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The Science of Hitting
The Science of Hitting
Articles (489) 

Equity Valuations and Long-Term Investing

Some thoughts on what the forward price-earnings ratio means for US equity returns

July 24, 2018 | About:

In Third Point’s second quarter investor letter, here’s what Dan Loeb had to say about market valuations (bold added for emphasis):

“Our view of the current economic backdrop is: 1) U.S. growth will remain buoyed at a high level due to the fiscal stimulus impulse from spending increases coming into the system. Barring an escalation of trade conflict, most of the deceleration in the global manufacturing cycle is likely behind us; 2) inflation has remained stable in the first half of the year, with little sign of impending acceleration, despite a record low unemployment rate; 3) the cycle can extend longer than many people think as companies are in good shape, particularly in the US, and the consumer is strong while carrying only modest debt levels; and, 4) equities are not expensive at 16x forward earnings. We believe the risk of recession in the next year remains low and, without this concern weighing heavily on markets and with the tailwinds we described, we believe equities should go higher but at a moderate pace.”

Here’s a graphic representation of the forward price-earnings ratio for the S&P 500 (from JPMorgan):

As the chart shows, the forward price-earnings for the index is roughly in line with where it has been since 1990. There’s a significant benefit to S&P 500 earnings in 2018 (which cuts the forward P/E ratio), which largely reflects a lower effective tax rate as a result of the Tax Cuts and Jobs Act. So by that measure, stocks are reasonably priced relative to recent history. For the individual investor, what should that mean for our expectations for the S&P 500 in the years to come? I think a different chart from JPMorgan is even more illuminating:

If you look at the peak before the financial crisis of 2008 - 2009, you’ll notice that the S&P 500 was trading at less than 16x expected forward earnings. Said differently, equity valuations appeared reasonable at that point as well. As the chart also shows, it turns out that this didn’t do much to lessen the pain of the financial crisis: From peak to trough, the S&P 500 fell by nearly 60%.

Here’s another way of thinking about that time period: If you invested in the S&P 500 at its October 2007 peak, right before one of the most devasting corrections in market history, the price return for the index over the ensuing 11 years has been roughly 80% (cumulatively). That's an annualized return of ~5.5% per year. Assuming dividend reinvestment, your total shareholder return (TSR) has been about 7.5% - 8.0% per year. It started out really badly, but you were left with a decent result if you hung in for the long run.

So what does this all mean? My takeaways are not mind-blowing, but I think they’re worth reiterating.

First, reasonable prices relative to historic valuations may be comforting, but they do not prevent the market from falling significantly in the near future. And unlike Loeb, I do not think I can intelligently handicap the likelihood of a recession or market correction in the next year. In my view, you should always positon your portfolio in a manner where you’re able to withstand a significant drawdown in equity markets over the next few years. Equities trading at reasonable valuations relative to recent history does not change that.

Second, trying to time the market is incredibly difficult. I’ve listened to people argue that U.S. equities have been overvalued since at least 2011. Many of these commentators made arguments that I believed were quite valid. But at the end of the day, even if their arguments were correct in the short run, they’re making a bad long-term bet (and have missed significant gains as a result). Even if you went from 0% to 100% invested in equities at the October 2007 peak, you still had a reasonable return over the past 11 years (meaningfully better than what you would’ve achieved with government bonds). And as shown in the first chart, those gains have been largely due to increases in intrinsic value, not multiple expansion.

There will be some 10 - 15 year periods where that doesn’t happen – but those times will probably be preceded by or followed by outsized returns. Given that we cannot predict what the next five years will look like, the goal should be to minimize bad outcomes and to maintain a long-term perspective. One way to do that is to avoid sudden, large changes in your asset allocation (like going from 0% to 100% equities in October 2007). Maintaining a relatively consistent allocation to equities has a higher probability of success than trying to dance in and out of the market.

I’ll close with a quote from Warren Buffett (Trades, Portfolio) that sums this up nicely:

“American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle."

Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: "We spend a lot of time looking for systemic risk; in truth, however, it tends to find us."

During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively financed American businesses will almost certainly do well.

Disclosure: None.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.9/5 (8 votes)

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Comments

stephenbaker
Stephenbaker - 2 months ago    Report SPAM

Another good article, Science - thanks. Interest rates are what distinguish the last 10 years from prior cycles. I'd get worried if the Fed gets too aggressive, too fast. Otherwise, run of the mill downturns and recessions, as well as the ocassional black swan the tends not to last, are to be expected.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Stephen - Thanks for the kind words!

danwatson888
Danwatson888 - 2 months ago    Report SPAM

good article Science - but i do think there are quite a few popular tech companies at way to high prices - best

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Danwatson - I'm sure there are a few. Does that mean betting against them for the long-term is a smart idea? That I'm much less sure of. But I'm open to the idea! Thanks for the comment.

danwatson888
Danwatson888 - 2 months ago    Report SPAM

Science = I agree with you to not bet against them ( I am not a short trader anyway) but I will trade in and out of many of the biotech and medtech stocks i take postions in - including, CELG, ABMD, ISRG, BIIB, REGN, I try to hold on to the biotech company's with dividends like AMGN, GILD, LLY, MDT - others = https://www.danwatson.com/seeking-alpha.html - best

jtdaniel
Jtdaniel premium member - 2 months ago

Hi Science, great article. While I would not invest in SPY or any of the FAANG stocks at prevailing prices, I do think there are a few opportunities for traditional value investors. Only considering US stocks in my current portfolio, I could project a basket of CVS, Exxon, Starbucks, Berkshire and Wells Fargo to provide a profitable return long into the future with minimal risk of permanent capital loss. My 27% cash position is insurance against any bear market or personal ignorance. Best, dj

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Jtdaniel - We continue to like some of the same ideas :) Thanks for the kind words!

georgedona
Georgedona premium member - 2 months ago

Awesome article! Finally, someone is writing a sensible article that is worth reading! I had a giggle at the sentence "ever-present naysayers may prosper by marketing their gloomy forecasts", sometimes forums are full of forecasters, LOL :)

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Georgedona - I'm glad you found the article worthwhile! Have a great day.

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