February 21, 2020
By Steve Blumenthal
“While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior
of most investors and speculators. The speculative urge that lies within most of us is strong;
the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.
It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker
is on the phone offering shares in the latest “hot” initial public offering.
Yet the avoidance of loss is the surest way to ensure a profitable outcome.”
– Seth Klarman
CEO/Portfolio Manager, The Baupost Group
This week I found myself in West Palm Beach, Florida. I spoke at an advisor event Thursday evening and will be landing in Philadelphia tonight, shortly after this week’s OMR hits your inbox. Two days of 84 degrees and sun. No complaints here.
On the flight to Florida, I ran into a dear friend. He was the first doctor that told me I needed my hips replaced. “I can give you a cortisone shot; it won’t work, your cartilage is gone,” he told me. It was a tough pill for me to swallow but I’m glad I did. I got my active life back. The hip-fix technology is fantastic these days.
My friend asked me to give him a call, and I will. He said 1.8% isn’t cutting it; he needs some capital gains and he’s looking for a few ideas. Here’s the hard part, though: almost everything is overpriced. The late great Sir John Templeton, founder of Templeton Funds (now Franklin Templeton), said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” My advice: This is EUPHORIA. Wait for PESSIMISM.
Everything cycles. Over time, the cap-weighted S&P 500 Index has gained 10.01% per year. That return can be visualized as the straight up-trending line that moves from lower left to upper right in the following chart. We humans bid prices up in a speculative frenzy to points above the long-term growth line, and when a shock hits the system, most sell, driving prices down below the long-term trend line.
In my view, the odds of earning 10.01% per year over the coming decade are near zero percent. The odds of earning 0% to 3% are very high.
If you are a long-time reader you’ll find a number of familiar charts in today’s piece. Each month, I like to scan through the data to keep my focus and stay balanced. If I don’t, I too risk getting pulled into the frenzy.
Back to my friend’s conundrum. I mentioned the hard part above: that everything’s overpriced. Well, here’s the really hard part: When I tell my friend it’s time to buy when many investors are panicking, my advice won’t be well received. Why? Because it feels like it’s the right time to buy now. It seems like everyone else thinks so, too. That makes my insight, that the odds are not in his favor, a tough pill to swallow.
But don’t fret: opportunity is near. The markets will be in crisis. It won’t feel like the right time to invest for capital gains, but it will be. Buckle up, stay patient, and be ready to switch from defense to offense.
Last week, I promised you we’d take a look at leverage and valuations. You’ll also find some helpful data that shows exactly where we sit in the current market cycle. You’ll see that investors have little cash and are all margined (leveraged) up. I’ve also got my favorite valuation charts—along with insight on what the current valuation levels tell us about coming returns. And I share one of my favorite forward-return charts that has nothing to do with valuations and everything to do with how much money households (individual investors) have allocated to stocks.
Take that first sip of joe and put your chart-reading goggles on. Let’s go.
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:
- A Look at Leverage, Market Cycles, and Current Valuations
- Trade Signals – HY Trend, Credit Conditions and Recession Indicators are Key Bear Market Indicators
- Personal Note – Traveling
We’re about to look at a dashboard of indicators that make the case that the market sits late cycle. How do we know? When we compare the current valuation level to periods throughout history, the dashboard is flashing red: “extreme overvaluation.” A number of the data points go back to the 1920s. The latest readings sit in the top 20% of all readings. Some sit in the top 2% of all readings. Meanwhile, we need “fair values” to get that 10.01% growth trend the market will give us over time. Overall, I think you will find the historical correlation data compelling. (Important note: Valuations tell us a great deal about coming returns. They tell us zero about the timing of the next bear market.)
Let’s begin. If your head begins to spin, just remember that the weight of evidence is flashing red. Investors have so bid up stock prices that it is clear to me that we sit well above the long-term growth trend line (check out the simple cycle chart shared above). We’ll zero in a few of the metrics below.
Chart 1 – Price-to-Sales
It’s easy for a company to keep track of its sales. When sales are good, everyone in the company sleeps well at night. This next data set looks at the combined gross sales of all the companies in the S&P Industrial Average from 1954 to December 31, 2019, and plots the sales data relative to the price of the Industrial Average. The data is updated quarterly.
In the middle section of the next chart, I’ve inserted a red “we are here” arrow. When the price of the market goes up relative to total sales, the orange line goes up. By this measure, the price of the market is at the highest level since 1954.
Ned Davis Research (NDR) does something really cool with their research. They look at each price-to-sales data point and determine the annual percent gain that follows certain readings. The box in the lower right shows that when the price-to-sales ratio was more than one standard deviation above its long-term average, returns were lowest. When this valuation indicator was below its long-term average, returns were highest.
When you have a recession, sales go down. How can record prices be justified today? We sit late cycle.
Chart 2 – Median P/E
Median is the price in the middle. If you have 500 stocks in the S&P 500 Index, this next chart plots the price-to-earnings ratio of the stock in the middle. What I like about this process is that it removes a lot of the accounting games that some companies play.
Further, when you look at all of the data going back to 1964, you can get a good feel for “fair value.” Think of “fair value” as the straight line that moves from lower left to upper right in the first cycle chart I shared. Again, that straight line is a return of about 10.01% per year.
The green dotted line in the middle section is the “fair value” line.
NDR does something cool here too. In the bottom section, they show just how overvalued or undervalued the current market price is relative to history. This gives us a sense of when we should switch from defense back to playing more offense. I’ll be calling my doctor friend when we move to “fair value,” or about 2,200 on the S&P 500 Index. And, a bear market panic could get us back to 1,556. That would be an exceptional opportunity. Given the high level of margin, when selling turns to panic, which turns to forced margin-call selling… we will have moved from euphoria to pessimism. The odds will then be stacked in our favor.
Chart 3 – Market Cap-to-GDP
Warren Buffett said this is his favorite valuation chart. So if it’s his favorite, it is certainly one of mine. Simply look at the current level: 145.4%. Compare it to the high at the top of the great tech bubble in 2000. And note the better buying opportunities that occurred in 1982, 2002 and 2008-09.
Chart 4 – Market Cap-to-GDP (Different Version)
Same story but a different look. In red, I’ve noted prior market peaks.
Chart 5 – Investor Money Market Balances vs. Margin Account Balances
I hope your eyes don’t cross when viewing this next chart. Let’s just keep it simple. The lower section of the chart plots actual investor credit vs. debt balances. Debt means margin balances. When cash is abundant and margin balances are low, investors have a lot of money available to buy stocks. When cash is low and margin account balances are high, investors have little money left to buy stocks. More buyers than sellers make stock prices go up. More sellers than buyers make stock prices go down. It’s basic supply and demand at work.
If investors are largely all in, who’s the next marginal buyer when the next recession occurs?
Chart 6 – Shiller P/E
The following chart captures the Shiller P/E level over time. As you can see, it sits at the second-highest level in history. Prices are high relative to smoothed ten-year earnings. What’s important is what the data tells us about coming returns (you’ll find that in chart 7).
Chart 7 – Ten-Year Real Annualized Returns Based on PE 10, or Shiller P/E
This data set looks at the price-to-earnings data, similar to above, and then asks, what happened to returns over the subsequent ten years?
What was the P/E in September 1929, and what happened to returns over the following ten years? What was the P/E in December 1999, and what were the actual returns ten years later? How about the P/E in October 2002 or March 2009? We have the data.
Month-end P/Es were broken into quintiles: the most expensive 20% of P/E readings to the cheapest 20% of readings. Results were then plotted. The green line shows the best ten-year returns, the red line the worst, and the solid line in the middle of the highlighted box shows the median return.
From a probability perspective, returns will come in somewhere in the middle of the box. For example, given “we are here” on 12-31-19, coming ten-year returns are likely to be somewhere between +5% to -1%.
My message is wait until we are in quintile 1 or 2. Then you get a lot more for your money.
Chart 8 – Where We Sit in the Market Cycle
We looked at price-to-sales above. This next chart shows us what it means in terms of annualized returns.
The yellow circle highlights where the price-to-sales ratio is compared to the longer-term trend. Above the dotted line is similar to the cycle chart shown at the top of this week’s missive. The bottom box plots the actual returns based on how high or low the price-to-sales ratio was at points in history.
Chart 9 – Household Equity Percentage
This chart is one of my favorites. I like it because it looks at just how much you and I and all of the friends we know and don’t know have invested in stocks vs. bonds and cash.
The left-hand side shows the percentage number. The blue line plots the household equity percentage number back to 1951.
The dotted orange line plots the actual total return for the S&P 500 Index that occurred over the subsequent ten years. I’ve noted several points in time.
The current level (most recent data 9-30-19) is telling us to expect a 2% annualized return over the coming ten years. Not a perfect historical correlation, but in geek terms a 0.89 correlation is very high.
Chart 10 – Stock Market Cap vs. Gross Domestic Income
We’ve finally come to the end of the valuation review. We sit today in the top quintile of readings, comparing the total value of the stock market to what we collectively earn. The middle section plots the long-term trend in this ratio.
Simply notice the gap in the orange line above the long-term blue dotted trend line. And note that when the line is in the top quintile, returns over the subsequent one to nine years were negative. Only at year 11 were returns positive.
Note: The returns are not annualized returns. Shown is the average gain. Simply, this is telling us returns will be zero over the coming number of years.
I could keep going with the charts but we’ll find ourselves in the same place. If you’ve gotten through the data today, I’m proud of you. I know it can get deep in the weeds, so thanks for hanging in there with me.
In summary: Stay patient, play defense until the next recession creates a better opportunity. This doesn’t mean your returns will be zero. If you protect against -40% to -60% and buy when we get to “fair value,” your returns will be good. And let me say that I am seeing a few select disrupting opportunities. More on that in another letter.
February 19, 2020
S&P 500 Index — 3,389 (open)
Notable this week:
No major changes to the trade signals since last week’s post. The equity, fixed income and gold signals remain in a bullish trend. The Ned Davis Research (NDR) CMG U.S. Large Cap Long/Flat model evaluates the price trends across 24 sub-industry sectors. Measured on a daily basis are the short-term, medium-term and long-term trends within each sector. The model then adds the scores together. The current high score indicates bullish conditions across almost all of the sub sectors. A sign of a strong bull market. Therefore, despite an abundance of concerns (trade, coronavirus, near-record high valuations, high recession risks in Europe and Japan, insane sovereign debt levels, European banks, EM debt, BBB bonds, bank loan funds, corporate leverage and the bubble in the U.S. high yield market), the weight of market trend evidences remains strong. Investor sentiment is extremely bullish, which suggests short-term caution. If you haven’t done so in a while, take a look at the recession watch indicators. They too tell a relatively bullish story. I’m watching the trend in HY, credit lending conditions and the recession watch charts closely. I believe they are keys to identifying the next bear market turn.
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.
“Focus on your goal. Don’t look in any direction but ahead.”
I have a number of trips coming up over the next few months. A conference in Park City in early March has me really excited. I’ve got short trips to New York City, Dallas, and San Diego, and the Mauldin Strategic Investment Conference May 11-13 in Phoenix as well. Sometimes I really love my job.
Racing to catch a flight home… wishing you a wonderful week.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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