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Market Valuations and Expected Returns – September 4, 2014

September 05, 2014
Vera Yuan

Vera Yuan

81 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%. In July, the market went down by 1.51%. However, the market gained 3.77% over August, which was the second-biggest monthly gain since 2014.

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 John Hussman's Second Quarter 2014 Letter to Shareholders, he said, “We believe that the financial markets are presently in the latter stages of what will ultimately be remembered as the “QE bubble” – a period of reckless speculation and overvaluation in a broad range of risky securities, particularly equities, high-yield debt and leveraged loans (loans to already highly indebted borrowers). We view this bubble as the result of the Federal Reserve’s policy of quantitative easing or 'QE,' which has driven short-term interest rates to zero, depriving investors of any source of safe return. This policy has encouraged investors to drive the prices of risky assets higher in a speculative 'reach for yield,' to the point that we presently estimate zero or negative total returns for the S&P 500 Index – from current price levels – on every horizon of 8 years or less.

“In our investment approach, the strongest expected market return/risk profile we estimate is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage can follow. Some of this may be on virtually no news at all, because that normalization is baked in the cake and is independent of interest rates. All that is required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.

In our view, this outcome is inevitable because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there is no way to defer this process permanently. Nor would the effort be constructive because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We do not believe that risk has been permanently removed from risky assets. The belief that it has been removed is itself the greatest risk that investors face here.”

In Jeremy Grantham’s GMO Second Quarter 2014 Letter, he mentioned, “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 Ron Baron’s Second Quarter 2014 Shareholder Letter, he said, “Stock valuations at present approximate 16 times earnings. That is the median level for the past hundred years. Stock prices are based on many factors. Among them are interest rates and our economy’s growth prospects. Interest rates have never been lower in the history of our nation. Low interest rates make stocks more valuable. If investors expected rates to remain at present levels, stock multiples would now be much higher. Further, our economy is steadily growing; unemployment is steadily falling; and our nation is fast becoming energy independent. These are all good things.”

In Steven Romick’s Q2 FPA Crescent Fund Shareholder Letter, he mentioned, “If you were to then surmise that there isn’t much trading at low valuations, you would be correct. With many stocks hitting new highs, the number of stocks trading at lower Price/Earnings (P/E) ratios is near its low. We continue to trust that long-term thinking will pay dividends in the form of good returns and allow us to avoid the frequent mistakes more commonly associated with the need for more immediate gratification. Patient investors have created more than one great family fortune over time and over diverse industries by disregarding present performance in an effort to create wealth at some point in the future; e.g., Buffett, Crown, Tisch, Koch, Frère and Pritzer, just to name a few.”

In Bill FrelsMairs & Power Balanced Fund Second Quarter 2014 Commentary, he said, “Everybody likes a winner. And, if the stock market was any gauge during the second quarter, there was a lot to like. Stocks extended their winning streak for the sixth consecutive quarter, as measured by the Standard & Poor’s 500 Index – a phenomenon surpassed only six other times since 1928. After such historic gains, though, should cautious investors grow concerned about the second half of the year? We don’t think so. Successful investment approaches never depend on the positive or negative market performance of any single quarter. At Mairs and Power, we base our portfolio decisions on the facts about companies, not the markets. In particular, we endeavor to identify and invest in those companies that have shown their ability to achieve consistent, above-average growth from a position of demonstrable and durable competitive advantage. Looking toward year end, we will continue to closely evaluate corporate earnings and revenue against the multiples we view to be still slightly above historical levels. The price/earnings (P/E) multiple of the S&P 500, a key gauge of corporate earnings health, stood just above its long-term average of around 15.5 at quarter end, almost exactly where it ended the first quarter. This is further proof to us that stock prices continue to be influenced more by actual, organic company earnings and revenue growth than by the Federal Reserve’s waning stimulus program. While we believe economic conditions appear sufficiently strong to support this current, positive earnings trend, a market correction in the near term would not surprise us. The advantages of investing in well-diversified portfolios, rebalanced regularly, provide one of the better, more reliable routes for meeting long-term goals regardless of the quarter.”

In Jean-Marie Eveillard’s First Eagle Global Fund Second Quarter 2014 Commentary, he said “in the U.S. the economy would appear to be overcoming earlier fiscal headwinds. There is increased optimism among business leaders and consumers alike, reflected in a general rise in stock and credit values. We are however mindful that excessive optimism is the enemy of the prudent investor. The U.S. fiscal deficit is declining in large part due to a cyclical improvement in tax revenues but also due to ongoing interest rate repression. With Federal Debt at nearly one times GDP and interest rates anchored close to 0%, compared to a more normal rate of 4%, it is no surprise that the deficit and economic outlook appear benign. However, were interest rates to rise to more normal levels, conditions could swiftly change. The deficit would feel pressure from higher interest rates despite better tax revenues. Companies whose margins benefited from reasonable demand being pulled forward from the future with easy policy coupled with moderating labor costs could see these trends reverse thereby making profits less responsive to the recovery.”

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

1409854774533.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 September 4, 2014, the total market cap as measured by Wilshire 5000 index is 124.7% 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 0.9% a year from this level of valuation, including dividends 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 September 2, 2014)

1409854973918.png

As of September 2, 2014, the ratio of Wilshire 5000 over GNP is 1.212.

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.

1409854996785.png

The prediction from this approach is never an exact number. The return can be as high as 5.8% a year or as low as -6.9% 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 26.3. This is 58.4% higher than the historical mean of 16.6. Implied future annual return is 0.7%. 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:

1409858336282.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 about 2% annually, with zero or negative expected total returns on every horizon shorter than 8 years.

In John Hussman’s commentary on August 11, 2014, “Low and Expanding Risk Premiums are the Root of Abrupt Market Losses,” he said “Through the recurrent bubbles and collapses of recent decades, I’ve often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.

“The past several years of quantitative easing and zero interest rate policy have not bent that Iron Law at all. As prices have advanced, prospective future returns have declined, and the 'risk premiums' priced into risky securities have become compressed. Based on the valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90%), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only about 2% annually over the coming decade.”

In Second Quarter 2014 Letter to Shareholders, John Hussman said, “We fully expect that the phrase 'QE bubble' will soon enough join the list of phrases like 'housing bubble,' 'tech bubble,' 'dot-com bubble,' 'New Economy,' 'go-go years,' and 'roaring '20s.' The delusions associated with each period seem self-evident now. It is easy to forget that overvalued, overbought, overbullish extremes are the same today as they were at those points, and investors then believed precisely the same thing: this time is different.

We believe that the financial markets are presently in the latter stages of what will ultimately be remembered as the 'QE bubble' – a period of reckless speculation and overvaluation in a broad range of risky securities, particularly equities, high-yield debt and leveraged loans (loans to already highly indebted borrowers). We view this bubble as the result of the Federal Reserve’s policy of quantitative easing or 'QE,' which has driven short-term interest rates to zero, depriving investors of any source of safe return. This policy has encouraged investors to drive the prices of risky assets higher in a speculative 'reach for yield,' to the point that we presently estimate zero or negative total returns for the S&P 500 Index – from current price levels – on every horizon of 8 years or less.

“In our investment approach, the strongest expected market return/risk profile we estimate is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage can follow. Some of this may be on virtually no news at all, because that normalization is baked in the cake and is independent of interest rates. All that is required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.

In our view, this outcome is inevitable because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there is no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We do not believe that risk has been permanently removed from risky assets. The belief that it has been removed is itself the greatest risk that investors face here.”

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 0.7-2.0% 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 July 31, 2014, GMO’s 7-year forecast is below:

Stocks

     

US Large

-1.4%

Intl Large

0.8%

US Small

-4.4%

Intl Small

1.0%

US High Quality

2.4%

Emerging

3.4%

Bonds

     

US Bonds

0.0%

Inflation Linked Bonds

-0.1%

Intl Bonds Hedged

-2.7%

Cash

-0.4%

Emerging Debt

1.7%

   

Other

     

Timber

5.4%

   

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBItKpxMQu4GxGTINZJndRPrSZBb4XkvGjZBIwNW%2bXBmfuiOqqJNtIR7Sdm3f7MaW4x5McKBJh6CP%2b8kxlL3dA1DEz%2bNSCF4uRxhdr8gWuJyw%3d%3d

GMO expected U.S. large cap real return is -1.4%. 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 2.4% 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:

1409858174849.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 0.7-2.0% 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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