November 5, 2021
By Steve Blumenthal
“Taking on a challenge is a lot like riding a horse, isn’t it?
If you’re comfortable while you’re doing it, you’re probably doing it wrong.“
― Coach Ted Lasso
Jerome Powell delivered the tapering news everyone expected. It begins. However, central bankers for some of the world’s biggest economies expressed more dovish views than the markets had expected, signaling rates will remain lower for longer. Stocks? New highs.
After one factors in inflation, bond yields for investors in the developed world are negative. Immediately following the Fed’s announcement on Wednesday, the 10-year Treasury moved higher, touching 1.60%; it’s at 1.52% this morning. The bond market is signaling what Dr. Lacy Hunt is talking about (see last week’s OMR on debt for more insight). With inflation north of 3% (or 5% in real life), net of inflation, bond yields are unprofitably negative. Where else is money going to go?
Early each month, I like to go through a checklist of my favorite valuation and forward return charts. It’s habit and it helps me stay focused on risk and reward. You’ll find the charts and data below.
We’ll also take a look at a piece from my friend Lance Roberts on corporate share buybacks. While low interest rates are bad for fixed income investors, they are great for borrowers. I’m putting in a Ring security system at home, and the Best Buy sales guy told me there’s 0% interest for two years. Why not take the offer?
The same type of thinking has been happening in corporate boardrooms. Companies are tapping the debt markets and using the capital to buy back their shares. That bids up stock prices. Lance Roberts says absent that leveraged buying, the S&P 500 Index would be at 2,800.
I conclude OMR with this week’s Trade Signals and another discussion on sports in the personal section. The Trade Signals dashboard continues to signal green on both the equity and fixed income markets (except for HY). Gold remains in a (red) sell signal. I hope you find today’s OMR helpful. Thanks for indulging me each week. It is much appreciated.
Valuation posts are always fun for me. Grab that coffee and find your favorite chair… Here we go.
Valuations and Coming Returns
Valuations signal degrees of risk and do a great job at forecasting coming three-, five-, seven-, nine-, ten-, and 11-year returns, but they are meaningless in terms of timing bull market top and bottoms. It’s important to note that excessive valuations can go on for a long time. It is for that reason that I like to view market valuations and future returns from a risk/reward perspective. And importantly, understanding where fair value sits helps me set strategy by knowing when coming returns will likely be best.
First, we’ll review current market valuations (select charts), and then see what they tell us about probable coming returns.
Let’s start with my favorite: Median P/E.
If you have 500 stocks in the index, median P/E is the price to earnings ratio of the stock in the middle of the data set. I like this process, as it tends to wash out some of the accounting games that some corporations play. There is no perfect method but this one seems most balanced to me.
Here’s how to read the chart:
- The 57.7-year median P/E average is 17.3. Call it “fair value.” That’s the dotted green line in the middle of the chart.
- The orange line plots each month-end median P/E number going back to 1964.
- You can see that the orange line rises above and below the green dotted line over time. Unusually rare moves take the market to the “overvalued” line. And there were only a few times in history when valuations moved above the “very overvalued” line.
- In statistics, standard deviation is a measure of movement above and below a long-term trend. 1STD moves happen infrequently and 2STD even more infrequently. You’ll see that Ned Davis Research (NDR) plots those lines in the chart as well.
- Now, focus in on the bottom data box. A 38.8% decline is necessary for the market to correct back to “fair value.” NDR calculates that number to be 2,818.49.
- Game plan-wise, that seems to be a good target to buy into stocks more aggressively and remove current hedges.
An extreme correction will take the stock market down to 1,902—a decline of 58.7% from current levels. Such a move can’t be ruled out. If that happens, back up your cash truck and put it all in (if that’s appropriate for you, of course). Risk will seem greatest then, but in reality, it will be least—and future returns most rewarding. Look at the opportunity that presented in 2008/09 (orange line in above chart).
Next, let’s look at price-to-sales. Here is how to read the chart:
- Note the regression to trend line in the center section of the chart.
- The orange line tracks the month-end price-to-sales ratio back to 1979. You can see it moves above and below the dotted trend line.
- The bottom section (light blue line) plots the percentage above or below the trend line. You can see it is way up in the nosebleed section.
- Lastly, the bottom data boxes plot the percent gain per annum when in various zones. The shaded area marks the current state.
Shiller P/E = 40.11
Here’s how to read the chart:
- Grab a glass of vodka and avoid sharp objects…
Fortunately, there is a way for us to quantify the above in terms of coming 10-year returns. In the next chart, NDR sorts the 10-year averaged P/Es into quintiles and then shows us what the subsequent real (meaning after inflation is factored in) 10-year annualized returns turned out to be.
Here’s how to read the chart:
- At 40.11, we are clearly in the “most expensive 20%” zone on the right-hand side of the chart.
- The yellow box marks the current state (most expensive 20%). Think of the yellow zone as the probability range of potential annualized returns over the next 10 years. Vegas odds makers would call it a positive 5% per year to a negative 1% per year. They’d pick a spot in the middle and call the highest probable outcome to be 2.5%. They would then set odds off of that mark. The green dash at the top of the line represents the single best annualized 10-year return instance (approx. +13% per year). Very low odds to that outcome. The red line below represents the worst instance (approx. -6% per year). Also, very low odds.
- Side note: The 10-year return from 2000–10 was -1.50% per year (not shown on the chart). But we can look at the Shiller P/E back in 2000, prior to the crash. We are near that level today. My best bet is we have a similar, slightly negative annualized return experience over the coming 10 years.
Stock Market Value to Gross Domestic Income
Next is one of the more popular charts I share, according to the feedback I’ve received over time.
Here is how to read the chart:
- The extent to which the market is overvalued or undervalued is determined by how far above or below the trend the ratio of stock market capitalization to total US gross domestic income is.
- The bottom section (light blue line) shows how far above or below the long-term trend we are.
- The data box in the upper left shows the subsequent one-, three-, five-, seven-, nine-, and 11-year annualized returns.
- Bottom line: We are in the “top quintile.” Expect negative returns over the coming 11 years. We’ll get the best annualized returns when the market is in the “bottom quintile.”
I hear you: But the Fed, the Fed, the Fed. Yes, agreed. Until it’s not all about the Fed. And that day will come. Next, I’ve got a valuation chart I rarely share with you. Same conclusion.
Tobin’s Q Ratio
Interpreting the ratio: The following is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.103, Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically, it is the ratio of market value divided by replacement cost. It might seem logical that fair value would be a one-to-one ratio. But that has not historically been the case.
The average (arithmetic mean) Q ratio since 1900 is about 0.79. The all-time Q ratio high at the peak of the tech bubble was 1.67.
- At 1.86, we sit at the highest level in the last 120+ years.
- Note the level in 2008.
Source: Advisor Perspectives
Bottom line: Hedge and wait for a better entry target. 2,800 is a reasonable point to remove hedges and add new exposure. 1,900 would be a gift and can’t be ruled out.
Note how neatly the 2,800 medium P/E “fair value” target fits into the argument Lance Roberts makes in the next section on corporate share buybacks.
A quick commercial plug for my book: On My Radar: Navigating Stock Market Cycles. Published by ForbesBooks and now an Amazon Best Seller. It is about how to grow and defend wealth.
If you are interested in the book, you can learn more here.
Corporate Share Buybacks
40% Of The Bull Market Is Due Solely to Buybacks
By Lance Roberts | October 29, 2021
What If I told you that 40% of the bull market rally over the last decade was from buybacks alone? That may not be as crazy as it sounds.
We previously discussed the misuse and abuse of stock buybacks over the last decade. Such is not surprising given the low interest rate environment. But, as we now know, there is a point where low rates deter economic activity. Companies become unwilling to “invest” due to the low return environment. The chart shows the problem of economic growth rates and monetary velocity.
The decline in monetary velocity is clear evidence the “economic transmission” system remains broken. One of the essential drivers of economic activity are banks lending money to support economic activity. As shown, the bank loan/deposit ratio has collapsed along with velocity. As a result, there is little benefit to loan money at ultra-low rates relative to the risk of default.
The problem for companies in a weak economic environment is the lack of topline revenue growth. Given higher stock prices compensate corporate executives, it is not surprising to see companies opt for a short-term benefit of buybacks versus investment.
While it may seem like “share repurchases” are a non-event, they are more insidious than they appear. Let’s start with a simplistic example.
- Company A earns $1 / share and there are 10 / shares outstanding.
- Earnings Per Share (EPS) = $0.10/share.
- Company A uses all of its cash to buy back 5 shares of stock.
- Next year, Company A earns $1 again, however, earnings are now $0.20/share ($1 / 5 shares)
- Stock price rises because EPS jumped by 100% on a year-over-year basis.
- However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
- The next year Company A still earns $1/share and EPS remains at $0.20/share.
- Stock price falls because of 0% growth over the year.
Yes, this is an extreme example but shows that share repurchases have a limited, one-time effect on the company. Such is why once a company engages in share repurchases, they get inevitably trapped into continuing to repurchase shares to keep share prices elevated. The problem is the continued diversion of ever-increasing amounts of cash from productive investments that could create long-term growth.
The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. As a result, a “miss” of Wall Street expectations can lead to a hefty penalty in the companies stock price.
In a previous Wall Street Journal study, 93% of the respondents point to “influence on stock price” and “outside pressure” as reasons for manipulating earnings figures. Such is why the use of stock buybacks has continued to rise in recent years. Following the “pandemic shutdown,” they skyrocketed.
Not A Return Of Capital
Share buybacks only return money to those individuals who sell their stock. Such is an open market transaction. If Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.
So, who primarily sells their shares?
As noted, it’s the insiders, of course, as changes in compensation structures since the turn of the century have become heavily dependent on stock-based compensation. Insiders regularly liquidate shares “granted” to them as part of their overall compensation structure. Such allows them to convert grants into actual wealth. As the Financial Times previously penned:
“Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.”
A recent report on a study by the Securities & Exchange Commission found the same:
- SEC research found that many corporate executives amounts of their own shares after their companies announce stock buybacks,Yahoo Finance reports.
What is clear is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:
“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”
In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their shares, there have been effectively no other real buyers in the market.
Exactly how much are we talking about?
The Market Should Be 40% Lower
The chart below via Pavilion Global Markets shows the impact stock buybacks have had on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:
- 21% from multiple expansion,
- 4% from earnings,
- 1% from dividends, and
- 5% from share buybacks.
In other words, in the absence of share repurchases, the stock market would not be pushing record highs of 4600 but instead levels closer to 2700.
To put that into context, the high-water mark for the S&P 500 in October 2007 was 1556. In October 2021, after 14 years, the market would be 2700 without share buybacks. Such would mean that stocks returned a total of about 3% annually or 42% in total over those 14 years.
Before you scoff at a 3% annualized return, such equates to an economy growing at 2% with a 1-2% dividend yield. Moreover, that calculation aligns with historical norms going back to 1900.
While share repurchases by themselves may indeed be somewhat harmless, it is when they get coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic.
Michael Lebowitz noted the most significant risk:
“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”
Money that could get spent spurring future growth, benefitting shareholders, instead got wasted benefitting only senior executives.
As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the CEOs who sanctioned buybacks are much wealthier and unaccountable for their actions.
For investors betting on higher stock prices, the question is what happens if “stock buybacks” reverse?
Source: SeekingAlpha – Original Post
Trade Signals – Taper Has Arrived
November 3, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
On Wednesday, the Fed announced it will start tapering bond purchases later this month. They will be buying $10 billion less per month in Treasurys and $5 billion less per month in mortgage-backed securities. There was a slight change to the Fed’s view on inflation, keeping the word “transitory” in the post-meeting statement but adding the pressures are “expected to” be temporary.
The S&P 500 Index rallied on the news while Treasury bonds sold off as rates rose to touch 1.60%. On Thursday, rates headed lower closing at 1.52%. The 10-year Treasury yield is where the “tell” is. One would think that pulling back on bond-buying would send rates much higher. Perhaps $15 billion less per month from the Fed’s $120 billion per month buying spree is not enough to scare markets.
Overall, the 10-year yield is approximately 30 bps higher than where it was after the September 21-22 FOMC meeting when Powell first signaled the QE program will fully wind up by mid-2022. Tapering has arrived.
You’ll find the dashboard of indicators next. The Ned Davis Research CMG U.S. Long/Flat breadth indicator hasn’t wavered. It is a measure of broad market strength (a combination of trend, vol, and mean reversion indicators across 24 market sectors). It remains in a buy signal. Don’t Fight the Tape and the Fed is a bullish +1. Green across the board.
Click HERE to read to the balance of Wednesday’s Trade Signals post.
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.
Personal Note – Futbol is Life!
Thank you for bearing with me as I share another peek into the Blumenthal world. If you are a regular reader, you know I’m crazy about my wife Susan. You also know that, coming from an athletic background, I have so much passion for sports and what they can teach young people about life. The work required, the heart needed to do the work, the winning, the losing, the many mistakes and correcting them, the challenges with teammates (some whom you like, some maybe not so much—but either way you find common ground and come together).
I hope you’ve had a chance to watch Ted Lasso. In the show, the joy-filled Dani Rojas (played by Cristo Fernández) often says, “Futbol is life.” And it’s really true about all sports—and anything one is passionate about: arts, theater, science, business, logistics, health care, service industries, etc.
In sports, many of life’s emotions are squeezed tightly into a season. Susan’s high school boys team has had a good year. It’s been Susan’s best season yet as the Malvern Prep head coach. Eight weeks ago, at the beginning of the season, I wrote about one kid I thought I’d be rooting for most. He has the athletic ability and competitive drive to play pro. One thing is for sure, when he turns his switch on, the kid is amazing to watch. He’s a goal–scoring beast.
But he can pose a challenge on the field. Sometimes he can be a handful to manage. Not just for Coach Sue, but also his teammates. He’s coming from a competitive place but so much so that he gets down on himself. Perhaps a bit too much at times.
The team is a mix of just a few high-level soccer players destined to play in college at some level and some very good athletes who have less experience, one of whom being a 6’7” goalie who had never played soccer before. A classmate convinced him to try out. It was a long shot, but he earned the starting spot. He tells Coach how much he loves playing soccer. But what I like most is the way he picks up the goal scoring beast when he’s down.
Last week, the reverse occurred. The team needed a win to clinch second place in a challenging suburban Philadelphia high school league. But the goalie let one slip under him, and the windy rain-soaked game ended 0-1. After the game, the goal-scoring beast comforted his keeper. And so did his teammates. Loved to see that! That’s the real win.
The team needs a tie or a win to finish in third place. One more league game remains, but today starts the playoffs for the PA State Independent Schools. Susan and her boys are seeded fifth. They play the 12th seed at 4pm. I’ll be hitting the send button early, heading to the game, and hoping for a celebratory ice-cold IPA at the Flying Pig post-game with my beautiful Susan. She’s happiest after a good W, as we all are.
Travel is picking up a bit. I’ll be in NYC on Monday night hosting a private dinner with John Mauldin and Rory Riggs; in Dallas on November 16 and 17 on business; and then I’m flying to London to visit son Kyle, who is doing a semester abroad. And I have two tickets to watch Chelsea vs. West Ham on December 4. Futbol is life!
Wishing you a fun week!
All the best,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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