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Market Valuations and Expected Returns – May 5, 2014

May 06, 2014 | About:
Vera Yuan

Vera Yuan

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In January 2014, the stock market benchmark S&P 500 lost 3.36% after the excellent 2013. The enthusiasm went back as the market gained 4.31% over February. In March, it went up only 0.69%. And in April, it was about even for the whole month.

As investors are happier with the higher balances in their account, they should never forget the word “RISK,” which is directly linked to the valuations of the asset they own. A higher current valuation always implies lower future returns.

In David Einhorn’s Greenlight Capital Q1 2014 Letter, he said, “Now there is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it. Given the enormous stock price volatility, we decided to short a basket of bubble stocks. A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to “twice a silly price is not twice as silly” is that when the prices reconnect to traditional valuation methods, the de-rating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.”

In our interview with Brian Rogers on April 22, 2014, “T. Rowe Price Chief Investor Brian Rogers Answers Investors' Questions,” when asked, “How much cash do you take in your fund? Is the cash position stable or do you tend to build up cash while the market becomes expensive? Also, how is your current personal private asset allocation (percent cash and cash equivalents, percent bonds, percent equity, percent alternative)?” he said, “The cash position in my fund is currently about 7%, which is up from 3-4% a year ago. It seems to me that there are fewer compelling opportunities today. Price earnings ratios are somewhat higher and our investment analysts have fewer buy rated recommendations. In my opinion there are more stocks to sell than there are to buy today. In terms of my personal asset allocation, I do not practice what I preach when it comes to the benefits of diversification, as 80% of my net worth is in T. Rowe Price stock. Ten percent is in our cash and fixed income funds and ten percent is invested in several T. Rowe Price equity funds, including the Equity Income Fund.”

In Brian Rogers’s T. Rowe Price Equity Income Fund First Quarter 2014 Commentary, he said, “In 2014, we expect to see more focus on company fundamentals. Economic conditions seem to be firming, and the severe weather events of the first quarter are unlikely to disrupt the recovery. Improving payroll trends, declining unemployment, and better manufacturing data provide compelling reasons to believe that the economy is on a path to modest growth through the year. We expect stocks to provide more moderate returns this year than they did in 2013.”

In FPA Capital Fund’s First Quarter 2014 Commentary, it mentioned, “While the major indices reached new highs in the first quarter, there was more volatility this quarter than the previous eight to ten quarters. We have been expecting increased market volatility for the better part of a year and were somewhat surprised we did not see more volatility in 2013. When valuations are stretched as high as they are, at least for small/mid-cap and technology stocks (as of March 31, 2014, Russell 2500 was trading at 27.5x trailing P/E and S&P 500 at 18.6x), coupled with the Federal Reserve being in the process of altering its monetary policies, it should come as no great shocker that some investors will get concerned and reduce their risk exposures. The antidote to rich valuations, of course, is strong earnings growth. Unfortunately, earnings growth was weak in 2013 and we do not foresee a sudden surge in the growth rate of earnings this year. The reason why we do not expect a large increase in the earnings growth rate is that corporate profit margins are very near post World War II highs and unlikely to materially improve from current levels. Moreover, the U.S. and global economies are unlikely to deviate much from their current growth trends, at least until more growth-friendly fiscal policies emerge from Washington and other world capitals. The above opinion does not mean the U.S. economy is destined for a recession in 2014, nor does it imply earnings are going to crater this year. Our hazy, fuzzy crystal ball shows that the economy and earnings should grow at a modest rate this year, barring any major macro-economic event like a war in Europe, Asia, or the Mideast.

In Steven Romick's First Quarter 2014 Crescent Fund Letter to Investors, he said, “We feel a little out of whack in today's investment environment. We'd like to think it's due to central bank policies, but maybe not. We do know that: junk bond yields are close to an all-time low, as is the benchmark risk-free rate and covenant-lite loans are at a record high. Equally remarkable is how few companies are trading at low multiples and even fewer companies are trading at steep declines from their highs – as the following two charts depict."

In Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham stated, “Best Guesses for the Next Two Years: With the repeated caveat that prudent investors should invest exclusively or nearly exclusively on a multi-year value forecast, my guesses are:

1) That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.

2) But after October 1, the market is likely to be strong, especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.

3) And then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”

In John Hussman’s commentary on May 5, 2014, “Cahm Viss Me Eef You Vahn to Live,” he said, “We’ve recently emphasized that our estimates for probable S&P 500 nominal total returns have now declined below zero on every horizon of 7 years and shorter. At longer horizons, the 6.3% growth rate that we’ve assumed for nominal GDP over the coming years will begin to bail investors out given enough time, and as a result, our projection for 10-year S&P 500 nominal total returns peeks its head up above zero, at about 2.4% annually from current levels. Looking out 15 years, the expected 15-year total return approaches 4.4% annually, and at that horizon, investors are unlikely to lose money even if actual returns are a standard deviation below our expectations. To the extent that 6.3% growth in nominal GDP seems too high (and there are certainly reasons to think so), just reduce those annual return projections accordingly.”

According to our last market valuation article, Buffett Indicator and Shiller P/E Both Imply Long Term Negative Market Returns; 2014 Market Valuation, the good news is that our account balance is higher, investors are more bullish. The bad news is that we will see lower future returns.

GuruFocus hosts three pages about market valuations. The first is the market valuation based on the ratio of total market cap over GDP; the second is the measurement of the U.S. market valuation based on the Shiller P/E. These pages are for the U.S. market. We have also created a new page for international markets. You can check it out here. All pages are updated at least daily. Monthly data is displayed for international market.

Why Is This Important?

As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.”

Knowing the overall market valuation and the expected market returns will give investors a clearer head on where we stand for future market returns. When the overall market is expensive and positioned for poor returns, the overall market risk is high. It is important for investors to be aware of this and take consideration of this in their asset allocation and investing strategies.

Please keep in mind that the long-term valuations published here do not predict short-term market movement. But they have done a good job predicting the long-term market returns and risks.

Why Did We Develop These Pages?

We developed these pages because of the lessons we learned over the years of value investing. From the market crashes in 2001 to 2002 and 2008 to 2009, we learned that value investors should also keep an eye on overall market valuation. Many times value investors tend to find cheaper stocks in any market. But a lot of times the stocks they found are just cheaper, instead of cheap. Keeping an eye on the overall market valuation will help us to focus on absolute value instead of relative value.

The indicators we develop focus on the long term. They will provide a more objective view on the market.

Ratio of Total Market Cap over GDP - Market Valuation and Implied Returns

1399347686357.png

The information about the market valuation and the implied return based on the ratio of the total market cap over GDP is updated daily. As of May 5, 2014, the total market cap as measured by Wilshire 5000 index is 116.6% of the U.S. GDP. We can see the equity values as the percentage of GDP are near their peaks. The only time they were higher was at the apex of the dot-com bubble. The stock market is likely to return about 1.7% a year in the coming years. The Stock Market is Significantly Overvalued. As a comparison, at the beginning of 2013, the ratio of total market cap over GDP was 97.5%, and it was likely to return 4% a year from that level of valuation.

A quick refresher (Thanks to Greenbacked): GDP is “the total market value of goods and services produced within the borders of a country.” GNP is “the total market value of goods and services produced by the residents of a country, even if they’re living abroad. So if a U.S. resident earns money from an investment overseas, that value would be included in GNP (but not GDP).”

The following chart is the Ratio of Total Market Cap over GNP (As of March 31, 2014)

1399347886097.png

For details, please go to the daily updated page. In general, the returns of investing in an individual stock or in the entire stock market are determined by these three factors:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company's stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over the long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividends are an important portion of the investment return. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, its stock price often does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B, etc. These ratios can be applied to individual businesses, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

Putting all the three factors together, the return of an investment can be estimated by the following formula:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

From the contributions we can get the predicted return of the market.

The Predicted and the Actual Stock Market Returns

This model has done a decent job in predicting the future market returns. You can see the predicted return and the actual return in the chart below.

1399348179439.png

The prediction from this approach is never an exact number. The return can be as high as 6.7% a year or as low as -6.2% a year, depending where the future market valuation will be. In general, investors need to be cautious when the expected return is low.

Shiller P/E - Market Valuation and Implied Returns

The GuruFocus Shiller P/E page indicates that the Shiller P/E is 25.3. This is 53.3% higher than the historical mean of 16.5. Implied future annual return is 1.1%. The historical low for Shiller P/E is 4.8, while the historical high is 44.2.

The Shiller P/E chart is shown below:

1399359453817.png

Over the last decade, the Shiller P/E indicated that the best time to buy stocks was March 2009. However, the regular P/E was at its highest level ever. The Shiller P/E, similar to the ratio of the total market cap over GDP, has proven to be a better indication of market valuations.

Overall, the current market valuation is more expensive than the most part of the last 130 years. It is cheaper than most of the time over the last 15 years.

To understand more, please go to GuruFocus' Shiller P/E page.

John Hussman’s Peak P/E:

John Hussman presently estimates prospective 10-year S&P 500 nominal total returns averaging just 2.4% annually, with negative expected total returns on every horizon shorter than seven years.

In John Hussman’s commentary on May 5, 2014, “Cahm Viss Me Eef You Vahn to Live,” he said “We’ve recently emphasized that our estimates for probable S&P 500 nominal total returns have now declined below zero on every horizon of 7 years and shorter. At longer horizons, the 6.3% growth rate that we’ve assumed for nominal GDP over the coming years will begin to bail investors out given enough time, and as a result, our projection for 10-year S&P 500 nominal total returns peeks its head up above zero, at about 2.4% annually from current levels. Looking out 15 years, the expected 15-year total return approaches 4.4% annually, and at that horizon, investors are unlikely to lose money even if actual returns are a standard deviation below our expectations. To the extent that 6.3% growth in nominal GDP seems too high (and there are certainly reasons to think so), just reduce those annual return projections accordingly.”

The key point is this – everything that investors can expect to obtain from selling stocks 7 years from now is already on the table today. Valuations might move higher over the very short run, but at present valuations, investors would require a positive surprise more than one standard deviation above expectations just to pull the likely 2-year return out of negative territory. The chart below provides a quick summary of our return expectations for the S&P 500 – from current price levels – over a variety of investment horizons. I emphasize the phrase “from current price levels,” as a significant retreat in valuations is likely to dramatically shift this profile, as it has over the completion of every market cycle in history.”

In all the three approaches discussed above, the fluctuations of profit margin are eliminated by using GDP, the average of trailing 10-year inflation-adjusted earnings, and peak-P/E, revenue, or book value, etc. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only 1.1-2.4% annually in the future years.

Jeremy Grantham’s 7-Year Projection:

In Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham said, “We are far off the pace still on both of the two most reliable indicators of value: Tobin’s Q (price to replacement cost) and Shiller P/E (current price to the last 10 years of inflation-adjusted earnings). Both were only about a 1.4-sigma event at the end of March. (This is admittedly because the hurdle has been increased by the recent remarkable Greenspan bubbles of 2000 and a generally overpriced last 16 years.) To get to 2-sigma in our current congenitally overstimulated world would take a move in the S&P 500 to 2,250.”

Best Guesses for the Next Two Years:

With the repeated caveat that prudent investors should invest exclusively or nearly exclusively on a multi-year value forecast, my guesses are:

1) That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.

2) But after October 1, the market is likely to be strong, especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.

3) And then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”

“The bull market may come to an end any time, indeed as I write it may already have happened. It could be derailed by disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation, or, perhaps most dangerous and likely, an extreme Chinese slowdown. But I believe it probably (i.e., over 50%) will not end for at least a year or two and probably not before it reaches a level in excess of 2,250 on the S&P 500. Prudent long-term value investors will of course treat all of the above as attempted entertainment (although I believe all statistically accurate) and be prepared once again to prove their discipline and man-hoods (people-hoods) by taking it on the chin. I am not saying that this time is different (attention Edward Chancellor). I am sure it will end badly. But given this regime of the Federal Reserve and given the levels of excess at other market peaks, I think it would be different to end this bull market just yet.”

As of March 31, 2014, GMO’s 7-year forecast is below:

Stocks

     

US Large

-1.3%

Intl Large

1.0%

US Small

-5.0%

Intl Small

0.3%

US High Quality

2.1%

Emerging

4.3%

Bonds

     

US Bonds

0.5%

Inflation Linked Bonds

0.7%

Intl Bonds Hedged

-2.3%

Cash

-0.4%

Emerging Debt

2.5%

   

Other

     

Timber

5.4%

   

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBtbYEu0yy2D%2fiCDRl0NlivnM4yGmRsi0Q3ZT%2buwXoJqwi%2byIou3qAJr2NJ8GA73uQXm4qRCb1vzM5HuHANlUuUoxp0IomhjzI%3d

GMO's expected U.S. large cap real return is -1.3%. This number does not agree with what we find out with market/GDP ratio and Shiller P/E ratio. The U.S. high quality’s return is expected to be 2.1% a year.

Insider Trends

As indicated by the three different approaches discussed above, the best buying opportunities over the last five years appeared when the projected returns were at their highest level from October 2008 to April 2009, when investors could expect 10% a year from the U.S. market.

If average investors missed this opportunity, corporate insiders such as CEOs, CFOs and directors did not. As a whole they purchased their own company shares at more than double the normal rate from October 2008 to April 2009. Many of these purchases resulted in multi-bagger gains. This confirmed again the conclusions of earlier studies: The aggregated activities of insiders can serve as a good indicator for locating the market bottoms. Insiders as a whole are smart investors of their own companies. They tend to sell more when the market is high, and buy more when the market is low.

This is the current insider trend for S&P 500 companies:

1399362280061.png

The latest trends of insider buying are updated daily at GuruFocus' Insider Trend page. Data is updated hourly on this page. The insider trends of different sectors are also displayed in this page. The latest insider buying peak is at this page: September 2011, when the market was at recent lows.

Conclusion: The stock market is not cheap as measured by long term valuation ratios. It is positioned for about 1.1% to 2.4% of annual returns for the next decade. By watching the overall market valuations and the insider buying trends investors will have a better understanding of the risk and the opportunities. The best time to buy is when the market valuation is low, and insiders are enthusiastic about their own company's stocks.

Investment Strategies at Different Market Levels

The Shiller P/E and the ratio of total market cap over GDP can serve as good guidance for investors in deciding their investment strategies at different market valuations. Historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high quality business and strong balance sheet will provide better returns in this environment. When the market is cheap, beaten down companies with strong balance sheets can provide outsized returns.

To Summarize:

1. When the market is fair valued or overvalued, buy high-quality companies such as those in the Buffett-Munger Screener.
2. When the market is undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener. Buy a basket of them and be diversified.
3. If market is way over valued, stay in cash. You may consider hedging or short.

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