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whose counterattack typically relies on new valuation criteria, arguments that historically sound valuation metrics are no longer valid, and talk of “new eras.”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.
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whose counterattack typically relies on new valuation criteria, arguments that historically sound valuation metrics are no longer valid, and talk of “new eras.”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.
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.