April 7, 2023
By Steve Blumenthal
“If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.”
– Charlie Munger
“The stock market is a device for transferring money from the impatient to the patient.”
– Warren Buffett
In both this week’s and next week’s OMRs, I’ll share several equity market valuation metrics. Importantly, we’ll be looking into what the data tells us in terms of coming 3-, 5-, 7-, 9-, 10-, and 12-year annualized returns.
“… a devise for transferring money from the impatient to the patient.” For all investors, especially pre-retirees and retirees, this is extremely important. This week’s post provides a wealth of tools to help you know where we are in the current market cycle and some guidance to better know when and at what level opportunities are best. It will be up to you to “pounce on them with vigor.”
With the latest revised data for Q4 2022 Gross Domestic Product and the first estimate out for Q1 2023 GDP, let’s begin today’s market valuation missive with a look at the popular “Buffett Indicator”, a long-term valuation indicator for stocks made popular by the great Warren Buffett.
In 2001, Buffett remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.” It is a measure of the total market value of all publicly-traded stocks in a country divided by the country’s GDP. It can be used as a way to assess whether the country’s stock market is undervalued, fair-valued, or overvalued. Source: AdvisorPerspectives
A quick look at the historical data shows valuations are much better than at the top of the Fed-driven mania peak in December 2021. Zero interest rates and massive QE drove everyone to buy equities. Remember the popular phrase; “There Is No Alternative” or TINA. Thirteen years of zero interest rates drove everyone into stocks and drove The Buffett Indicator to an insane high of 211.1% (you see in the following chart).
Today, the picture is improving. The March 31, 2023 reading of 151.8% is well off the record high; however, compared to the 2000 Tech Bubble peak of 159.2% and the Great Financial Crisis peak of approximately 120%, levels remain historically high. Take a quick glance at the purple line in the chart – data back to the 1950s, and you are likely to come to the same conclusion I did, now is the right time. Factor into the equation that Powell has aggressively hiked the Fed Funds rate to 5% and money market funds now yielding 4.75%; it’s evident to everyone that no one is talking about TINA anymore – there are indeed alternatives.
Where might that better entry target be?
I suggest it is somewhere under the red regression line, with an opportunity between the “Great Financial Crisis” low of 66.5% and 100%. Most didn’t see the opportunity at the GFC low. Fear ruled reason. We’ll all feel that same way the next time. That is when the opportunity will be best.
Grab a coffee and find your favorite chair. Let’s look at the data and set some targets. You’ll find more on valuations and, importantly, what they tell us about coming 3-, 5-, 7-, 10-, and 12-year expected returns.
“… It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles, and when opportunities came along, you pounced on them with vigor.” – Charlie Munger.
I like the quarterly valuation update review as it gives us a good sense of knowing when to pounce. I hope you find it helpful as well.
Also, I had a chance to speak with my good friend Barry Habib this week, and he shared his thoughts on housing (video link below). I then listened to his presentation on ChatGPT. You and I are going to use it in a very big way. It really is an iPhone-like moment—more in future letters.
Each week’s OMR is broken into sections. Feel free to read them one at a time or all in one sitting. Here are this week’s sections:
- Valuations and Coming 3-, 5-, 7-, 10-, and 12-year Expected Returns
- Barry Habib – Bullish on Housing
- IMF confirms “Daisey Chain” QE of foreign bonds
- Random Tweets
- Trade Signals: Buy Signals on Bonds, Oil, and Gold, April 5, 2023
- Personal Note: Belated Happy Passover, Happy Easter, and the Masters
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
Valuations and Coming 3-, 5-, 7-, 10-, and 12-year Expected Returns
I want to begin this valuation section with the following statement: Our investment approach does not rely on cap-weighted stock market indices like the S&P 500 Index to grow wealth. Alternative ideas include niche short-term well-collateralized senior secure private credit yielding in the high single digits to mid-double digits, other forms of specialty lending, multi-family housing, long-short trading strategies, agriculture, farmland, and select commodities, including gold and oil. There is much you can do; I don’t believe now is an opportune time for traditional buy-and-hold cap-weighted equity funds.
We are focused on current valuations primarily because they tell us a great deal about coming expected returns, and they tell us a great deal about risk relative to reward. We look at market internals to help us navigate shorter-term cycles (see Trade Signals below).
Summary of popular valuation metrics
- Bottom line: Red is bad, and Green is good.
- There is No green here.
Shiller PE – 29.27 April 6, 2023
- First, note the current level and view it relative to the data back to 1870
- Next, compare vs. other valuation extremes like 1929, 1966, 2000, and 2008
- We’ll then look at what the current level is telling us about likely coming returns
- Note: I update this chart each week in Trade Signals along with various other short-term and intermediate-term market indicators.
S&P 500 Index Total Return By Decile
What this means in terms of actual 10-year Annualized Returns (most expensive 10% of all readings = DECILE 1 (highest PEs), to least expensive 10% of all readings DECILE 10 (lowest PEs). Data 1909 to 2022):
- Bottom line: The red “We are here” arrow points to the current state. The best subsequent 10-year total annualized return was 3.6%, the worst was -1.8%, and the average of all DECILE 1 PE readings was 1.3%
- 1.3% is a reasonable guesstimate to what the next 10-year annualized returns may look like.
- Note the “We’d be better off here” green arrow. With Shiller PE at 29.27, a good target is to wait until it drops to the 15 to 17 range.
Stock Market Capitalization as a Percentage of Nominal Gross Domestic Income
We looked at the Buffett Indicator earlier. This next chart looks at Stock Market Cap to Nominal Gross Domestic Income. What I like about how NDR sorted the data here is showing the subsequent 1-, 3-, 5-, 7-, 9-, and 11-year average % change in the S&P 500 index based on “Top Quintile” of most expensive readings vs. “Bottom Quintile” of least expensive readings.
- We sit in the top quintile (Red “We are here” arrows).
- Note the negative annualized returns that have occurred, 1 year later to 11 years later, when in the most overvalued zone over the coming years.
- The green “We’d be better off below the long-term trend line” arrow sets a target for you to keep in mind.
- Anywhere in the “Bottom Quintile” zone located in the bottom section of the chart, like what occurred in 2009, would be excellent.
S&P 500 Monthly MACD Indicator
- The downside target is 3,000 to 3,200
- My personal view, and I could be wrong, is the Fed will Pivot at that point.
- If not, 2,200 is the next probable technical support area.
GMO’s 7-Year Asset Class Real Return Forecasts
- -1.1% annualized real return forecast for U.S. Large cap stocks, -1.4% for U.S. Small cap stocks
- below historical average returns for International Developed market stocks
- The best return forecast is for Emerging Market Value stocks
- Bonds remain unattractive
Hussman’s Edge of the Edge post:
He looks at the present state, probable 12-year coming annualized returns (negative), and downside risk targets:
- He is forecasting a negative annualized total return of approximately -1% over the coming 12 years.
- A market loss of -51%, to the 1900 level on the S&P 500, would presently be required to restore a historically normal 5% expected return premium above Treasury bonds (an 8.4% expected nominal total return).
“With regard to current financial market conditions, several updated charts will help to explain why we continue to estimate the potential for severe downside market risk. The green line in the chart below shows the level of the S&P 500 that we associate with run-of-the-mill expected returns averaging 10% annually. The blue dotted line is the level we associate with a historically run-of-the-mill 5% premium over-and-above Treasury yields, and the orange dotted line shows the level of the S&P 500 that we associate with 10-year expected returns no better than those of 10-year Treasury bonds. The yellow bubbles show periods when our 10-year estimate for S&P 500 total returns was below the prevailing 10-year Treasury bond yield.
We presently estimate that a market loss of -26%, to the 2900 level on the S&P 500, would presently be required simply to restore expected S&P 500 total returns to 3.4%, the present yield of 10-year Treasury bonds. A market loss of -51%, to the 1900 level on the S&P 500, would presently be required to restore a historically normal 5% expected return premium above Treasury bonds (an 8.4% expected nominal total return). Finally, a market loss of -58%, to the 1650 level on the S&P 500, would presently be required to restore historically run-of-the-mill expected returns of 10% annually.”
“Notice that the S&P 500 has typically been above the green 10% line since 1995. It’s tempting to believe that the market should hug these valuation estimates. But that’s not how valuations work. Valuations only describe the mapping between prices and subsequent returns. Overvaluation doesn’t imply an immediate market decline. It implies lower long-term returns and deeper full-cycle loss. Our most reliable valuation measures have a strikingly good history of estimating both.
The distance between the S&P 500 and the green line in the chart above is proportional to our most reliable valuation measure: nonfinancial market capitalization to gross-value added, including estimated foreign revenues. Here’s how this valuation measure maps to subsequent market returns, in data since 1928. For an extensive discussion and analysis of factors that investors use to “justify” current valuations, including profit margins, interest rates, S&P 500 composition, growth, FANG stocks, and other factors, see the February market comment, Headed for the Tail.”
- SB here: Note the 03/17/23 arrow pointing to the current forecast of ~ -1% annualized returns for the coming 12-years. Meaning a $1 million investment in the S&P 500 Index will be worth approximately $886,000 in March 2035.
- Before inflation is factored in!
- How about that for a retirement investment game plan?
Let’s conclude this section with a look at the potential downside. I thought this next chart to be particularly clever.
- The blue line in the following chart is the level the S&P 500 Index would need to decline to produce an expected annualized market return of 10% per year.
- The red plots the actual percentage loss of the S&P 500 Index over the subsequent 3-year period.
- Not perfect, of course, but with a high historical correlation.
- The current state of play – Hussman is forecasting a 58% decline in the S&P 500 Index to get to that really good 10% annualized return opportunity.
Finally, I beg to differ with Hussman.
One of my favorite valuation charts (that sets reasonable price targets) is NDR’s Median PE.
Here’s how to read the chart:
- Focus on the orange line in the center section, then on the data box in the bottom section
- Median PE is the PE of the stock in the middle of all the stocks that make up the S&P 500 index. This, to me, makes sense as it tends to filter out the account manipulations companies often play. Also, I don’t like Forward PE valuation metrics (what you see Wall Street promoting) because those estimates tend always to be way too optimistic, only to be later adjusted lower.
- The Median PE as of 3-31-23 is 24.2. That puts it in the “Overvalued” zone. Better than December 2021 but still high historically, as you can see viewing the orange line.
- Fair Value, based on the last 59.1 years, is a Median PE of 17.6.
- Based on March 31, 2023, S&P 500 closing level of 4,109.31, a 27.4% correction is needed to get to “Fair Value.” That’s a much better entry target.
- A market correction (let’s call it a crash) would take the market down 50.8% to 2,021.78. That would present a great “Bargain” to investors and can’t be ruled out.
- Reflecting back on the S&P 500 Monthly MACD indicator chart shared above, the Median Fair Value target of 2,983.36 fits pretty nicely with the downside target I presented in that chart.
I hope this gives you a high-level summary of the current state of valuations and what they tell us about probable coming returns. More importantly, I hope it helps you channel your inner Warren Buffett and Charlie Munger and set some targets to get ready to “pounce with vigor,” as Munger suggested.
Barry Habib – Bullish on Housing
Highlights: Remains bullish on housing, inflation is coming down, interest rates are coming down, and recession is near.
Click on the photo to watch Barry and his team’s update from earlier this week.
IMF confirms “Daisey Chain” QE of foreign bonds
No Random Tweets this week. Let’s keep the focus on valuations and future returns.
More Random Tweets next week. Follow me @SBlumenthalCMG.
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Trade Signals: Buy Signals on Bonds, Oil, and Gold, April 5, 2023
What a fantastic trade it has been for bonds… the trend remains bullish, signaling lower bond yields and higher bond prices. Gold has had an excellent move as well. And this week, I am adding Brent crude oil to the dashboard. You will notice the recent intermediate-term MACD buy signal in oil.
As for stocks, the S&P 500 Index Daily MACD signal remains bullish for the third week. You will see in the following chart that the S&P 500 Index has rallied to the 4,100 – 4,200 resistance zone (yellow). That, combined with the Daily Investor Sentiment reaching the “Extreme Optimism” zone, suggests caution.
With investors back in an extremely optimistic mood and the market bumping against resistance, it may be an opportune time to book profits.
Recession remains a high probability by Fall 2023. The downside target remains in the 3,000 to 3,200 area (see the monthly S&P 500 chart in the Primary Equity Market Indicators Section below).
If you are a subscriber, click below to log in to view the valuation data and market indicators dashboard. Please email me at email@example.com if you’d like a sample of this week’s Trade Signals or have any questions.
About Trade Signals
Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. We provide a summary of technical indicators to help you identify where we sit in short, intermediate, and long-term cycles. We track important valuation metrics to determine the probability of future returns (i.e. when return opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. Trade Signals is now a low-cost subscription service, about the cost of two Starbucks lattes every month. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.
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Personal Note: Belated Happy Passover, Happy Easter, and the Masters
With a heavy heart, I canceled the Denver trip at the last minute. The plate is full, and although nothing could be better than skiing a few days with my kids, I let them know Dad won’t be coming this weekend.
I was lucky to play Augusta National in 2018. Mauldin called me and said, “if you get a call from area code “706” drop what you are doing and answer the call.”
One of John’s long-time readers is an Augusta National member, and over the years, he and John became good friends.
The call came, and a most polite, warm, and friendly southern voice introduced himself and asked me if I’d like to join as his guest, along with John, for two days of golf at Augusta National. It was the invite of a lifetime, and I hung up the phone over the top with excitement. For non-golfers, you are likely scratching your head. For golfers, you totally get me.
Following are a few photos from that wonderful trip in November 2018.
The Hogan Bridge – Rae’s Creek
Steve and John Mauldin
Ben Hogan – Here is a close-up of the plaque.
The 2023 Masters
I’ll be watching this weekend and thinking about my old man. Dad loved to golf, and I remember sitting with him as a young child watching the Masters together. He passed in 2011, two days after the Masters’ tournament concluded. He was mostly in and out, more checked out than in until Brianna brought him a Starbucks extra hot soy latte. While lying next to him in his hospital bed. Dad looked at me and asked softly, “Am I allowed to drink this?”
After a few sips, the coffee kicked in, and he lit up. Now aware of his surroundings, he asked, Is that the Masters on TV? And boy, did that make him smile. It was a wonderful afternoon as we watched Charl Schwartzel birdie the final four holes to win his first major championship, two strokes ahead of runners-up Adam Scott and Jason Day. Dad graduated two days later.
I’ll be thinking about him this weekend and holding my glass high. His go-to was a Michalob Ultra. Mine a glass of red wine… Forever grateful!
A quick aside, Dad was obsessed with golf. My sister Amy found this note tucked carefully inside one of Dad’s golf hats. When she sent me some of his ashes, she used the baggie with the note in it. When I finished the 11th hole at Augusta, I quickly walked and sat down behind the 12th tee box. Looked towards the hole, said a pray, and gently placed his ashes in the ground. Dad went on to par the hole! Pictured is the note placed on the ground behind the 12th tee at Augusta National. I kept the note, and part of Dad stayed. I’ll be thinking about him while watching the action on the famed 12th hole.
“Stay over the ball
Right knee in
Right palm open
Dad would give swing advice to everyone. As I’m watching and writing to you late Friday afternoon, Tiger is +2 after nine holes, and the cut line to make the weekend is +2.
If he hears a whisper in his ear on the tee box at 12, “No sway Tiger, right knee in.” Just know the old guy couldn’t resist.
Thanks for indulging me. Call your old man, or if he is no longer with us, raise your glass high and let him know you love him… and call your mom too. No human, on the face of this planet, is more important than Mom!
A special hat tip to my 2018 hosts. I am thinking about you again this year and wish you a wonderful tournament. I’ll be watching!
Happy belated Passover and Happy Easter!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com
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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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