bad news. Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III. Been there, done that! And in a real stock bubble like that of 2000, bearish news in the U.S. will be greeted like news of the bubonic plague; bearish professionals will be fired just to avoid the dissonance of hearing the bear case, and this is an example where the better the case is made, the more unpleasantness it will elicit. Here again it is easier for an individual to stay cool than it is for a professional who is surrounded by hot news all day long (and sometimes irate clients too).Not easy, but easier.
But on rare occasions, try hard to be brave. You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks – extreme loss of clients and business – does not exist for you. So, if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it. This goes against the natural psychological behaviors of humans.
Resist the crowd: cherish numbers only. We can agree that in real life as opposed to theoretical life, this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. Watching neighbors get rich at the end of a bubble while you sit it out patiently is pure torture. The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time).Then hero-worship the numbers and try to ignore everything else. Ignore especially short-term news: the ebb and flow of economic and political news is irrelevant. Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies, let alone the broad asset classes that you should concentrate on. Leave those complexities to the professionals, who will on average lose money trying to decipher them
Remember too that for those great opportunities to avoid pain or make money – the only investment opportunities that really matter – the numbers are almost shockingly obvious: compared to a long-term average of 15 times earnings, the 1929 market peaked at 21 times, but the 2000 S&P 500 tech bubble peaked at 35 times! Conversely, the low in 1982 was under 8 times. This is not about complicated math!
In the end it’s quite simple. Really. GMO predicts asset class returns in a simple and apparently robust way: we assume profit margins and price earnings ratios will move back to long-term average in 7 years from whatever level they are today. We have done this since 1994 and have completed 40 quarterly forecasts. (We started with 10-year forecasts and moved to 7 years more recently.) Well, we have won all 40 in that every one of them has been usefully above random and some have been, well, surprisingly accurate. These estimates are not about nuances or PhDs. They are about ignoring the crowd, working out simple ratios, and being patient. (But, if you are a professional, they would also be about colossal business risk.) These forecasts were done with a robust but simple methodology. The problem is that though they may be simple to produce, they are hard for professionals to implement. Some of you individual investors, however, may find it much easier.
“This above all: to thine own self be true.” Most of us tennis players have benefited from playing against non-realists: those who play to some romanticized vision of that glorious September day 20 years earlier, when every backhand drive hit the corner and every drop shot worked, rather than to their currently sadly atrophied skills and diminished physical capabilities. And thank Heavens for them. But doing this in investing is brutally expensive. To be at all effective investing as an individual, it is utterly imperative that you know your limitations as well as your strengths and weaknesses. If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late, or getting out early, is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head.
Good luck. Uncle Polonius
Let’s Be Like Japan
There has been a lot of angst lately over the rise in interest rates and the question of whether the government will be able to continue to fund itself given the massive surge in the fiscal deficit since the beginning of the year.
While “spending like drunken sailors” is not a long-term solution to creating economic stability, unbridled fiscal stimulus does support growth in the short-term. Spending on natural disaster recovery last year (3-major hurricanes and two wildfires) led to a pop in Q2 and Q3 economic growth rates. The two recent hurricanes that slammed into South Carolina and Florida were big enough to sustain a bump in activity into early 2019. However, all that activity is simply “pulling forward”future growth.
But the most recent cause of concern behind the rise in interest rates is that there will be a “funding shortage” of U.S. debt at a time where governmental obligations are surging higher. I agree with Kevin Muir on this point who recently noted:
“Well, let me you in on a little secret. The US will have NO trouble funding itself. That’s not what’s going on.
If the bond market was truly worried about US government’s deficits, they would be monkey-hammering the long-end of the bond market. Yet the US 2-year note yields 2.88% while the 30-year bond is only 55 basis points higher at 3.43%. That’s not a yield curve worried about US fiscal situation.
And let’s face it, if Japan can maintain control of their bond market with their bat-shit-crazy debt-to-GDP level of 236%, the US will be just fine for quite some time.”
That’s not a good thing by the way.
Let’s Be Like Japan
“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010
While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out previously:
“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”
The belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.
“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”
Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.
The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum” should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset many of the benefits.
The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week as their long-term projections, along with the CBO, remain mired at 2%.
The US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.
Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.
One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.
Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.
But yet, the current Administration believes our outcome will be different.
With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.
This is the same problem that Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
A decline in savings rates to extremely low levels which depletes productive investments
An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
A heavily indebted economy with debt/GDP ratios above 100%.
A decline in exports due to a weak global economic environment.
Slowing domestic economic growth rates.
An underemployed younger demographic.
An inelastic supply-demand curve
Weak industrial production
Dependence on productivity increases to offset reduced employment
The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.
If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.
Japan, like the U.S., is caught in an on-going “liquidity trap” where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.
More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.
As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges.
Unfortunately, for the current Administration, the reality is that cutting taxes, tariffs, and sharp increases in debt, is unlikely to change the outcome in the U.S. The reason is simply that monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.
But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, but we can always hope for a different result.
What’s the worst that could happen?
VLOG: Rising Rates Send A Warning & Why It Matters
While it has been stated that rising interest rates don’t matter, the reality is that they do. I take a deeper look at the impact of higher rates across the financial and economic spectrum and the warning that rates are currently sending to investors.
All Markets Are Cyclical – When Will This One End?
I always enjoy reading John Stepek’s work at MoneyWeek. Just recently he addressed the question of where are we in the current market cycle. To wit:
“In his latest memo to clients, [Howard Marks] outlines his basic philosophy and how it affects Oaktree’s investment process at the moment. Marks’ basic point – which appears pretty self-evident, though you’d be surprised by how many people try to deny it – is that markets move in cycles.
The tricky part is trying to work out when the cycle is going to turn.”
This is a fascinating point as it is not just individuals who try and deny that markets, and the economy, move in cycles but also the Federal Reserve and Government agencies. As I noted last week, the Congressional Budget Office is currently estimating the next 10-years of growth in the economy at a steady 2%.
Given this is already approaching the longest economic growth cycle in history, at the lowest rate of growth, and with the Federal Reserve hiking rates, it is highly unlikely the economy will remain “recession free” for another decade. It is also important to note the CBO didn’t predict the recessions in 2001-2002 or in 2008. In fact, in 2000 the CBO predicted the U.S. would be running a $1 Trillion surplus by 2010. They were only off by $2 Trillion when 2010 finally rolled around.
What is clear is that both markets and the economy do not only cycle, but cycle together.
However, knowing when these cycles will occur isn’t that simple. As John notes:
“Of course, it’s not that simple. You might know that winter is coming; you’ll also know when it’s here. But can that knowledge tell you when the first snow will fall – or if it will fall at all?
And there’s your problem right there. Markets might be cyclical but timing them is almost impossible. You might know that the equivalent of an asset-market winter is coming. But you don’t know when it will hit and you don’t know how severe it will be.
So – to put it bluntly – what is the use of a theory of market cycles if it can’t tell you when to invest and when to pull out?”
That is absolutely correct. But it also the same analysis given for valuations.
Just like market and economic cycles, valuations are a horrible “timing” indicator. But like cycles, valuations are simply an indication of expected returns in the future.
As Marks noted there is no magic formula, or timing device, that can tell you “go to cash now” or “go all in today”. However, it is quite obvious that when valuations are elevated, and interest rates are rising, taking on excessive portfolio risk will have a very low future return.
The same goes for market and economic cycles. Today, there are plenty of warning signs which suggest we are nearer the top of this particular cycle versus than not.
It is worth noting that valuations clearly run in cycles over time. The current evolution of valuations has been extended longer than previous cycles due to 30-years of falling interest rates, massive increases in debt and leverage, unprecedented amounts of artificial stimulus, and government spending.”
No matter how you look at the markets currently, there are substantial signs of excess:
Corporate leverage is at all time highs
Margin debt is a record levels
Investor allocations to equities are pushing record levels
Investor allocations to cash are at record lows
Investor confidence is at record levels
Economic confidence is at record levels
Rates are rising
Jobless claims are at record lows
Stock valuations are at the second highest level in history
Marks also cited several points as well:
Private equity funds are raising record amounts of money to invest
A record proportion of loans are now classed as “covenant-lite” (ie, few if any protections for the lenders)
The quality of debt is deteriorating, and;
Investors are paying ever-higher multiples for increasingly-indebted companies.
All of these signs suggest an economy, and a market, that is fully matured with investors are behaving imprudently. In other words, things are as “good as they can get,” which happens at the end of a cycle rather than the beginning.
“With housing and auto sales already a casualty of higher rates, it won’t be long before it filters through the rest of the economy. The chart below shows nominal GDP versus the 24-month rate of change (ROC) of the 10-year Treasury yield. Not surprisingly, since 1959, every single spike in rates killed the economic growth narrative.”
I urge you not to fall prey to the “This Time Is Different” thought process.
Despite the consensus belief that global growth is gathering steam, there is mounting evidence of financial strain rising throughout the financial ecosystem. The recent spurt of economic growth has been a direct result of massive fiscal stimulus which will fade, wage growth has been weak, and job growth remains below the rate of working-age population growth.
While the talking points of the economy being as “strong as an ox” is certainly “media friendly,” the yield curve, as shown below, is telling a different story. While the spread between 2-year and 10-year Treasury rates has not fallen into negative territory as of yet, they are certainly headed in that direction.
Of course, the yield curve has been a strong predictor of the end of economic and market cycles. As such can it provide us with a clue as to when this cycle is likely to end? As Jesse Colombo recently noted in Forbes:
“At the current rate the yield curve is flattening, many economists estimate that the yield curve may invert as soon as December 2018, so we will use that time frame for this exercise. It took an average of 9.7 months between the time that the yield curve inverted and the stock market peaked, which means that the current bull market would peak in September 2019. It also took an average of 5 months between historic market peaks and the start of recessions, which means that the next U.S. recession would start in February 2020, assuming the current cycle follows the historic average perfectly.”
“Two-thirds of business economists in the U.S. expect a recession to begin by the end of 2020, while a plurality of respondents say trade policy is the greatest risk to the expansion, according to a new survey.
About 10 percent see the next contraction starting in 2019, 56 percent say 2020 and 33 percent said 2021 or later, according to the Aug. 28-Sept. 17 poll of 51 forecasters issued by the National Association for Business Economics on Monday.
Forty-one percent said the biggest downside risk was trade policy, followed by 18 percent of respondents citing higher interest rates and the same share saying it would be a substantial stock-market decline or volatility.”
See, nothing to worry about for another 12-months.
Not so fast.
A Funny Thing Happened On The Way To The Recession
The majority of the analysis of economic data is short-term focused with prognostications based on single data points. For example, let’s take a look at the data below of real economic growth rates:
January 1980: 1.43%
July 1981: 4.39%
July 1990: 1.73%
March 2001: 2.30%
December 2007: 1.87%
Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.
You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”
I myself was rather brutally chastised in December of 2007 when I wrote that:
“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”
Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis was the recession officially revealed. Unfortunately, by then it was far too late to matter.
The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.
There are three lessons that should be learned from this:
The economic “number” reported today will not be the samewhen it is revised in the future.
The trend and deviation of the data are far more important than the number itself.
“Record” highs and lowsare records for a reason as they denote historical turning points in the data.
Here is the important point.
When will this cycle end? No one really knows for sure.
Will it end? Absolutely.
The recent spike in rates, combined with rising oil prices, is a toxic brew for a heavily indebted consumer both domestically and globally. The recent rise in rates has already accelerated the timing of the next recession and it is now only a function of time until “something breaks.”
As Mr. Stepek concludes:
“Be defensive when everyone else is being aggressive.
Why? So that when the time comes when there are lots of opportunities but hardly any money around (and it will come, because markets are cyclical and winter eventually arrives again), you’ll be in a position to take advantage.
And keep an eye on corporate debt. That’s where we’ll see the strains first.”
While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.
But then again, “no one could have seen it coming.” Right?
The Two Biggest Threats To This Bull Market
This bull market seems unstoppable.
Regardless of short-term events, investors have quickly looked beyond those risks to in a bid to push stock prices higher. For example, in February of this year the markets dove roughly 10% as “trade wars” became a “thing.” Over the next two months, the markets vacillated coming to grips with what “Trump’s war with China” would actually mean. Last week, the Administration announced a further $200 billion in tariffs against China, China cancels talks with the U.S., and China imposes similar tariffs against the U.S. – and the market barely budges..
However, in my opinion, the two biggest threats to the bull market may very well be the two issues which are the most visible currently – tariffs and interest rates.
One of the biggest drivers of the “bullish thesis” is the explosion in earnings due to the tax cuts passed in December of 2017. However, the issue is that tax cuts only provide a very short-term benefit and, since we compare earnings on a year-over-year basis, growth will drop back towards the growth rate of the economy next year.
For now, the issue has been overlooked due to the surge in earnings from the changes to the tax code as well as the massive surge in repatriated dollars from overseas due to that lower tax rate. As shown by the Federal Reserve:
“Balance of payments data show that U.S. firms repatriated just over $300 billion in 2018:Q1, roughly 30 percent of the estimated stock of offshore cash holdings. For reference, the 2004 tax holiday, which provided a temporary one-year reduction in the repatriation tax rate, resulted in $312 billion repatriated in 2005, of an estimated $750 billion held abroad.”
Of course, while it was expected to go to CapEx and wages, it went to share buybacks instead.
“The top 15 firms account for roughly 80 percent of total offshore cash holdings, and roughly 80 percent of their total cash (domestic plus foreign) is held abroad. Following the passage of the TCJA in late December 2017, share buybacks spiked dramatically for the top 15 cash holders, with the ratio of buybacks to assets more than doubling in 2018:Q1.”
Not surprisingly, since buybacks reduce the number of shares outstanding, bottom line EPS surged sharply despite a quarterly decline in revenues/share which slumped from $329.59/share in Q4 to $320.39/share in Q1.
While the bull market thesis continues to be that earnings expansion will justify higher valuations, such may not be the case. Tariffs, which are a “tax on profits,” could effectively eliminate the majority of the temporary benefits provided by tax cuts to begin with.
“As I wrote recently, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”) but an ongoing trade war could effectively wipe out the entire benefit of the tax cut bill. For the end of 2019, forward reported estimates have declined by roughly $9.00 per share.”
But it isn’t just this year where estimates are falling, but into 2019 as well. The chart below shows the changes in estimates a bit more clearly. It compares where estimates were on January 1st versus April, June, and September 1st. Currently, optimism is exceedingly “optimistic” for the end of 2019.
However, those estimates are likely to be revised down sharply in the months ahead as the number of S&P 500 companies issuing negative EPS guidance is now the highest since 2016.
The more tariffs that are laid on companies which do international business, the more likely we are going to see further decreases in earnings expectations. This is particularly the case given the divergence between the U.S. and the global economy.
“The trade war is now a reality. The recently announced imposition of US tariffs on a further $200 billion of imports from China will have a material impact on global growth and, even though we have now included the 25 percent tariff shock in our GEO [Global Economic Outlook – Ed.] baseline, the downside risks to our global growth forecasts have also increased.” – Fitch Chief Economist Brian Coulton.
Of course, the other issue that will weigh on corporate profitability and earnings is interest rates.
Interest Rates Matter
Yesterday, the Fed hiked interest rates for a third time this year and is set to raise again by the end of the year. With the Fed Funds rate now at 2%, it is equivalent to the Fed’s long-term outlook of the economy and inflation. More importantly, the Fed removed the word “accommodative” from their statement which also suggests they may be nearing the “neutral rate policy setting.”
Nonetheless, markets have continued to discount the risk of rising rates.
They most likely shouldn’t.
Rising interest rates, like tariffs, are a “tax” on corporations and consumers as borrowing costs rise. When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.
The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.
The same applies for heavily levered households. With household debt is also at historic highs, rising rates eventually lead to a reversion in household net worth.
With leverage, both corporate and household, at historical peaks, the question is not “if” but “when” rising interest rates pricks the debt balloon.
As Doug Kass recently noted – rising interest rates do matter:
The private and public sector have inflated debt loads today. Rising interest rates raise the cost of servicing that debt and reduce spending and productive investment.
Private sector activity is importantly influenced by interest rates:
Rising mortgage rates and higher mortgage payments reduce home affordability and hurt home turnover and refinancings.
Slowing home sales and reduced refinancings hurt spending on renovations and remodeling.
Given record-high auto prices and the difficulty in further lengthening out already long auto loan maturities, rising interest rates will hurt auto sales by raising monthly payments.
Consumer, mortgage and corporate loans that are variable rate are hurt by climbing interest rates.
The credit markets fall when interest rates rise, serving to have a negative wealth effect on consumers and corporations that own bonds.
Rising interest rates impede corporate profit margins, overall profits and earnings per share
Debt is issued by corporations in order to buy back stock and pay dividends. Advancing rates reduce a company’s return on investment on those buybacks.
Corporate capital spending is partially dependent on borrowings. Higher borrowing costs could lead to lower capital spending.
Public sector activity and profitability are greatly influenced by interest rates:
The deficit/GDP ratio will increase as interest rates rise and the expectation for lower future deficits will crumble.
Dividend discount models are based on future estimates of cash flow discounted back at an appropriate interest rate:
Rising interest rates reduce the value of those future cash flows and, in turn, the value or worth of a company’s stock.
There is now an alternative to stocks as the yield on the one-month Treasury bill (2.06%) and two-year Treasury note (2.85%) compare favorably to the S&P’s dividend yield of only 1.75%. Additional increases in interest rates will serve as an even more competitive and attractive alternative to stocks.
As long as the backdrop is healthy, in this case strong earnings and economic growth, the markets can fend off attacks from higher rates and geopolitical issues. However, as tariffs attack corporate profitability, and weakens economic growth, it makes the system much more susceptible to the virus of higher rates. This will most likely expose itself as credit-related event which will be blamed for a bigger correction in the market. However, “Patient Zero” will be the Federal Reserve.
Even one of the most bullish individuals on Wall Street, Wharton finance professor Jeremy Siegel, is now turning cautious. While he isn’t abandoning his bullish backdrop for stocks, particularly since he is involved in everything from ETF’s to Robo-advisors, he suggests it is vital for investors to be aware of growing risks stemming from tariffs and interest rates which could spark a sell-off.
“This market has had a great run, and I wouldn’t be surprised to see another correction. We have some major challenges. The trade war is not yet resolved.
We’re going to see how hawkish [the Fed] is with the labor market as tight as it is. I still believe that they’re going to be on track for four increases this year. The question is how will they feel about another raise in December. And, I think between the trade situation and the interest rate situation, and then, of course, the midterms in November, there are a lot of challenges facing Wall Street.” – Trading Nation.
While Siegel only expects a sell-off like the one we saw in February of this year, the real risk is of one much deeper in nature. As noted just recently in “Ingredients Of An Event.”
“The risk to investors is NOT just a market decline of 40-50%. The real crisis comes when there is a ‘run on pensions.’
This is a $4-5 Trillion problem with no resolve to “fix” the problem before it occurs. This leaves a large number of pensioners already eligible for their pension at risk and the next decline will likely spur the “fear” benefits will be lost entirely. The combined run on the system, which is grossly underfunded at a time when asset prices are dropping, will cause a debacle. With consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt, they too will be forced to liquidate assets to meet payment demands.
All the ingredients for a more severe market correction are currently present. Between Trump’s “trade war” and the Fed insistence on hiking rates, it certainly seems as if they are “hell-bent” on lighting the fuse.
VLOG – Why 80% Of Americans Face A Retirement Crisis
Clarity Financial Chief Investment Strategist Lance Roberts reviews grim statistics about the majority of soon-to-be retiring American’s who will not have enough to live on.
VLOG – Why Smart Investors Should Fear An Inversion
Clarity Financial Chief Investment Strategist Lance Roberts shows why the danger of asset bubbles in every investment class is part of a recipe for reversal as the bond yield curves begin to invert…and what that means for your money.
Clarity Financial Chief Investment Strategist Lance Roberts examines the divergence of world markets to the U.S. and discusses the message they may be sending to investors.
VLOG – A Shift In Valuations & Investor Perspectives
Clarity Financial Chief Investment Strategist Lance Roberts examines stock valuations vs investor sentiment, and agrees with Prof. Robert Shiller’s assessment that investors have become complacent to the risk of higher valuations.
The Longest Bull Market In History & What Happens Next
“Barring a breathtaking plunge, the bull market in U.S. stocks on Aug. 22 will become the longest in history, and optimistic investors argue it has miles to go before it rests.” – Sue Chang, MarketWatch
Depending on how you measure beginnings and endings, or what constitutes a bear market or the beginning of a bull market, makes the statement a bit subjective. However, there is little argument the current bull market has had an exceptionally long life-span.
But rather than a “siren’s song” luring investors into the market, maybe it should serve as a warning.
“Record levels” of anything are “records for a reason.”
It should be remembered that when records are broken that was the point where previous limits were reached. Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.
Therefore, when a “record level” is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.
The chart below has been floating around the “web” in several forms as “evidence” that investors should just stay invested at all times and not worry about the downturns. When taken at “face value,” it certainly appears to be the case. (The chart is based up Shiller’s monthly data and is inflation-adjusted total returns.)
The problem is the entire chart is incredibly deceptive.
More importantly, for those saving and investing for their retirement, it’s dangerous.
“Most investors don’t start seriously saving for retirement until they are in their mid-40’s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push toward saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals.
This is where the problem is. There are periods in history, where returns over a 20-year period have been close to zero or even negative.”
Currently, we are in one of those periods.
Lies, Damned Lies, And Statistics
Secondly, percentages are deceptive.
Back to the first chart above, while the mainstream media and bloggers love to talk about gains and losses in terms of percentages, it is not an apples to apples comparison.
Let’s look at the math.
Assume that an index goes from 1000 to 8000.
1000 to 2000 = 100% return
1000 to 3000 = 200% return
1000 to 4000 = 300% return
1000 to 8000 = 700% return
A 700% return is outstanding, so why worry about a 50% correction in the market when you just gained 700%?
Here is the problem with percentages.
A 50% correction does NOT leave you with a 650% gain.
A 50% correction is a subtraction of 4000 points which reduces your 700% gain to just 300%.
Then the problem now becomes the issue of having to regain those 4000 lost points just to break even.
Let’s look at the S&P 500 inflation-adjusted total return index in a different manner.
The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.
What you should notice is that while the original chart above certainly makes it appear as if “bear markets” are no “big deal,” the reality is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the the previous bull market advance. This is shown more clearly when we convert the percentage chart above into a point chart as shown below.
Here is another way to view the same data. The table and chart below overlays the point AND percentage of gain and loss for each bull and bear market period going back to 1900 (inflation-adjusted).
Again, the important thing to note is that while record “bull markets” are a great thing in the short-term, they are just one half of the full-market cycle. With regularity, the following decline has mostly erased the previous gain.
While the financial media is anticipating a new “record” being set for this “bull market,” here is something to think about.
Bull markets END when everything is as “good as it can get.”
Bear markets END when things simply can’t “get any worse.”
While everything is certainly firing on all cylinders in the market and economy currently, for investors this should be taken as a warning sign rather than an invitation to pile on additional risk.
In the near term, over the next several months, or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity.
This bull market will easily set a “new bull market record.”
But, as I said, “records are records” for a reason. As Ben Graham stated back in 1959:
“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’
The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound, then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.
In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”
He is right, of course, things are little different now than they were then.
For every “bull market” there MUST be a “bear market.”
While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering “passive” approaches will also “pace” the decline.
Understanding that your investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of what a devastating effect corrections have on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-terminvesting always wins,” ask yourself who really benefits?
This time will not be “different.”
If the last two bear markets haven’t taught you this by now, I am not sure what will.
Maybe the third time will be the “charm.”
8-Measures Say A Crash Is Coming, Here’s How To Time It
“The stock market’s return over the next decade is likely to be well below historical norms.
That is the unanimous conclusion of eight stock-market indicators with what I consider the most impressive track records over the past six decades. The only real difference between them is the extent of their bearishness.
To illustrate the bearish story told by each of these indicators, consider the projected 10-year returns to which these indicators’ current levels translate. The most bearish projection of any of them was that the S&P 500 would produce a 10-year total return of 3.9 percentage points annualized below inflation. The most bullish was 3.6 points above inflation.
The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point above inflation. Ten-year Treasuries can promise you that return with far less risk.”
Here is one of the eight indicators, a chart of Livermore’s Equity-Q Ratio which is essentially household’s equity allocation to net worth:
The other seven are as follows:
As Hulbert states:
“According to various tests of statistical significance, each of these indicators’ track records is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.
However, the differences between the R-squared of the top four or five indicators I studied probably aren’t statistically significant, I was told by Prof. Shiller. That means you’re overreaching if you argue that you should pay more attention to, say, the average household equity allocation than the price/sales ratio.”
“No matter, how many valuation measures I use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.”
This is shown in the chart below, courtesy of Michael Lebowitz, which shows the standard deviation from the long-term mean of the “Buffett Indicator,” or market capitalization to GDP, Tobin’s Q, and Shiller’s CAPE compared to forward real total returns over the next 10-years. Michael will go into more detail on this graph and what it means for asset allocation in the coming weeks.
The Problem With Valuation Measures
First, let me explain what “low forward returns” does and does not mean.
It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low.
This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)
From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.
The problem with using valuation measures, as Mark Hulbert discusses, is that there can be a long period between a valuation warning and a market correction. This was a point made by Eddy Elfenbein from Crossing Wall Street:
“For the record, I’m a bit skeptical of these metrics. Sure, they’re interesting to look at, but I try to place them within a larger framework.
It’s not terribly hard to find a measure that shows an overvalued market and then use a long time period to show the market has performed below average during your defined overvalued period. That’s easy.
The difficulty is in timing the market.
Even if you know the market is overpriced, that doesn’t tell you much about how to invest today.”
He is correct.
So, if valuation measures tell you a problem is coming, but don’t tell you what to do, then Wall Street’s answer is simply to “do nothing.” After all, you will eventually recover the losses….right?
However, getting back to even and actually reaching your financial goals are two entirely different things as we discussed recently in “Crashes Matter.”
There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as the principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”
Or more simply put – “getting back to even” is not the same as “growing.”
Is there a solution?
Linking Fundamentals To Technicals
I have often discussed an important point in reference to our portfolio management process:
“Fundamentals tell us ‘what’ to buy or sell, technicals tell us the ‘when.'”
Fundamentals are a long-term view on an investment. From these fundamental underpinnings, we can assess and assign a “valuation” to an investment to determine whether it is over or undervalued. Of course, in the famous words of Warren Buffett:
“Price is what you pay. Value is what you get.”
In the financial markets, however, psychology can drive prices farther, and further, than logic would dictate. But such is the nature of every stage of a bull market cycle where the “momentum” chase, or rather the physical manifestation of “greed,” comes to life. This is also the point where statements such as “this time is different,” “fundamentals have changed,” or a variety of other excuses, are used to justify rampant speculation in the markets.
Despite the detachment from valuations, as markets continue to escalate higher, the fundamental warnings are readily dismissed in exchange for any data point which supports the bullish bias.
Eventually, it has always come to a rather ignominious ending.
But why does it have to be one or the other?
Currently, the Equity Q-ratio, as graphed above, is at levels that have historically denoted very poor future returns for investors. In other words, if you went to cash today, it is quite likely that over the next 10-years the value of your portfolio would be roughly the same.
However, before that “mean reverting event” occurs the market will most likely continue to advance. So, there you are, sitting on the sidelines waiting for the crash.
“Damn it, I am missing out. I should have just stayed in.”
The feeling of “missing out” can be overpowering as the momentum driven market rises. Like gravity, the more the market rises, the greater the pull to “jump back in” becomes. Eventually, and typically near the peak of the market cycle, investors capitulate to the pressure.
Understanding that price is a reflection of short-term market psychology, the trend of prices can give us some clue as to the direction of the market. As the old saying goes:
“The trend is your friend, until it isn’t.”
While the Equity Q-ratio implies low forward returns, technical analysis can give us the “timing” as to when “psychology” has begun to align with the underlying “fundamentals.”.
In the chart below we have added vertical “gold” bars which denote when negative price changes warrant reducing equity risk in portfolios. (The chart uses quarterly data and triggers a signal when the 6-month moving average crosses the 2-year moving average.)
Since 1951, this “equity reduction” signal has only occurred 17-times. Yes, since these are long-term quarterly moving averages, investors would not have necessarily “top ticked” and sold at the peak, nor would they have bought the absolute bottoms. However, they would have succeeded in avoiding much of the capital destruction of the declines and garnered most of the gains.
The last time the Equity-Q ratio was above 40% was during the late 2015/2016 correction and the technical signal warned that a reduction of risk was warranted.
The mistake most investors make is not getting “back in” when the signal reverses. The value of technical analysis is providing a glimpse into the “stampede of the herd.” When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When its not, equity risk should be greatly reduced.
Unfortunately, investors tend to not heed signals at market peaks because the belief is that stocks can only go up from here. At bottoms, investors fail to “buy” as the overriding belief is the market is heading towards zero.
In a recent post, It’s Not Too Early To Be Late, Michael Lebowitz showed the historical pain investors suffered by exiting a raging bull market too early. However, he also showed that those who exited markets three years prior to peaks, when valuations were similar to today’s, profited in the long-run.
While technical analysis can provide timely and useful information for investors, it is our “behavioral issues” which lead to underperformance over time.
Currently, with the Equity Q-ratio pushing the 3rd highest level in history, investors should be very concerned about forward returns. However, with the technical trends currently “bullish,” equity exposure should remain near target levels for now.
That is until the trend changes.
When the next long-term technical “sell signal” is registered, investors should consider heeding the warnings.
Yes, even with this, you may still “leave the party” a little early.
But such is always better than getting trapped in rush for the exits when the cops arrive.
Emerging Markets: Acting Badly & Getting Cheaper
A version of this article originally appeared in Citywire.
Emerging market stocks have lost their luster for US investors in 2018. After gaining more than 35% in 2017, the MSCI Emerging Markets index dropped by 6.7% over the first two quarters of 2018. Investors have been spooked by president Trump threatening a tariff war and by rising interest rates in the US, causing the dollar to soar and squeezing emerging market countries and companies with dollar-denominated debt.
But should they abandon their allocations to emerging market stocks? At least two prominent investors I spoke to thought these assets were cheaper and more enticing than their US counterparts, but they advocated rather different approaches to the asset class.
Jeffrey Sherman, deputy CIO at DoubleLine Capital, felt that emerging market valuations were cheap, but he will wait for markets to stabilize before adding more exposure. ‘[Over the past month] the pain hasn’t really stopped,’ he said.
DoubleLine manages stock funds by applying the Shiller price/earnings ratio (price relative to the past decade’s real, average earnings) to market sectors and investing in the ones that are cheapest relative to their own histories. Many investors use the metric to gauge the relative value of country and regional markets. Although Sherman noted that the data doesn’t go back very far for emerging markets, he argued that the Shiller metric still has some validity with regard to them and currently shows that emerging market stocks are cheaper than their developed market counterparts.
Overall, Sherman did not foresee a 1994-style currency crisis crushing emerging market currencies and stocks. The next move for the dollar could well be down, and he noted that over the longer term, ‘the supply of bonds doesn’t look accretive for the dollar.’ When emerging market stocks stabilize, he will probably buy.
While Sherman waits to increase his exposure, Chris Brightman, CIO at Research Affiliates and co-manager of the Pimco All Asset and Pimco All Asset All Authority funds, has already placed his bets – and suffered mildly for it in the first half of 2018. Around 30% of the All Asset fund is in emerging market stocks, bonds and currencies, while the All Asset All Authority fund has around 40% in various emerging market assets. The funds closed the first half of the year down 2% (All Asset) and 3% (All Asset All Authority).
Brightman argued that emerging market countries are now healthier than they were during previous crises, and that their stocks are cheap. Since 2000, China’s real GDP per capita in purchasing power parity terms has jumped by 60%. India’s, South Korea’s and Taiwan’s have each grown by more than 20%, while Italy’s has contracted. Germany’s, Japan’s, the UK’s and the US’ have all grown by between 7% and 8%. Emerging market countries have also gradually increased their foreign exchange reserves.
This more certain financial footing means that emerging markets are not at risk of a funding crisis. Using Russia as an example (and without arguing for a major allocation to the country), Brightman suggested that, for all its political problems, ‘Russia does not need to borrow from abroad to finance its consumption and investments. It sells more in oil and gas to its European neighbors than it buys in goods from the rest of the world. With little external debt, ample foreign exchange reserves and a large current account surplus, the risk of a financial crisis is remote – especially with the price of oil hovering between $60 and $80 a barrel.’
Brightman agreed with Sherman that emerging market stocks trade at cheap valuation multiples. Before the 1997/1998 crisis, emerging market stocks were trading at higher cyclically adjusted price/earnings (Cape) multiples than US stocks, owing to high growth expectations for the former. Today though, ‘emerging market equities are priced at less than half of the US Cape… [and] they seem to provide fair compensation for their risks,’ he said.
A low Cape ratio doesn’t mean that emerging market stocks are poised to rally soon. But it does suggest that they will have delivered better returns than US stocks by the end of a decade.
It’s Okay To Hold Some Cash
The great sage and baseball legend, Yogi Berra, once said:
“It’s tough to make predictions – especially about the future.”
But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.
The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.
The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.
Hope for a correction? Move some money to cash?
Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.
Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.
Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)
If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.
These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.
A Recession Says Nothing About Future Stock Returns
(Thanks to Morningstar’s John Rekenthaler for including one of my emails to him in a column consisting of reader reponses while he tended to his wife who, as he reports, suffered a fainting spell. We wish both of them well, of course.)
Do we need a recession or another credit event similar to 2008 to tell us stocks are overpriced and cause them to tumble? John Rekenthaler of Morningstar seems to think so. I sent him an email in response to an article he wrote doubting the verdict of recent bubble-callers like GMO and Research Affiliates. I said stocks were objectively expensive (using the Shiller PE), and that meant future returns would likely be low.
But John thinks that a turn in the economic cycle will determine a downturn in the stock market, and tell us, after the fact, if stocks are overpriced. Since we don’t know when that will occur or what it will look like, we must remain agnostic as to the future returns of the stock market. As he responds to my email in a new article:
“One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today’s values should look reasonable.”
Unfortunately, while stock markets tend to tumble when the economy goes South, since the Great Depression there’s scant evidence that single recessions tell us anything about how stocks are priced or indicate anything about their future 10-year returns. For that all-important forecast, one must consult starting valuations more than recessions or moment in the economic cycle.
Consider the 50% decline the S&P 500 Index suffered from 2000 through most of 2002. The recession in 2000 was minor. In fact, it didn’t’ even meet the standard definition of two straight quarters of GDP contraction. GDP contracted in the second quarter of 2000, then again in the fourth quarter of that year, and never again.
Did that recession warrant a 50% price reduction in stocks? Did it somehow prove that stocks were overpriced? Or were stocks just wildly overpriced to begin with, as the Shiller PE hit 44 in early 2000?
The point isn’t that we may or may not have a recession over the next 2, 3 or 5 years. The point is stocks are at a Shiller PE seen only twice before in history – 1929 and the run-up to 2000. Come recession or not, over the next decade investors in the S&P 500 will capture a 2% dividend yield. They may also capture 4%-5% earnings-per-share growth. That puts nominal returns at 6%-7%, which isn’t bad at all. Unfortunately, the third component of future returns consists of where the future PE ratio will sit. Will the Shiller PE maintain itself above 30? Or will it contract to something resembling the historical average of nearly 17? Even if that average is outdated, is the new norm 32? Or is it more like 20 or 22?
Whether a recession comes within the next 5 years or not has little to do with these questions. And though it may send stocks down for most of its duration, it ultimately will have told us nothing about longer term returns compared to how much starting valuation can tell us. In fact, the two features of the Shiller PE are that it’s based on a prior decade’s worth of earnings and is pretty good at forecasting the next decade’s worth of returns. It’s not based on short-term earnings, and it’s not good at forecasting short-term stock returns. A recession doesn’t matter one whit insofar as it’s a typical part of a full cycle that the Shiller PE aims to capture in its earnings calculation and in its stock return forecast.
It’s possible we might wake up in a decade to a 32 Shiller PE. And it may have remained there all along, or it may have arrived there again as the result of any number of gyrations. The question is what should financial writers be telling their readers (and financial advisers telling their clients) about that possibility?
Shiller’s CAPE – Is There A Better Measure?
In “Part 1” of this series, I discussed at length whether Dr. Robert Shiller’s 10-year cyclically adjusted price-earnings ratio was indeed just “B.S.” The primary message, of course, was simply:
“Valuation measures are simply just that – a measure of current valuation. If you ‘overpay’ for something today, the future net return will be lower than if you had paid a discount for it.
Valuation models are not, and were never meant to be, ‘market timing indicators.'”
With that said, in this missive I want to address some of the current, and valid, arguments against a long term smoothed price/earnings model:
Beginning in 2009, FASB Rule 157 was “temporarily” repealed in order to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars of assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.
The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.
Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I addressed this issue specifically in this past weekend’s newsletter:
“What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 221%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 28% during the same period.”
The use of share buybacks improves underlying earnings per share which also distorts long-term valuation metrics. AstheWSJ article stated:
“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.
Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”
This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.
“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.
What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“
As shown, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.
The extensive interventions by Central Banks globally are also contributing to the distortion of markets.
Due to these extensive changes to the financial markets since the turn of the century, I do not completely disagree with the argument that using a 10-year average to smooth earnings volatility may be too long of a period.
Think about it this way. When constructing a portfolio that contains fixed income one of the most important risks to consider is a “duration mismatch.” For example, let’s assume an individual buys a 20-year bond, but needs the money in 10-years. Since the purpose of owning a bond was capital preservation and income, the duration mismatch leads to a potential loss of capital if interest rates have risen at the time the bond is sold 10-years prior to maturity.
One could reasonably argue, due to the “speed of movement” in the financial markets, a shortening of business cycles, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.
The first chart below shows the annual P/E ratio versus the inflation-adjusted (real) S&P 500 index.
Importantly, you will notice that during secular bear market periods (green shaded areas) the overall trend of P/E ratios is declining. This “valuation compression” is a function of the overall business cycle as “over-valuation” levels are “mean reverted” over time. You will also notice that market prices are generally “sideways” trending during these periods with increased volatility.
You can also see the vastly increased valuation swings since the turn of the century, which is one of the primary arguments against Dr. Shiller’s 10-Year CAPE ratio.
Introducing The CAPE-5 Ratio
The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s periods of “valuation expansion” are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of “valuation compression” returns are much more muted and volatile.
Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.
There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.
A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The recent decline in the CAPE-5, which was directly related to the collapse and recovery in oil prices, has so far been an outlier event. However, complacency “this time is different,” will likely be misplaced as the corrective trend currently remains intact.
To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average. The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.
The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.
Currently, the 56.97% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed five (5) other times in history. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the five previous periods, you can clearly see that the eventual results were much less optimal.
However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.
Again, as with the long-term view above, the current deviation is 44.19% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed three times previously over the last 70 years in 1996, 2005 and 2013. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.
Is this a better measure than Shiller’s CAPE-10 ratio?
Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.
Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.
Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past eight years. Therefore,if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.
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