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Market Valuations and Expected Returns - August 5, 2014

August 05, 2014
Vera Yuan

Vera Yuan

78 followers

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%. In April, it was about even for the whole month. In May, the market gained 2.10% and in June, the market benchmark S&P 500 went up 1.91%. However, in July, the market went down by 1.51%.

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 a lower future returns.

In Jeremy Grantham’s GMO Second Quarter 2014 Letter, he said, “Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect. What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. The very disappointment in the rate of recovery thus becomes a virtue for deal making. Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed. My final thought on this issue is the following point, which I failed to make in my bubble discussion last quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of a bubble in the quantity of credit that was being created.”

In John Hussman’s commentary on July 28, 2014, “Yes, This Is An Equity Bubble,” he said “Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000. The median price/revenue ratio of S&P 500 components is already far above the 2000 level, and the average across S&P 500 components is nearly the same as in 2000. The extent of this bubble is also partially obscured by record high profit margins that make P/E ratios on single-year measures seem less extreme (though the forward operating P/E of the S&P 500 is already beyond its 2007 peak even without accounting for margins).”

In Oakmark Fund - Second Quarter 2014 Letter, Bill Nygren thought three main reasons explain many investors’ negative outlook that the market being overvalued.

First, the market was much cheaper five years ago. The S&P 500 bottomed in March 2009, and, including dividends, it has more than tripled since then. Almost by definition, more investors were negative at the market bottom than at any other time. The speed of this stock market recovery has made it especially difficult for those bears to admit their mistake and get invested again. Future earnings expectations are much more important than historical prices for assessing where a company should be priced today. And based on reasonably good earnings expectations, we don’t believe the case has been made for declaring the market overvalued.

Second, many of the stocks that now have low P/Es on expected earnings are financials, and after their role in the crisis, many investors, including many value investors, have completely sworn off owning them. Financial companies had too much leverage; they let their underwriting standards decline, and most importantly, the real estate market crashed. Our big mistake was that we didn't see the real estate crash coming. Today, financials are less levered, they have tighter underwriting standards, and most importantly, they do not seem likely to face another crash in real estate prices. One of my co-managers for Oakmark Select, Tony Coniaris, posted an excellent piece on our website outlining our rationale for being so positive on financials. Today, the sector most of the Oakmark Funds are invested the heaviest in is financials, and I think we are in good company. As of year-end, Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway had invested over 40% of its public stock portfolio in financials, and, if you include its Bank of America warrants, that percentage increases to the mid-40s.

The third reason investors cite for not owning stocks is that it has become hard to find stocks selling at low P/E ratios. The median multiple on forward earnings estimates for the S&P 500 stocks today is 17x. (Low multiples on some mega-cap companies reduce the cap-weighted S&P 500 to 15x.) Though certainly higher than the 11x median in 2009, on its own, the level of 17x isn’t terribly problematic. A bigger issue is the distribution. Though we too are always looking for average businesses at great prices, we believe the tight P/E distribution creates a different opportunity. When the market is pricing everything as if it were average, we’ll happily buy great businesses. To us, buying great businesses at average prices is just as much value investing as is buying average businesses at great prices. So we see opportunity today in the other half of the distribution—companies selling at a smaller premium than usual.”

In Dodge & Cox’s Second Quarter 2014 Commentary, it stated out “In the second quarter, U.S. equity markets continued to rise: the S&P 500 posted its sixth consecutive quarter of gains. While every sector of the index generated positive returns, Energy and Utilities were the strongest. In the United States, growth in economic activity rebounded, which assuaged concerns the economy was losing momentum after a slow start to the year. The labor market and household spending showed further signs of improvement, and businesses invested more in fixed assets. However, the housing recovery remained slow and turmoil in the Middle East modestly increased oil prices. Corporate balance sheets and cash flows continue to be robust; we remain optimistic about the long-term prospects for corporate earnings growth. Despite strong returns in recent years, we believe U.S. equity market valuations remain reasonable relative to long-term averages: the S&P 500 traded at 15.6 times forward estimated earnings with a 2.0% dividend yield at quarter end. Acknowledging that markets can be volatile over the short term, we encourage shareholders to remain focused on the long term.”

In Mario Gabelli’s The Gabelli Equity Income Fund Second Quarter 2014 Shareholder Commentary, he said, “The second quarter of 2014 saw stocks rise once again, adding to the modest gains of the first quarter. The bull market we have been experiencing since March of 2009 has now been going on for sixty-three months, and the S&P 500 has almost tripled in that time. Some might say that those impressive gains are a sign that the market has gone up too far, too fast. However, we think it is more indicative of just how oversold the stock market was during the depths of the great recession. Our economy has been dealing with many problems, not the least of which is polarization in Washington. Although we still have political bickering in the capital, the budget deficit is finally starting to come down, and we no longer need to worry about issues such as a government shutdown. The housing market, which collapsed a few years ago during the great recession, has been making a steady comeback. We are starting to see home prices rise across the country and more homes are being built. Another bright spot for the economy continues to be the energy sector. In fact, we believe that 'fracking' is truly a game changer, and that the U.S. is well on its way to becoming energy independent in the next few years. We already have very low natural gas prices here in North America as a result of fracking, and our energy prices should stay low versus the rest of the world for the foreseeable future. This competitive advantage in energy is a major plus for our manufacturing sector as well, especially for heavy users of energy such as the chemical industry. We are in the camp that believes the U.S. is now in the midst of a manufacturing renaissance  good news for our overall economy. Along with the improving economy comes less need for monetary easing by the Federal Reserve. The markets, both equity and fixed income, have benefited from QE3, but we are finally nearing the end of QE3 and we expect the program to conclude before the end of the year. Sometime in the first half of 2015, we expect the Fed will start to move short term interest rates up, in a slow, measured manner. Although the retail investor may still be somewhat shell-shocked from the financial crisis of a few years ago, corporate America has been a very aggressive buyer of stock over the past few years through buyback programs.”

Daniel Loeb mentioned in Third Point Second Quarter 2014 Investor Letter that “In the U.S., the Second Quarter’s strength was magnified by the rebound from poor weather that depressed Q1 results. Despite strong recent data on jobs and manufacturing, it remains unclear whether growth will be robust enough to merit tightening action by the Fed this year. We believe we are entering a decisive period and normalized Third Quarter economic growth will mark a key inflection point. Looking ahead, we expect market volatility to continue.”

Quoting from MarketWatch, Mark Cook, a veteran investor included in Jack Schwager’s best-selling book, “Stock Market Wizards,” and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble. Cook predicts that within 12 months, the market will suffer a 20% or greater pullback. Says Cook: “It may take months and months for the correction to develop. I don’t look at how low the market drops, but how it rallies. I will look for lower highs and lower lows. Every rally aborts before the previous high, and every decline penetrates and accelerates below the previous low.”

Professor Robert Shiller said on June 25, 2014 that “I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

According to our market valuation article at the beginning of 2014, 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 2001-2002 and 2008-2009, 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

1407265969981.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 August 4, 2014, the total market cap as measured by Wilshire 5000 index is 119.6% of the US 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 1.4% 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 “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 June 30, 2014)

1407266089731.png

As of June 30, 2014, the ratio of Wilshire 5000 over GNP is 1.208.

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 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.

1407266112905.png

The prediction from this approach is never an exact number. The return can be as high as 6.3% a year or as low as -6.5% 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 25.5. This is 53.6% higher than the historical mean of 16.6. 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:

1407266200260.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 nominal total returns averaging just 1.9% annually, with zero or negative expected total returns on every horizon shorter than 7 years.

In John Hussman’s commentary on July 28, 2014, “Yes, This Is An Equity Bubble,” he said “Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000. The median price/revenue ratio of S&P 500 components is already far above the 2000 level, and the average across S&P 500 components is nearly the same as in 2000. The extent of this bubble is also partially obscured by record high profit margins that make P/E ratios on single-year measures seem less extreme (though the forward operating P/E of the S&P 500 is already beyond its 2007 peak even without accounting for margins).”

“Recall also that the ratio of nonfinancial market capitalization to GDP is presently about 1.35, versus a pre-bubble historical norm of about 0.55 and an extreme at the 2000 peak of 1.54. This measure is better correlated with actual subsequent market returns than nearly any alternative, as Warren Buffett (Trades, Portfolio) also observed in a 2001 Fortune interview. So if one wishes to use the 2000 bubble peak as an objective, we suggest that it would take another 15% market advance to match that highest valuation extreme in history – a point that was predictably followed by a decade of negative returns for the S&P 500, averaging a nominal total return, including dividends, of just 3.7% annually in the more than 14 years since that peak, and even then only because valuations have again approached those previous bubble extremes. The blue line on the chart below shows market cap / GDP on an inverted left (log) scale, the red line shows the actual subsequent 10-year annual nominal total return of the S&P 500.”

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 1.1-1.9% 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.”

In GMO Second Quarter 2014 Letter, he said “Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect. What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. The very disappointment in the rate of recovery thus becomes a virtue for deal making. Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed. My final thought on this issue is the following point, which I failed to make in my bubble discussion last quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of a bubble in the quantity of credit that was being created.”

As of June 30, 2014, GMO’s 7-year forecast is below:

Stocks

     

US Large

-1.7%

Intl Large

0.7%

US Small

-5.2%

Intl Small

0.5%

US High Quality

2.2%

Emerging

3.6%

Bonds

     

US Bonds

0.0%

Inflation Linked Bonds

-0.1%

Intl Bonds Hedged

-2.6%

Cash

-0.4%

Emerging Debt

1.6%

   

Other

     

Timber

5.4%

   

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBtnjt5uucdOPTDOS6iaxprnp3nh4RKMz2vuFFstHPGOQXB76XbDN34ZEN2TMTZCJKoWxPr575%2bQTggND%2b0g25QwvkTUbFNbB3wNZIjDEq%2fNw%3d%3d

GMO expected US large cap real return is -1.7%. This number does not agree with what we find out with market/GDP ratio and Shiller P/E ratio. The US high quality’s return is expected to be 2.2% 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:

1407269300657.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 of 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 1.1-1.9% 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 overvalued, stay in cash. You may consider hedging or short.

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