Thursday, September 25, 2014

The Truth About US Equity Valuations

Co-authored by Ron Granberg, CFA, ClearWater Capital Management 

It has been said that there are multiple stages leading to the acceptance of a great truth. It may initially be dismissed as absurd, then violently opposed, and finally accepted as though it were never in doubt. Warnings of investment bubbles follow a similar pattern. Because valuations correlate poorly with returns over the subsequent one-to-two years, early warnings that valuations are becoming stretched are often dismissed as stocks surge higher. As valuations rise further into the stratosphere, such warnings draw the ire of most investment professionals, whose counterattack typically relies on new valuation criteria, arguments that historically sound valuation metrics are no longer valid, and talk of “new eras.” When the bubble collapses, investors are left with steep losses and self-recrimination as they realize the market was indeed seriously overvalued.
Currently, we appear to be in the second stage of truth regarding the bubble in US equities, the third in just the last 15 years. The current narrative rests largely on the fallacy that you “can’t fight the Fed,” its corollary that investors must buy equities due to absurdly low bond yields, and that price-to-earnings ratios remain reasonable. The problem with this narrative is that easy monetary policy is not prophylactic against bear market declines and simple trailing and forward price-to-earnings multiples are not reliable indicators of subsequent equity market returns.

First, let’s address the argument that you “can’t fight the Fed.” Simply put, you could have followed that mantra down the rabbit’s hole in each of the last two bear markets. During 2001, the Fed cut the Fed Funds rate from 6.50% to 1.75%, where it remained until a 0.50% cut in November 2002. From January 2001 through September 2002 the S&P 500 declined 36.71%. Similarly, the central bank lowered its benchmark rate from 5.25% to just 2% from September 2007 through April 2008, at which point, what turned out to be one of the worst bear markets in history was still being called a correction. By December 2008 the Fed had cut the rate to 0-0.25%, where it remains today. For those keeping score, from the Fed’s first rate cut in September 2007 through the market lows in March 2009, the S&P 500 fell more than 50%. In short, “fighting the Fed” can be challenging, but failing to do so in the aftermath of one of their liquidity driven bubbles can be damaging to your financial health. While Fed largesse can induce complacency and provide fuel for a bubble, it’s of no consequence whatsoever once investors begin to re-price risk. 
Second, those suggesting market valuations are reasonable are either misinformed or disingenuous. We have often heard investment professionals state that “valuations are not demanding,” yet such statements reference price relative to either trailing or forecasted earnings, neither of which correlate strongly with returns over the subsequent seven to 10-years. Lacking organic revenue growth, corporations have driven per share earnings higher through massive stock buyback programs (while the ratio of insiders buying to those selling is among the lowest in the last 15 years). Additionally, earnings have benefited from new all-time highs in profit margins despite weak revenue growth due to significant declines in labor and interest expense. Revenue will only be driven higher if consumer incomes begin to rise and that will likely be accompanied by rate normalization. Any further reduction in interest and labor expense would likely only occur if the economy returns to recession, further reducing revenue. In short, investors would be wise to remember that profit margins, among the most mean reverting statistics in finance, are likely to revert yet again. As such, today’s valuations are far more excessive that simple price/earnings ratios suggest. Meanwhile, valuation metrics such as Robert Shiller’s cyclically adjusted price-to-earnings ratio, i.e. CAPE, the ratio of company assets to their replacement cost, i.e. Tobin’s Q, or non-financial market capitalization-to-gross domestic product, are among their highest levels in history. Each is flashing serious warning signals and each correlates strongly with future returns.  

In light of the aforementioned, one would expect investment professionals to be cautioning clients about the risk of a bear market in US equities. Why then are the vast majority screaming “you can’t fight the Fed” and telling clients that valuations are reasonable? The answer likely resides in self-interest and career risk. As Keynes noted, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Additionally, there is the self-interest of the mutual fund industry, which collects enormous fees from the equity funds it manages. Simply put, their chief strategists are loathe to suggest significant reductions in client equity allocations and they likely wouldn’t have their jobs very long if they did. As a result, the investment industry’s response to each of the last two bear markets has essentially been “Who could have known? You can’t time the markets.” While not an advocate of market timing, the great Ben Graham noted that there are valuation levels as which investors “certainly should refrain from buying and probably would be wise to sell.” Today, if you aren’t concerned about valuations, you aren’t looking at the right metrics or simply don’t care to acknowledge them. Those that correlate strongly with long-term returns are at levels that in each and every instance have been followed by bear markets.
There are no valuation metrics that we know of that correlate well with returns over the subsequent 12-24 months. Yet market internals have deteriorated measurably this year. Nearly half of the stocks in the NASDAQ Composite are down 20% from their 52-week highs with the average stock in the index down 24%. Simply put, the benchmark’s solid year-to-date return is a function of the performance of a rather small number of its largest components. Similarly, about 40% of the stocks in the Russell 2000 are down at least 20%. Given the significant deterioration in market internals coupled with the excessive valuation exhibited by metrics that correlate well with long-term returns, prudent investors should aggressively reduce their exposure to US equity markets. Doing so will enable them to preserve capital and deploy additional money into equity markets when risk is far lower and potential returns much higher.