After more than 40 years of work in the financial markets, studying all the data I could get my hands on, I’ve found it to be universally true that those who argue “history doesn’t matter” have never actually studied history. (View Highlight)
Easy money does nothing to support the market when investor psychology is risk-averse, as investors should recall from the 2000-2002 and 2007-2009 collapses, but it’s a remarkable amplifier of speculation if investors have psychologically ruled out the possibility of price losses – getting a yield greater than zero becomes the only thing that matters. (View Highlight)
We’ve adapted in recent years, becoming content to align our outlook with prevailing market conditions – mainly valuations and market internals, which are our best gauge of speculative versus risk-averse investor psychology – without assuming “limits” to either. (View Highlight)
When investors are inclined to speculate, they tend to be indiscriminate about it (View Highlight)
I constructed our gauge of market internals in 1998, with minor adaptations since, to measure the “uniformity” of market action across thousands of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness (View Highlight)
Indeed, as I’ve detailed in prior market comments, uniformly favorable internals can provide opportunities for what Benjamin Graham might describe as “rational speculation” even in an overvalued market (View Highlight)
While Fed easing can amplify speculation when investors are inclined to speculate, it does nothing to support stocks when investors are risk-averse. That’s (View Highlight)
because when investors are risk-averse, they treat safe liquidity as a desirable asset rather than an inferior one (View Highlight)
Indeed, all of the cumulative gains of the S&P 500 across history, over and above Treasury-bill returns, have occurred during periods of favorable internals on our measures, regardless of whether Fed policy has been easy or tight. (View Highlight)
Despite the extremes in historically reliable valuation measures, we can be certain of one thing: investors don’t care. They never do at market extremes. If they did, the financial markets could never reach extremes like 1929, 2000, and today in the first place. (View Highlight)
The economic and financial history that we take for granted is replete with bubbles, collapses, inflation, deflation, expansion, recession, depression, world wars, and countless innovations that had profound economic impact – automobiles, commercial aviation, automation, television, pharmaceuticals, electronics, computers, biotechnology – not to mention Otto Frederick Rohwedder’s 1928 introduction of sliced bread. But hey, the iPhone 14 is coming out. (View Highlight)
If rich valuations alone were enough to stop speculation, it would be impossible to reach the breathtaking extremes that precede the collapse (View Highlight)
Our response has been to give far more priority to the condition of market internals. As Graham & Dodd noted of the 1929 peak, investors abandoned their attention to reliable valuation measures precisely because “the records of the past were proving an undependable guide to investment.” Then the market lost 89% of its value. (View Highlight)
It’s been the rule, not the exception, for the largest 10 stocks in the market to comprise between 20-30% of market capitalization. For a century, bull markets have peaked amid public perception that these behemoths stood behind utterly impenetrable fortresses. (View Highlight)
It’s been the rule, not the exception, for earnings to appear glorious at market peaks, encouraging investors to pay top dollar on top dollar. Yet (View Highlight)
It’s been the rule, not the exception, for low interest rates to encourage rich valuations. The problem is that low rates do nothing to mitigate the poor market returns that follow those rich valuations (View Highlight)
Indeed, despite the wild departures of Fed policy variables in recent years, information about monetary variables does very little to explain fluctuations in output or employment in recent decades, beyond what can be explained using wholly non-monetary variables. (View Highlight)
So yes, zero-interest rate policy has been unprecedented, but its main impact has been on yield-seeking investor psychology, resulting in a greater need to rely on market internals (View Highlight)
The chart below – thanks go to our resident math guru Russell Jackson for compiling the data – shows the median price/revenue across S&P 500 components over time. The current level is twice where it was at the 2000 market peak. (View Highlight)
I would argue that the current set of high multiple stocks are more deserving of their multiples than they were in 2000. But then, back in 2000 I projected (correctly) that technology stocks stood to lose about -82% of their value. I don’t expect market losses of that magnitude over the completion of this cycle. (View Highlight)
What’s odd is how adamant investors seem to be not only that profit margins will remain above average, but that they will not retreat even from current extremes (View Highlight)
They’re not just higher than the historical norm – they’re higher than at every point in history prior to the past two years. Yet Wall Street analysts describe P/E ratios as “cheap” and “reasonable” without a moment’s hesitation about the denominator. (View Highlight)
Well, based on 30 years of forward earnings estimates from Wall Street analysts, it’s straightforward to show that the forward operating P/E has a very high correlation of about 0.92 with the Shiller cyclically-adjusted P/E (CAPE). When we estimate the relationship between the two, the best fit for the S&P 500 forward operating P/E is 2.5 + 0.5 x CAPE. (View Highlight)
Using that relationship, we can impute the forward operating P/E all the way back to 1900. The norm is 11. Eleven. Not a typo (View Highlight)
For investors who are willing to believe that elevated profit margins will be sustained forever, these are the most optimistic valuation measures they can choose. Even then, to imagine that the current forward P/E of 19 is “normal” is to have no idea what “normal” means. (View Highlight)
Unfortunately, the financial industry often encourages investors to imagine this is how markets work. Is there some meaningful structure that drives returns? The answer is yes. Understanding it offers clear insights about how we got here, and where we may be going. (View Highlight)
Though our most reliable market valuation measures have a correlation of over 0.9 with subsequent 10-12 year S&P 500 total returns, understanding the structure of returns does not mean that returns are entirely predictable. (View Highlight)
Again, the smoother the fundamental is, and the more representative it is of very long-term cash flows – not just this year’s income – the more reliable it tends to be (View Highlight)
As I noted during the tech bubble, earnings tend to surge during economic expansions, making P/E ratios look “cheap” based on the temporarily bloated denominator (View Highlight)
The gradual slowing in economic growth rates is enormously relevant to the question of whether current market valuations can be “justified” by low interest rates (View Highlight)
Now consider a situation where interest rates are lower, but the growth rate of cash flows is also lower. In this case, no “valuation premium” is needed to align equity market returns with interest rates, because the low growth rate has already done the job. That’s roughly the situation we have today. (View Highlight)
What I call “structural growth” captures demographic labor force growth, plus trend productivity. “Cyclical growth” captures changes in the rate of employment vs unemployment. The structural growth rate of the U.S. economy is currently down to about 1.6% annually (View Highlight)
In a nutshell, long-term investment returns are driven by precisely three factors: long-term growth in fundamentals (which have well-defined structural drivers), the annualized change in valuation multiples, and the dividend yield (View Highlight)
Worse, if interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” at all, because the low growth rate has already done the job of lowering the expected return on stocks. (View Highlight)
The scatterplot below shows the relationship between our most reliable valuation measure – nonfinancial market capitalization to corporate gross value-added – in nearly a century of data. From the current extreme, we expect the S&P 500 to lose an average of about -2.9% annually over the coming 12-year period. (View Highlight)
A key feature of the chart above is that the slope of the relationship between valuations and returns since 1995 is steeper than the historical relationship. Measured from low valuations, subsequent returns have been substantially higher than during the pre-bubble period, but measured from rich valuations, subsequent returns have not been much different from what investors could expect in the pre-bubble period. (View Highlight)
That pattern actually a “tell.” It’s not the relationship between valuations and returns that has shifted up in parallel. Rather, it reflects a sequence of bubbles since 1995 that front-load returns, and then resolve with negative returns, as usual. (View Highlight)
If it did, the blue line would collapse to the red one. Put simply, the apparent “shift” in the relationship between valuations and returns is an artifact of front-loaded returns and speculative overpricing. (View Highlight)
Investors seem unanimous in expecting stocks to at least outperform the low yield on Treasury bonds in the coming years. Unfortunately, based on measures that are well-correlated with subsequent market returns (aside from periods ending at bubble peaks), we estimate that S&P 500 returns are likely to fall short of bonds just as badly as they did from the 2000 and 1929 peaks. (View Highlight)
The present combination of rich equity market valuations and low interest rates doesn’t create a “justified” or “fair” situation for the financial markets (View Highlight)
If one examines the components that drove those returns (growth in fundamentals, dividend yield, change in valuation), we know precisely what caused those outliers: record valuations at the endpoint of each of those 12-year investment horizon (View Highlight)
Still, keep in mind that a negative 10-12 year outlook can shift to a more favorable one even within a year or two, if the market experiences a material retreat in valuations (as it did from 2000-2002 and 2007-2009). It’s just the current long-term return prospects that investors may want to reconsider. (View Highlight)
The cash flows generated by the economy are nowhere near enough to service bloated market capitalizations in a way that provides adequate long-term investment returns. (View Highlight)
As usual, no forecasts are required. We certainly have long-term and full-cycle market views, driven by valuations, but we’ve abandoned our belief in speculative “limits,” which in turn restores our flexibility in response to shifts in market conditions, particularly those that help to distinguish periods of speculation versus risk-aversion (View Highlight)