May 5, 2017
By Steve Blumenthal
“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
– Sir John Templeton
I presented at a recent advisor conference alongside a famous economist. He told a story about an investment manager who told him, “You know… it is easy to pick out the investment amateur in any room.” He said, “He’s the person who says, ‘it’s different this time’.” He then looked at the economist and said, “Unfortunately, it really is different this time.”
We had the Nifty Fifty stocks craze in the 1970s, Portfolio Insurance in the mid-1980s, Tech in the 1990s and Real Estate in mid-2000s (easy mortgage capital creatively engineered on Wall Street – those slices and dices of subprime junk somehow sleeved into AAA-rated tranches that enabled massive amounts of mortgage liquidity that turned out to not be AAA). Who would have imagined the near collapse of the global financial system?
What remained relatively consistent in all of the prior periods was the relationship between equity market valuations and the subsequent 10-year return outcome. What is also true is that on the other side of those bubbles was a great investment opportunity. So what is the relationship between valuations and returns telling us today? Let’s take a close look.
But first a quick comment: I believe we’ll one day look back at today and point to two bubbles – one in passive index investing and the other in massive size, relative to GDP, of developed market government debt. It is fair to say that with 71% of developed market sovereign bonds yielding less than 1% and 33% yielding less than zero, which counts as “it is different.” But let’s not get nervous and instead simply look at the data, set a plan in place and be prepared to act when the next great opportunity presents.
The good news is that the data can tell us a great deal about probable coming returns and levels of risk. But how do we best explain this to our clients? Since we advisors get lost in our world of financial terminology (confusing to our clients), I’m going to try my best to explain where we are today in a way that my wife Susan or your retail client might better understand.
This morning, with coffee in hand and sitting in my favorite chair, Susan asked me what I’m writing about today. I told her the piece is about current valuations and coming returns and tried to explain in layman’s terms how to know when to buy low and sell high. What does P/E mean? Many people don’t know.
I then told her to think in terms of her soccer coaching business. If she earned $50,000 (a made-up number) and her company had 50,000 shares outstanding, her company earned $1 per share. I told her to just think of it as a data point.
Next, if I could invest in her business by purchasing her stock and at a price of $24 per share, how do I know if I’m getting a good deal or a bad deal? I want to make as high a return as I can. The price means nothing if I don’t consider how much money her company can earn.
So we can look at the price of Susan’s stock ($24) relative to her company’s earnings ($1) and determine if you are getting a lot for our money (high future return on our investment) or little for our money (low return).
If her company earns a $1 and is trading at $24, then her price relative to her earnings is a P/E ratio of 24. Think of it a second data point. What is important about that number is that we can compare it to other points in time and see if you are getting a bargain or paying too much.
Of course, her business might hit a home run in regards to earnings next year but if we think of the overall stock market in general, companies collectively grow their earnings by about as much as the U.S. grows its economy each year (for the last 17 years that’s been about 2% per year). And we can also factor in things like debt levels, tax cuts and global growth to see if that earnings number can pick up, but let’s keep it simple for now. We don’t need all those other factors because current actual reported P/E levels tell us a great deal about future returns.
Now, if Susan’s stock price was $17 per share, her company would be trading at 17 times that $1 of earnings. If her stock was at $10, her company would be trading at 10 times earnings. That’d be a steal so long as she could maintain that $1 of earnings. Can you see how what you pay relative to what a company can earn can help you determine the good or bad future return you might receive?
So, let’s do just that but look at the broad stock market. You’ll see that the evidence shows that prices are high relative to earnings and thus future returns will be low (statistically). Next, you’ll find several of my favorite valuation charts. If you are a long-time reader, you will be familiar with many of the charts but I like to review them at the beginning of each month because it helps me stay grounded in terms of return probabilities and levels of risk.
I also share with you a cool (well, cool if you are a quant geek like me) chart I found that looks at the data over the coming one-, two-, three-, four- and five-year returns based on where the current price is relative to current earnings. The data tells us to expect low returns. The chart would be even cooler if the returns were higher.
Let’s start with median P/E, then look at forward 10-year returns, then a few selected dates and subsequent 10-year returns and then the cool chart and then see what that may tell us about where we are today and what forward returns might look like.
Here is how you read Chart 1:
- Many people consider the stock market to be the S&P 500 Index. So let’s use the S&P 500 as the proxy for the market.
- Think of Susan’s company and consider what she earned relative to what her current price is. The S&P 500 Index is a collection of 500 large U.S. companies, but think of it as one large company you can buy (and you can in a low-fee ETF such as SPY).
- Here we look at the April month-end median P/E based on actual earnings. Median P/E is my favorite way to measure P/E (there are many others as you’ll see when you click through below). The current number is 23.8.
- For now, just think of the number as a data point. If Susan earned $1 per share and the price of her stock was $23.80 per share, her current P/E ratio would be 23.80. So the overall market is trading at 23.80 times more than its earnings. A data point.
- Look at the chart again. The red line in the middle section plots the month-end median P/E from 1964 to present. At any point, we can see if the price we are paying is a high price, a fair price or a low price in comparison to other points in time.
- The green dotted line plots the median P/E over the last 53.2 years. The current median P/E over that time span is 17. Ned Davis Research (NDR) calls that “Fair Value.”
- The S&P 500 Index was at 2384.20 at the end of April. The large red arrow in the lower section shows us three levels. Overvalued in the data set is a measure that is 1 standard deviation higher than Fair Value. Undervalued is 1 standard deviation below Fair Value.
- For non-quant geeks: Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are further from the mean, there is higher deviation within the data set.
Chart 2: Forward 10-year Returns by Quintile (1 least expensive, 5 most expensive)
Here is how you read the chart:
- I had my research team sort median P/E into 5 different categories. Median is the P/E in the middle. If there were 500 stocks in the S&P 500 Index it is the P/E where 250 P/Es where higher and 250 were lower. It is the one stock in the middle.
- Quintile 1 represents the lowest 20% of month-end P/Es. Quintile 5 is the most expensive.
- Data from 1981 through December 2015.
- We then looked at each month-end median P/E and then calculated the actual subsequent 10-year annualized rate of return. If you bought at a low P/E, what did you earn? If you bought at a high P/E, what did you earn?
- The conclusion is as you would expect. Best to buy low and sell high.
- Following is a graph of the results.
Also note one last section on the chart. At the bottom we also took a look at what the maximum return was (the best of all returns based on starting median P/E in each quintile) and what the minimum return was.
- Note in Quintile 1, the best was an annualized return of 18.8% and the worst was a return of 12.4%. A tight min/max range.
- Note in Quintiles 3, 4 and 5 the range widens with quintile 5 producing the lowest max and the lowest min.
- We’re in Quintile 5 today.
One last point: The period included the greatest bull market of all time (1982 – March 2000). Data over longer periods of time showed lower. Here is the data from 1926 – 2014 courtesy of NDR:
Chart 3: Select Starting Dates and Subsequent 10-year Returns
In Chart 3, we cherry picked several month-end P/E’s starting dates with the last date being March 31, 2017 and show the actual subsequent 10-year annualized return (red is bad, green is good.) Median P/E improved from 24.1 at March 2017 month-end to 23.8 at April 2017 month-end. Nonetheless, median P/E remains in the most expensive quintile.
Also notable is that risk is highest when valuations are highest and lowest when stocks go on sale (as measured by drawdowns – declines materially from quintile 5 to quintile 1). We’ll save that chart for another day. Please let me know if you’d like to see it.
Chart 4 – The “Cool” Chart: Probable Returns over the Next 1, 2, 3, 4 and 5 Years
Here is how you read Chart 4:
- Take a look at the yellow highlighted section in the middle of the chart. It shows just how much the S&P 500 Index is overvalued in comparison to its historical trend.
The S&P 500 Index has an annualized gain of 10.62% over the last three years and 14.20% over the last five years. Take a look above at where the market was valued in five years ago in 2012. It was zero percent overvalued vs. the 51 percent overvalued reading on April 30, 2017. Who do you know that was buying then?
Just consider all of this as logical data. Think in terms of probabilities. We clearly find ourselves today in a high valuation and low potential forward return environment.
This time is different?
- What isn’t different is the relationship between valuations and forward returns. I wouldn’t take the bait and jump in as many investors are doing today.
- What is different is that 71% of developed market sovereign bonds are yielding less than 1% and 33% are yielding less than zero.
- Risk parity is different. Approximately $500 billion is positioned in the popular “risk parity” trade. It reminds me of the “portfolio insurance” days just prior to the crash in 1987. That insurance was supposed to keep you from losing. It didn’t. When volatility spikes, the money that is invested in equities will be forced to sell. It’s built into the rules. “Risk parity,” Paul Tudor Jones told a Goldman Sachs audience, “will be the hammer on the downside.” Leon Cooperman and especially JPM’s Marko Kolanovic famously repeated on several occasions that the greatest “crash catalyst” facing the market is, you guessed it, risk parity. Ok – it’s a risk…
- Combined together, risk is high. Despite the fact that it feels so good today.
The point today is about current market valuations and probable forward returns. If valuations were low and returns high, then I’d advise to ignore all of the risk noise. Unfortunately, that’s not the place we find ourselves today.
I told Susan that I’d much rather buy her company at a price that is attractive relative to what she can earn. Stocks were on sale five years ago. They are not on sale today.
We work with hundreds of advisors. It is clear from our phone calls that clients are chasing back into equities. They are having a hard time keeping clients in diversified portfolios. Investors may feel like the right thing to do but is it? I don’t think so. Is it Sir John’s “euphoria” phase? I’m sensing “optimism.” Yet, it’s beginning to feel to me like 1999 all over again. I saw the other day data that shows Millennials now pouring money into stocks. They have been among the most cautious group.
My Wharton professor friend, Dr. Chris Geczy talks about his students’ aversion to equities. Children of the great financial crisis. Fear has subsided it seems.
If you feel it is appropriate, share this data with your clients. What isn’t different this time is how we humans tend to behave. We humans behaviorally and consistently buy what we wish we had and sell what we need. To that end, this time is not different.
You’ll find more on valuations below in this week’s OMR plus a few interesting “Charts of the Week.” The evidence tells us to expect roughly 0% to 3% returns before inflation over the coming 7 and 10 years. No guarantees, of course, but highly logical and historically probable data. Simply use it to identify when to and when not to get aggressive.
Below you will also find a link to our most recent Trade Signals, which contains our current index performance. My favorite equity market trend indicator is our Ned Davis Research CMG U.S. Large Cap Long/Flat indicator. Despite my valuation concerns, the weight of trend and market breadth evidence remains bullish for both stocks and bonds. Thus, our investment process continues to have our equity strategies positioned risk on.
Please feel free to reach out to me if you have any questions.
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Included in this week’s On My Radar:
- April Month-End Equity Market Valuation Charts
- Charts of the Week
- Trade Signals — S/T Gold Sell Signal, Equity & FI Trends Remain Bullish
- Personal Note
April Month-End Equity Market Valuation Charts
Chart 1: Median P/E (same chart as above)
Here is how you read the chart:
- I want to point out to you the large red arrow at the bottom.
- The S&P 500 Index was at 2384.20 at April month-end.
- Fair value (or a P/E of 17) is at 1702.32. It will take a decline of 28.6% to get to fair value.
- Overvalued is at 2224.46. By this simple measure (1 standard devation) the market is currently 6.7% overvalued.
- Undervalued is at 1180.18. It will take a 50.5% correction to get there.
Chart 2: GMO’s 7-Year Asset Class Real Return Forecasts
Here’s how you read the chart:
- Big red arrow!
- Red circles!
- Not good…
Chart 3: Household Equity Percentage vs. Subsequent Rolling 10-Year S&P 500 Index Total Returns
Here is how you read the chart:
- Household equity percentage is on the vertical line – left-hand side of chart.
- When households own a high percentage of stocks in their portfolios, they are mostly fully invested. Less money to invest.
- When a smaller percentage, more money available to buy stocks.
- More buyers than sellers, prices move higher, better returns.
- Dotted black line shows the actual subsequent 10-year returns. It stops in 2007 because the actual 10-year number is not yet known.
- Important to note the high correlation between household ownership percentage and subsequent 10-year returns.
- This chart is telling us to expect between 2% and 3% (yellow circle – red arrow)
We could look at Price-to-Sales, Price-to-Book, Price-to-Operating Earnings, Price-to-Forward P/E Estimates, etc. Same conclusion: Let’s just call it expensive across the vast majority of valuation methods.
Charts of the Week
Chart 1: A Look at Bull and Bear Markets
Here is how you read the chart:
- Top section is the S&P 500 Index over time. It shows the annualized returns during secular (long-term) bull markets and bear markets. 1900 – present.
- The middle section is Long-term Government Bond Yields.
- The bottom section is the Commodity Market.
- I found this chart interesting so I thought I’d share it with you.
Chart 2: Nominal and Real Returns on the DJIA
Here is how you read this chart:
- I like that NDR shows Real (after inflation) returns and sorts it by bull and bear markets (graph in upper left = bull markets, graph in lower left = bear markets)
Chart 3: Comparison of Current Secular Bull vs. Other Secular Bull Markets
Here is how you read the chart:
- The bottom section shows the current bull market. Note how far it has come in comparison to the other secular bulls.
- The message is that there could be more run left in the move. However, past performance means nothing. The market remains expensively priced.
Chart 4: 200-day Moving Average Rule
Here is how you read the chart:
- Data in the bottom left shows the bull market gains when the DJIA is above its 200-day moving average smoothing. From November 17, 1900 through May 2, 2017.
- It also shows the returns when it is below.
- The bottom right hand section shows data 2007 to present.
- This is why I believe a trend following strategy using the 200-day MA rule (buy when it crosses above and sell when it crosses below) absent other more advanced processes may serve you well. Participate and protect.
Next week I’m going to share some data on Total Real Returns that looks at where you are in life (age-wise) and factors in your life expectancy. This piece is getting long so let’s stop here.
Trade Signals — S/T Gold Sell Signal, Equity & FI Trends Remain Bullish, Sentiment Excessively Optimistic
S&P 500 Index — 2,388 (5-3-2017)
Notable this week: The Zweig Bond Model remains in a buy signal. The equity market, as measured by the Ned Davis Research CMG U.S. Large Cap Long/Flat Index, remains bullish. The short-term gold trend indicator is in a sell signal. Investor sentiment is now Extremely Optimistic, which is S/T bearish for equities.
Click here for the charts and explanations.
One final thought on risk parity. A troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10-year Treasury Note could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds and lead to a self-fulfilling crash across asset classes.
There were pro and con arguments for portfolio insurance in 1987 and there was certainly great conviction that the Long-Term Capital Management team had a conservative way to make money, a team that included several Nobel Prize winners. A team that almost brought down the system in 1998.
The point is simply to note that when everyone leans heavy on one side of the trade – whether it is the massive amount of money invested in index funds or the record low level of volatility that has the popular risk parity risk on or whether it is the record levels of margin debt. Complex systems flow from high risk to low risk levels back to high risk levels.
My concluding two cents is to keep expectations realistic and have stop-loss capital preservation processes firmly in place. A much better buying opportunity will present. I told Susan I’d much rather buy her stock at $12 to $17 per share vs. $24 today. Then, the return on my investment in her company will be better.
The point is where you begin your investment journey matters. The point is valuations matter and if we look at nothing else, valuations can tell us about probable forward returns and can be valuable information to help you know when to play more defense than offense (today) and when to play more offense than defense (someday soon – best guess within the next three years).
If you are a pre-retiree or retired, ask yourself if you have the time left that will be required to overcome the next -40% to -60% — a really bad reality the next recession will bring us. See the data as simply data and use it to your advantage.
I had a great day at the S&P Dow Jones Global offices yesterday. Here is a shot from the event. I’ll share the video interview when it is ready.
Michael Mell (S&P), Ed Lopez (VanEck), Steve Blumenthal and Robert Schuster (NDR)
We talked about our Ned Davis Research CMG U.S. Large Cap Long/Flat Index. S&P is the calculation agent for the index and we’re really excited to be working closely with them (and my friends at Ned Davis Research and VanEck). Dallas follows on May 17-18 for a Mauldin Solutions Advisor Due Diligence Meeting. I’ll be in Orlando on May 22-25 for John’s annual Strategic Investment Conference. I’ll be taking notes and sharing them with you.
Wishing you a fun weekend!
If you find the On My Radar weekly research letter helpful, please tell a friend … also note the social media links below. I often share articles and charts during the week via Twitter and LinkedIn that I feel may be worth your time. You can follow me on Twitter @SBlumenthalCMG and on LinkedIn.
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With kind regards,
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.
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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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