Tag Archives: Stock Market Valuation

Does $97,000 Matter To You?

The S&P 500, including dividends, has produced a meager 4.86% annualized return for the 19-year period since 2000. That return has beaten inflation, but I call it meager because it’s not the 10% or so that many stock brokers, financial advisors, and market historians have taught much of the public to expect for such a long period of time. The return is way below the market’s long term average, even if our starting point is a bit arbitrary and convenient (the start of the technology stock meltdown).

But there is another lesson from the past 19 years besides subpar annualized returns. Those returns are radically bifurcated or back-loaded. In other words, they have accumulated recently or in the second half of the nearly two-decade period, not the first. And that means people in the age range of, say, 45-55, who have been investing by contributing steadily to work-sponsored savings plans like 401(k)s and 403(b)s for the past couple of decades, have been the beneficiaries of an amazing sequence of returns. It also means they may be unprepared for a less beneficial sequence in the future.

A way to illustrate this point is to compare a $95,000 lump sum investment in the S&P 500 TR Index in 2000 to a series of 19 $5,000 annual investments from 2000 through 2018. Amazingly, the final dollar value of the periodic investments nearly equals the dollar value of the initial large lump sum.

If the compounding is steady a large lump sum should outstrip periodic contributions because only a few of the contributions are getting the benefit of compounding for a long time. Only if the compounding is completely lop-sided, with positive returns occurring overwhelmingly in later years (which is what has happened), should these investments be nearly at the same dollar level. Another way of saying this is that, assuming reasonably even compounding, you should always want to invest a large lump sum immediately rather than dribble money into an investment over time. But the sequence of compounding over the last two decades has been anything but even or steady.

Volatility doesn’t matter for a one-time, lump sum investment. It makes no difference to the final amount when, over the investment period, the returns arrive; the annualized return will tell you what you have at the end. But when you get the returns matters a lot in cases of periodic contributions or withdrawals. When you’re saving periodically, you want the big returns, if possible, after you’ve accumulated some money. And you’d like to get the inevitable bad years out of the way in the beginning of a periodic saving or investment period when you don’t have a lot invested. That’s exactly how it’s worked out for middle aged people today who have been lucky enough to work steadily and earn enough to save periodically for the past two decades. The bad years came early when very little was at stake, and the good years came much later when much more was at stake.

To illustrate the importance of sequence of returns further, the chart below repeats the first chart with an additional line showing contributions made in reverse chronological order (2018-2000). Clearly, getting the big returns in the beginning, and poor returns at the end of a contribution period matters a lot for the final result. In the reverse chronological order scenario, the amount of final savings decreased roughly $97,000 (or 43%), from around $221,000 to around $124,000.

If investors were also able to ramp up their savings in the second decade, when returns were much higher, that’s worked out even worse for them in the reverse chronological scenario and better for them in the chronological scenario. Of course, it could also work out badly in the future if the larger contributions are buying stocks that, in retrospect, look like they might have been overpriced. Time will tell.

Last, it’s likely that those doing periodic investing haven’t realized how lucky they are in taking their lumps early and reaping benefits later. The poor overall or annualized return of the market over the full 19 years is less apparent to them. It also might not be apparent to them how quickly their luck can change, and that losses would matter a lot now that they have much more money saved. The poor returns of their early investing years could re-materialize, and that would be much worse for them now than it was when they first started saving money.

Target date funds might provide some protection to middle-aged investors in that they are surely less allocated to stocks for someone who’s 45, 50, or 55 than they were when the person was 25 or 30. But are they as conservative as they should be given today’s valuations, which the boffo returns of the past decade have produced?

Many financial pundits and advisors say you should just try to control the things you can. As an investor, that means the rate of savings, fees, and little else. You can’t know what your sequence of returns might be, according to the conventional advice. Sometimes you’ll get lucky, and sometimes you won’t; either way, just keep investing in an allocation driven by age and distance to retirement. Maybe that’s true in the end, but if you’re not wondering about how lucky the past long sequence has been for middle-aged savers and whether the next one will be as favorable to them, now that they have more at stake than they did 15-20 years ago, you might not be thinking hard enough. Even if you make no moves in your portfolio or investment strategy, you should probably be girding yourself emotionally for a less benign environment.

Are Stock Multiples Moving Targets?

Many observers dismiss, or at least question, the market’s rise since around 2013 as mere “multiple expansion.” That means the prices of stocks have risen disproportionately to underlying earnings, and either prices must decline or earnings must catch up in order to return to some normal or historically average PE multiple.

In a recent blog post, serving as the latest installment of “stockbroker economics,” Barry Ritholtz argues that all bull markets involve multiple expansion. (We accept Andrew Smithers’ definition of stockbroker economics – 1. All news is good news. 2. It’s always a good time to buy stocks.)

Using a chart from Mark Lehmann at UBS, Ritholtz asserts that all bull markets consist of rising PE multiples. The chart also shows PE rising overall in recent decades. The implication (it’s not really a fully formed argument) is that those who distrust the market rally of recent years as mere multiple expansion don’t realize that all bull markets involve multiple expansion.

There’s multiple expansion and there’s multiple expansion

It seems reasonable and not that surprising that all bull markets involve multiple expansion. But what would make Rittholtz’s post more complete is if it asked what kind of expansion is reasonable and what kind isn’t. For example, using the Shiller version of the market multiple, is the PE moving from single digits, or from 10 to 20? Or is it moving from 20 to 30? Or is it moving to 44 as it did in the late 1990s? Investors should want to know that, but Ritholtz doesn’t mention it.

Perhaps Ritholtz thinks all prices are “random walks” and that nobody can say what is a reasonable price to pay for stocks and what isn’t. But he doesn’t say that, and the reader is left wondering what he thinks about that important question. Does the market get prices right, and deliver inflation-beating returns to long term investors over, say, every 10-year period? We don’t know from reading the post.

What about the upward trend of PE ratios from the 1980s? Is that justified or not? It is possible to comment or make an argument about that. After all, investors like Rob Arnott and Jeremy Grantham, who organize the portfolios they manage around valuation have implied recently that it might be too rigid to treat historical averages as immutable. But we don’t know what Ritholtz thinks. All we know is that Ritholtz doesn’t make an argument. He only gestures in this direction.

When reading Ritholtz’s post, one is reminded of the ancient Greek philosopher, Cratylus, who thought language was inadequate to describe reality. Appropriately, Cratylus wound up moving his finger instead of speaking. I don’t know what Cratylus would say — or motion — about a Shiller PE of 32. Cratylus was a student of Heraclitus who thought the world was always in flux and that nobody could “walk into the same river twice.” According to Aristotle, Cratylus said you can’t even walk into it once. Maybe there’s a new normal, or even an ever-changing normal, for stock multiples, but advisors should think hard if they’re going to bet on that with clients’ money.

If you think your advisor isn’t assessing risks adequately, please click the link above to schedule an appointment and tell us which article drove you the link.

Don’t Be A Victim of Recency Bias

Is it possible that stocks aren’t overpriced? Financial adviser Josh Brown raises the possibility, arguing that earnings can grow into their prices. After all, Amazon, Netflix, and Nvidia have seemed overpriced to investors for a long time, but their economic performance keeps improving. As Brown puts it, with all of these stocks in the recent past, “[t]he fundamental stories grew up to justify the valuations investors had already been paying (Brown’s emphasis).”

And this can also happen to entire markets. Five years ago, the market’s cyclically adjusted P/E ratio (CAPE or Shiller PE) was higher than it had been in 87% of all readings up until that point. But the stock market has been up 90% since then. “No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually,” according to Brown.

This last statement is odd. In May of 2013, the S&P 500 carried a CAPE of 23. Now its CAPE is 31. It’s not clear from this simple valuation metric that stock earnings have grown into their new, elevated prices. Past ten-years’ worth of earnings ending in 2013 were $78, according to Robert Shiller’s data. For the most recent ten-year period, they are $84. Ironically, one could make the argument that earnings have grown into the 2013 price five years later, but not the 2018 price. It we apply the May 2013 price to the past decade’s worth of earnings ending today, we get a CAPE of around 21. That’s much more reasonable than the current one of 31.

In fact, if we agree that the long-term historical average CAPE of nearly 17 is outdated, and that the new average should be around 20 or 22, then the 2013 price of the market relative to the past decade’s worth of earnings ending today is roughly the correct valuation. That also means all the price advances the market has made since 2013 do not reflect underlying economic reality or earnings power value of the market. In other words, earnings have increased, but stock prices have increased much more so that the market should be trading at 2013 prices given the past decade’s worth of earnings.

Brown’s point, of course, is that the earnings growth of the past decade can repeat over the following decade. But that also means that for stocks to deliver robust returns, the current 31 CAPE valuation must reappear 10 years from now. That’s possible, but investors and advisers must contemplate how they would like to bet and what they must tell clients if they are behaving as fiduciaries.

It’s possible that we could wake up to a 31 CAPE in a decade, and that U.S. stocks will have delivered 7% or so nominal returns (2% dividend yield plus 4%-5% EPS growth). It’s also possible that earnings-per-share can increase at a greater clip than they have historically. Nobody should say those things are simply impossible. But if you are managing your own money, or advising others in a fiduciary capacity (which means you must treat their money with all the care you do your own), how reasonable is it to expect that as what forecasters might call a “base case?” At best, assuming we’ll all wake up to a 31 CAPE in a decade must be a very rosy, low-probability scenario.

There’s an irony to Brown warning against those who carry on about backward looking valuation metrics. One of the most well-known observations of behavioral finance is that human beings can be seduced by recent patterns, including recent securities price movements. We tend to assume, without any evidence other than the recent pattern, that price trends will continue. Everyone will have to decide for themselves whether deriving encouragement from a 90% stock price move without a commensurate earnings increase, as Brown does, reflects proper attention to simple arithmetic or our susceptibility to extrapolate recent stock price movements and returns into the future.

Divorced From Reality: Prices & Fundamentals

There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are likely the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently long periods of time.

But those metrics do have a good record of forecasting future long-term (one decade or more) returns. And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must plug in an estimated return into a formula for retirement savings. And if an advisor is plugging in a 7% or so return for a balanced portfolio currently, he or she is likely not doing their job well. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17.

Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at a particular earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

So I created a chart showing sales per share growth and price per share growth of the S&P 500 dating back to the end of 2008. From the beginning of 2009 through the end of 2016, companies in the index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8 year period, sales grew less than 50% cumulatively, while share prices tripled.

Anyone invested in stocks should worry about this chart. How do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class.

And yet, the decline in rates over the past four decades has been breathtaking, as has Federal Reserve intervention. James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was.

If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced, but think they can be the first ones out when the inevitable decline begins.