February 12, 2021
By Steve Blumenthal
“Trying to figure out if the economy is in recession is like trying to assess
if you had a fever after you just took a large dose of aspirin…
But as with frogs in water that is slowly being heated to a boil,
investors are being conditioned not to recognize the danger.”
– Seth Klarman,
Chief Executive and Portfolio Manager,
Baupost Group (Financial Times)
You’re probably familiar with the purpose of a lighthouse: to warn or guide ships at sea, via its beacon light. I think valuations can serve a similar purpose, warning and guiding our investment ships.
The market peaks this week, then gets choppy. So says my mind and all the value sensors I’ve employed… and so says the data. Valuations are at record extremes, investors are concentrated in the same few stocks, and euphoria is ringing the bell. Easy to see, says my mind and my gut. The reality is timing is unknown.
Each month, I review valuation data just to keep my footing and set targets. You’ll see that, again this month, what was overvalued has grown to be more overvalued. When should we get more aggressive with the stock market?
Target #1: 2,700 on the S&P 500 Index
Target #2: 2,054 on the S&P 500 Index
This week, my goal is to show you a visual picture of what that looks like. Ultimately, you decide what’s best for you.
Median Price-to-Earnings Ratio
How did I come up with these targets? Let’s take a quick look at where we sit today and start with my favorite valuation chart – Ned Davis Research’s Median Price-to-Earnings Ratio.
P/E is the most commonly used stock valuation ratio. It allows investors to quickly gauge the valuation of a company based on its current reported earnings. When looking at the S&P 500 Index, the median P/E is the one for which exactly half of all stocks have higher ratios and half have lower ratios.
The theory is pretty simple: If what you buy is expense, you get less for your money. If it’s inexpensive, you get more for your money. Warren Buffett compares buying stocks to buying hamburgers. When the price of hamburger meat goes down, you can buy a lot more for your money. Same with investing. Lower prices, higher future return. Higher prices, lower future return.
I like median P/E because it is based on the last 12 months of reported earnings and not some Wall Street forward estimate (though you’ll see that measure of P/E is also very high). Looking at actual data and comparing it to history shows us exactly what Buffett is talking about. We can then see the potential for future returns and set some realistic targets so we can tune out the noise and have a better sense of when to play more offense (overweight stocks) or more defense (underweight stocks).
Here is how to read the median P/E chart:
- Note the red “we are here” arrow as of 1-31-2021. The current reading of 31.2 puts median P/E well into the “very overvalued” zone.
- NDR plots a 56.9-year history of each month-end median P/E back to 1964.
- The orange line charts that 56.9-year history.
- NDR then plots zones that range from “very overvalued” to “bargains.”
- The zones are based on something called standard deviation or “SD.” The simple translation is the further the data is from the mean, the higher the deviation from the data set. Extreme deviations from what I’d call fair value (that 56.9-year median P/E of 17.3) are rare. You can see just how extreme the current deviation is from the norm. We are nearing a 3 SD move.
- What I really like about this chart is the data at the bottom. It plots precisely how far the S&P 500 needs to drop to get back to the “overvalued” zone, to “fair value, to “undervalued,” and to “bargains.” Think about how that can help you know when to buy.
Is a -27.3% to 2700.25 in the cards? Highly likely. It will take a -44.7% decline just to get back to the 56.9-year median P/E of 17.3 or 2053.97. Let’s call that “fair value.” Probable? Yes. A -62.1% decline to 1407.70? A long shot, but we can’t rule it out.
Here are a few sample dates to give you a feel for what happened 10 years later based on median P/E (I share this in my book, On My Radar: Navigating Stock Market Cycles):
Green circles are low P/Es, red circles are high P/Es. Green is good, red is bad…
We actually have the data sorted into quintiles. Think of it as a ranking of all month-end median P/Es dating back to 1964. Quintile 1 reflected the lowest 20% of all median P/E readings and quintile 5 the highest 20% of all month-end median P/Es. Next, the analysis plotted the all the actual subsequent 10-year returns from each month-end median P/E to see what the actual returns turned out to be. Then, the analysis looked at the median 10-year returns by each category.
Bottom line: Essentially, Buffett is right.
Valuations are not perfect. It’s the extremes that are concerning: Extreme leverage, extreme valuations, and extreme euphoria.
What do you do about it?
If you are a pre-retiree or retiree, keep this insight from Leon Cooperman top of mind: “When I started in the business in 1967, the DJIA was at 1000 and it was at 1000 nearly 15 years later. I’m not in the business of making long-term predictions, but I do believe we are in for a long period ahead where the major averages make little progress.” It is possible the next 10 to 15 years may mirror the 1966 to 1982 period—a period in which the U.S. and the world experienced inflation pressures that haven’t been seen since.
If you are younger and “buy and hold” index funds, even if the next 10 to 15 years prove to be a return dud, I believe you will do well in the long run—assuming you dollar-cost average (which takes advantage of the sell-offs) and hold on for the ride.
In the last ten years, all you had to do was buy an index fund. In the next ten years, I think risk management, a focus on value, and stock selection are critical. There are transformational opportunities in battery technology that powers cars and homes, AI and deep learning, genomics and gene therapies, advances in health care, and biotech gene editing in agriculture that reduces the need for application of chemicals and overall carbon footprint (better for the plant, the earth, and the human).
Index funds and strategies that track them hold most of the money. Further, most are cap-weighted, which I argue is not the best structure. This is because it forces the funds to overweight to the best-performing stocks. Think of it like dollar-cost averaging up. The higher it goes, the more stock the fund is required to buy. Thus, the overconcentration problem we have today––you can quickly name the six stocks.
Side note: I’ve promised you a podcast on option hedging. Many investors have stock positions with low-cost bases that, if sold, will incur a large capital gains tax. The long-term capital gains tax rates are 0 percent, 15 percent, and 20 percent, depending on your income. These rates are typically much lower than the ordinary income tax rate. Under President Biden, they will most likely go up. Option hedging is an effective risk management alternative to selling. The podcast will be recorded next week and I’ll share the link in next week’s OMR. Stay tuned.
It’s not just Median P/E.
Next up is a valuation dashboard.
Here is how to read the chart:
- Red is bad.
The High-Yield Junk Bond Market – Keep HY Price Activity at the Top of Your Signal List
One last and important beacon light to warn and guide our ship is the high-yield junk bond market. Yes, junk bonds. The CMG Managed High Yield Bond Program is a strategy I’ve been trading and guided by for nearly 30 years, and the HY market has always cracked first (though no guarantees next time). Our current signal is risk-on.
But there’s a whisper in my ear that this time really is different than the last three major breaks. The current yield hit sits at a record low of 4.10%, as of yesterday. And the quality collateral investors get has never been worse.
Here’s how to read the chart:
- Take a look at just how high the yield spiked in late 2008 to early 2009… 22%!
- And I thought the 13% yields in 2001-02 was an exceptional buy opportunity (which it was).
- The current yield, as of February 10, 2021, is 4.10%. Not a lot of hamburger meat for the money.
Just how junky is the junk? Moody’s has an indicator that scores the quality of covenant protection. The range is from 1 to 5. 1 is good; 5 is bad. It was above 4 at the end of Q3 2020. It’s likely higher today.
What that means is simple: In the next credit default cycle, there won’t be enough collateral protection. Junk bond holders will get little recovery from the companies that fail. In past periods, it was normal to expect a 40% price decline. This time around, I estimate -60% to -70%. Think about how great that opportunity will be if one gets there with money preserved.
Unless the government invents a “Make America’s Junk Bond Great Again” program, the next debt crisis will see yields above 30%. Not a typo… I could be wrong. I think I’m right. Time will tell.
Each week, I share our signal with you in the Trade Signals section (link below). It is currently a buy signal.
I’ll conclude today’s missive with this quote from Jeremy Grantham, GMO Co-Founder and Chief Investment Strategist: “You can’t maintain this level of near ecstasy. It can’t be done, because you’ve put in your last dollar. You are all in. What are you supposed to do beyond that point? You can’t borrow any more money. You can’t take any more risk.”
Grab a coffee and find your favorite chair. If you have some extra time this weekend, plug in and take a walk and listen to two outstanding interviews. The first is Danielle DiMartino Booth’s discussion with William White. I’ve written about William in OMR before. He headed the Bank for International Settlements – the central bankers’ central bank. He is extremely critical of recent and current policy. Frankly, this is one of the best discussions on how this debt and underfunded pension mess is likely to play out.
The second is Bloomberg’s Eric Schatzker’s interview with Jeremy Grantham. Buckle up and keep your risk breaks in place. After you finish your walk, grab a cold beer, a glass of wine, or break out the bourbon and throw one back. I see an ice-cold IPA in my immediate future.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Danielle DiMartino Booth – William White Interview
- Why Grantham Says the Next Crash Will Rival 1929, 2000 (Bloomberg Exclusive Interview)
- Trade Signals – Falling Dollar is Inflationary
- Personal Note – Smile and Dance!
January 22, 2021 — Jeremy Grantham, co-founder and chief investment strategist of Boston’s GMO, believes U.S. stocks have become an epic bubble and will burst in a collapse rivaling the crashes of 1929 and 2000. In this interview, he explains why, discusses the futility of Federal Reserve policy, criticizes the state of American capitalism, and shares his thoughts on gold, Bitcoin, emerging markets and climate change. He spoke exclusively to Erik Schatzker on Bloomberg’s “Front Row.”
Via YouTube – 1.78 million views (wow)
February 10, 2021
S&P 500 Index — 3,900 (close)
Notable this week:
One of my favorite Inflation Indicators is signaling “High Inflationary Pressures.”
From Ned Davis Research, “The model consists of 22 individual indicators primarily measuring various rates of change of such indicators as commodity prices, the Consumer Price Index (CPI), producer prices, and industrial production.”
- Focus on the light blue line in the bottom section of the chart. Current reading as of 12-31-21 is 11. A reading above 10 signals High Inflationary Pressures.
- High Inflationary Pressures have occured 22.50% of the time since 1962.
- The DJIA performs worst when inflation pressures are high, losing -5.03% annualized.
It is important to note that the above indicator is a cyclical (intermediate-term) indicator and not a secular (long-term) indicator.
One last thing: a Falling Dollar is Inflationary.
- As of 1-31-21, the current signal is in the Falling Dollar Inflationary zone (light blue line – lower section).
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
This really made my day. It’s 13 seconds of pure joy. Click below, and I hope you enjoy it as much as I did (h/t to my wife Susan for sharing the tweet).
Stay safe, stay healthy and “Smile and Dance!”
Wishing you a great week.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Consider buying my newly published Forbes Book, described as follows:
With On My Radar, Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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