Unfortunately – depending on your perspective – our recent stretch of light-hearted, more simplified quarterly updates is about to come to an end. This is in no small part due to the current renovations being performed on our offices, resulting in our 2 weeks of working from home. While only 3 days into this experience, I have learned quickly that lack of normal office interaction leads to a rather unhealthy amount of reflection on all of the financial data, analysis and opinion that we digest on a daily basis. For better or for worse, those that continue reading from here are about to take the brunt of all of that reflection!
Today, we are returning to our favorite topic of discussion – valuations. Whether we realize it or not, every one of us who even watches the evening news is subject to this discussion on a daily basis. Each and every time we hear "the Dow Jones Industrial Average once again achieved an all-time high”, we are talking about valuation in one way or another. It is important to note that markets achieving “all-time highs” is not in any way evidence of overvaluation. After all, stocks generally go up more than they go down over time – why else would we buy them? What is unique however is when stocks seemingly go up every single day.
So, we are going to spend some time analyzing the risks and opportunities that we believe exist in the current environment. We will be examining bonds and interest rates as well as stocks, and make what we believe to be a compelling case as to how they may be more intertwined than in any other time in history.
Let’s start on the stock side of the equation. It is important to note that none of the metrics that we discuss below (or any others for that matter) should be taken as a guarantee that stocks will go up or go down going forward. Anyone that tells you differently is either misguided or dishonest….or both. They do however provide valuable historical context that we can use to analyze the current environment.
SHILLER PE (CAPE)
Source: http://www.multpl.com/shiller-pe/ (covering period between Jan 1, 1881 thru October 19, 2017)
The Shiller PE was created by Dr. Robert Shiller – who won a Nobel Prize in economics for his work on the subject. First, let’s start with explaining what a simple P/E ratio is. It’s simply the current price / share of any stock (or index) divided by its earnings / share. We will discuss the traditional PE a bit later. Dr. Shiller believed that the traditional PE ratio was not sufficient – mainly because of the cyclicality of corporate earnings and the fact that it did not account for inflation. Simply put, his CAPE ratio measures 10 years worth of earnings, then makes adjustments for inflation. The chart above shows the CAPE ratio for the S&P 500 as a whole throughout history. You will note that today’s reading (31.19) is higher than any other point in history, except for the “internet bubble” in the 90s. Both Black Monday and Black Tuesday are indicated on the chart for comparison, and you can see on the chart that we were around 27 right before the Great Recession (and corresponding equity correction) hit.
It should be noted that Dr. Shiller has stated over and over again that this metric should not be used as a market-timing tool. In other words, he views it less as predictive of what stocks will do tomorrow, but rather what we should expect in the coming 10 years or so. Using this particular metric, the S&P 500 is more overvalued than in any other time in history, less the period in the mid to late 90s. So using his metric, we could prognosticate that stock returns over the next 5-10 years could be significantly less (or even negative) than the historical norm.
Warren Buffet’s Market Cap to GDP
Source: https://www.gurufocus.com/ (chart showing December 30, 1970 thru October 19, 2017)
So you might be saying to yourself, “Well, that’s only one metric – and this Shiller guy’s analysis might be wrong”. In fact, you should be questioning any of these metrics as – this can never be stated enough – no person or metric can predict the future of stocks with any degree of certainty. With that, let’s turn to arguably the most widely known and respected investor out there – Warren Buffet. The above chart represents his “market-cap to GDP” indicator, which Mr. Buffet himself describes as “the single best investing indicator”. As the name would suggest, it is derived by taking the total market cap of the Wilshire 5000 Total Market Index divided by GDP.
While the above analysis only goes back to 1970, we can see that the current level of this metric is significantly higher than both the “internet bubble” as well as prior to the Great Recession. Like Robert Shiller, Mr. Buffet states that this metric does not mean that the market is about to come crashing down tomorrow. Instead, he believes that we might expect muted returns from stock investments going forward – at least until valuations once again “normalize”.
Traditional P/E Ratio
Source: http://www.multpl.com/ (chart covers the period from January 1, 1871 thru October 19, 2017)
The most common argument that we hear against either of the two previously mentioned metrics is that “the traditional PE ratio on the S&P 500 is not stretched”. Using the above table, we remain somewhat dumbfounded by this statement. Looking at the chart above, there once again are only two instances – coinciding with the bursting of the internet bubble and the more recent Great Recession – where valuations were higher. So once again, this data might lend itself toward a more cautious view of stocks moving forward.
But let’s not leave it there. The higher the PE, the more overvalued a stock or index is perceived to be (earnings don’t justify the price). Conversely, the lower the PE the more reasonably / undervalued a stock or index is perceived to be (price not adequately reflecting earnings). Remember that PE ratios are derived by dividing the current price of the stock (or index) by its current earnings per share.
Logically, there are two ways that a company can increase its earnings per share. Preferably, the company would be growing its business and overall earnings. But there is another way – simply reduce the number of shares outstanding by buying them back. In that scenario, your business could be stagnant or declining – but you could still show earnings per share growth because you have simply reduced the number of shares outstanding. This is commonly referred to as “financial engineering”, and we are once again at or near historical highs in terms of the amount of money corporations are spending on the repurchases of their own stock.
Interest Rates and The Federal Reserve
10 YEAR TREASURY RATES
Source: http://www.multpl.com/10-year-treasury-rate (chart covers period between Jan 1, 1871 thru Oct 19, 2017)
No talk about equity valuations would be complete without at the same time examining the interest rate environment. The above chart illustrates the interest rates associated with 10 year bonds issued by the US Government throughout history. It is important to note that – since peaking in the 80s – interest rates have dropped in a “straight line” for the past 30+ years.
We could literally add about 100 pages to this update if we wanted to get into detail about all of the ways interest rates specifically affect the economy and markets. Because we are speaking specifically to market valuations in this letter, we are going to narrow that analysis down, along with over-simplifying as necessary. Here’s what we need to understand for this discussion:
- Lower interest rates mean lower borrowing costs for corporations. Companies may borrow more for expansion / investment purposes, or to buy back their own stock using borrowed funds. The latter is seemingly occurring with much greater frequency than the former – and this is important to note going forward.
- Lower interest rates means lower borrowing costs for consumers. Consumers are then willing / able to spend more – particularly on bigger ticket items – because they can borrow the funds at a low cost. As consumers spend more, the companies that manufacture and sell these items should stand to benefit.
- Lower interest rates mean lower borrowing costs for governments – including at the state and local levels. This may make it easier for them to borrow for specific projects, or to simply lower the cost of maintaining debt they have already assumed.
- Lower interest rates mean lower borrowing costs for investors. Investors of all sizes can borrow against their existing investments to purchase even more. Like anything, greater demand (more buying) leads to higher prices.
So, just looking at the four items above, we can see why lower interest rates are a huge benefit to corporations, consumers and governments alike. At the same time, it is easy to see the potential dangers of interest rates moving the other way – less spending across the board leading to less demand and lower prices rather than higher.
The beauty of a free-market system is that it will tend to correct “excess” on its own – before it gets too out of hand. The problem that we now face is that the free-market is no longer “free” – at least in our opinion. Beginning in 1987 with the appointment of Alan Greenspan as the chair of the Federal Reserve, the Fed has seemed much more interested in placating their friends on Wall Street along with the politicians who appointed them. And if there is one thing that pleases both politicians (and those that voted for them) and Wall Street alike – it’s a rising stock market.
To us, there is very a clear correlation between manipulated interest rates and stock prices over the past 30 years. If you don’t believe us, then go back and look at all of the charts provided above, and try to explain otherwise – it’s the exact same pattern. Interest rates manipulated lower by the Fed, bubble created, bubble bursts, interest rates manipulated even lower – then repeat. We like to describe this cycle and our opinions on it using a modified version of an old adage. “Fool me once, shame on you. Fool me twice, shame on me. Fool me again, and I’m a (expletive) moron.”
Which brings us to why we believe that stocks and interest rates are more intertwined than at any other point in history. We have already discussed the direct benefits to the economy and markets from today’s extremely low rates. We know that margin levels (amount being borrowed against existing positions) are at or near all-time highs – undoubtedly aided by the ultra-low borrowing costs available. We know that companies are buying back their own stock at a record pace, and that they are taking advantage of artificially low interest rates (taking on additional debt) to facilitate doing so. And we know that our Federal Government has approximately $20 trillion of debt outstanding that they are currently able to roll over at these ultra-low rates, not to mention the debt levels of our state and local governments – or other governments around the world.
So the natural question that we have to consider is, “what happens when interest rates finally rise in any significant fashion”? While one can never know for sure, I hope that we have made our concerns apparent.
And so, our Short-Term Outlook Remains….Bullish??
That would be a correct statement. Interest rates remain stubbornly low. The Fed is slowly raising rates on their end, but still constantly making mentions of “market conditions” – meaning it remains one of their primary concerns. It seems more and more likely that corporate tax reform will be happening. If it does, our guess is that it will most favor big corporations. And while the politicians will tell us how many jobs it will create, we view it much more likely that the savings will be used for further repurchasing of company stock as described previously. All said – when asked to make predictions for the remainder of the year – we believe the path of least resistance is for markets to continue higher.
We are often asked, “Well, why not put all of my money in stocks now – then get out when things get bad”? Unfortunately, it’s not that easy (although there are many that will try to tell you otherwise). NO one knows for certain if, how or when a significant market turn will occur – or how long it will last once it does. We happen to think it will once again be interest rates in some form (by design or forced) – but there are certainly enough political / geographic / overall valuation concerns out there to keep us up at night.
And while we certainly feel that bonds remain overvalued, I’m not sure that we share the doom and gloom scenario of some. While a move in the 10 year to a historical average of 4.5% or so would certainly cause some short-term pain for bond holders, we don’t see evidence that a move in rates back to levels seen in the 70s and 80s is warranted – at least in the current inflation environment. Maybe most important (these days), governments around the globe are in NO hurry to see rates rising, given the trillions upon trillions of debt they currently have to service on their balance sheets.
Which brings us to a final important thought. There is an immense difference between short and long-term thinking when it comes to one’s investments. Again acknowledging the psychology of it, most of us are wired to favor the short-term over the long. We see the markets making all-time highs and think, “boy, I should have more money in stocks – I’m missing the boat”! When markets are plummeting, we start thinking “I can’t take any more – at this rate, I am going to lose all of my money”! I’m sure most reading this can relate.
The most common (and dangerous) mistake made by investors is letting this kind of emotion dictate investment decisions. There has been study after study done on the topic – and it is the easiest way to completely destroy your long-term financial plan. If you take nothing else away from this update, please consider and understand the following: Psychologically, we will always feel the urge to get more aggressive while / after markets have run up substantially (“I’m missing the boat”), and to get less aggressive during / after big market downturns (“I’m going to lose all of my money”).
At the same time, virtually everyone understands that the ultimate goal of any type of investing is to “buy low and then sell high”. Hopefully, everyone can see the contradiction between the two!
A final, final note to all that have made it this far. A recurring theme of ours is to remind our readers of the dangers associated with the belief that “this time is different”. It’s not easy, as most of us are wired to where our recency biases tend to over-shadow our longer-term memory. There are few, if any, areas of life where this is more apparent than with one’s investing.
We were told that the unsustainably rapid rise of stock prices in the 90s were in fact sustainable because “the internet changed everything”. We were then told that the obvious bubble in real estate was in fact not a bubble, because “real estate never goes down – there is only so much land”. Everyone knows how both of those ended.
You may have heard recently that this is the “new normal” for interest rates – that they would never again rise in any significant fashion for “one reason or another”. When speaking of stock valuations – and in response to many of the metrics we have discussed above – we hear that they really don’t matter because of some other “this reason or that”.
In other words – you guessed it – this time is different. I doubt it, and I certainly wouldn’t suggest betting your financial goals and dreams on it. I can promise you that we won’t….
Thanks for putting up with the longer-than-normal rant. And to all of our clients, we can never thank you enough for the trust and confidence you have placed in Round Hill.
President & Wealth Advisor
Principal & Wealth Advisor
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
The Wilshire 5000 Total Market Index is widely accepted as the definitive benchmark for the U.S. equity market, and measures performance of all U.S. equity securities with readily available price data.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through HighPoint Advisor Group, LLC, a registered investment advisor. HighPoint Advisor Group, LLC and Round Hill Wealth Management are separate entities from LPL Financial.