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On My Radar: A Mid-Year Look at Valuations and Future Returns (Better)

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July 1, 2022

By Steve Blumenthal

“Adjusting for inflation, first half S&P 500 down 25-26%, NASDAQ down 34-35%, Bitcoin down 64-65%.
That was multiple compression, next up earnings compression so maybe halfway there.”

– Michael Burry @MichaelJBurry

If quantitative easing helped the stock and bond markets on the way up, quantitative tightening should hurt the markets on the way down. The inflation fight is on. I’m sure you are well aware that it was a rough first half for stocks and bonds. Today, let’s look at mid-year valuation levels and see what they tell us about coming returns. Bottom line: Better, but not yet good enough.

With inflation over 8% in the U.S. and Europe, the Fed will continue raising rates until something breaks. The recession probability in the second half of this year is high. Markets are not factoring in recession. In recessions, things break. As Burry put it, “… maybe halfway there.” That makes sense to me.

Grab that coffee and find your favorite chair. The Buffett Indicator is up next followed by Price to Sales, Median PE, and Stock Market Cap to Gross Domestic Income. The Trade Signals section begins with what may turn out to be a quote for the history books from Jerome Powell. The Fed Chairman said this week, “I think we now understand better how little we understand about inflation.” Yikes! 

Overall, consider today’s OMR a “get ready to get ready” piece. I share my thinking and set a few targets to consider.

For discussion purposes only. Talk with your investment advisor. Not a recommendation to buy or sell any security. 

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The Buffett Indicator

“This is the one thing I can never understand. To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing “Hallelujah Chorus” in the Buffett household. When hamburgers go up, we weep. For most people, it’s the same way with everything in life they will be buying – except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”
– Warren Buffett’s famous hamburger quote

Warren Buffett has said that his favorite market valuation indicator is the total value of the U.S. stock market relative to what the U.S. as a country produces, otherwise known as Stock Market Cap to GDP. Advisor Perspective has a clean chart so you can see where we currently sit relative to historical data back to 1970. The first chart is data through May 2022. The second chart (from NDR) is through June 30, 2022. Mentally plot 159.2% just below the 184.6% May number on Chart 1. Better but stealing a line from Stan Druckenmiller, “there is more wood to chop.”

Chart 1

Chart 2

Shown differently with data updated through June month-end, the NDR Estimated value of 4600 US common stocks compared to GDP puts the current ratio at 159.2%. Well off the high, lower than the Tech Bubble March 2000 peak, but still high. If you are looking for an excellent risk-back-on reentry point, 115% Stock Market Cap to GDP is a good target (the dotted regression line rising from lower left to upper right). Take a look at how attractive the market got in Feb 2009. The future opportunity will present in crisis. It won’t feel like an opportunity, but it will be.

Next, let’s take a look at several other valuation indicators.

Price to Sales – Median PE – Price to Gross Domestic Income

Warren Buffett has said that his favorite market valuation indicator is the total value of the U.S. stock market relative to what the U.S. as a country produces, otherwise known as Stock Market Cap to GDP. Advisor Perspective has a clean chart so you can see where we currently sit relative to historical data back to 1970. The first chart is data through May 2022. The second chart (from NDR) is through June 30, 2022. Mentally plot 159.2% just below the 184.6% May number on Chart 1. Better but stealing a line from Stan Druckenmiller, “there is more wood to chop.”

Chart 1 – Price to Sales

Like the Buffett Indicator, Median Price to Sales is still overvalued but better.

Here’s how to read the chart:

  • Focus on the orange line in the center of the chart. It is historical tracking or each month’s end of the median price to sales ratio of the S&P 500 index stocks – data back to 1979.
  • The bottom section compares how far above/below the orange line was from its long-term regression line.
  • The sell when everyone is buying opportunity is when the median price to sales is in the “Overvalued” zone. The buy when everyone else is selling opportunity is when it is in the “Undervalued” area.
  • Think of fair value as somewhere in the middle zone. That’s when we can shift our forward return expectations from 0% per year to approximately 9% per annum.
  • Bottom line: Still overvalued by this vital metric. Stay ready to be ready. More defense than offense until valuations improve.

Chart 2 Median PE

Each month, NDR plots the Median PE of the S&P 500 companies. Think of it as the PE for the one company in the middle of the 500 companies. I like looking at Median PE because, to some extent, it takes some of the earnings gimmicks corporations may play out of the equation. And I like how NDR compares the current median PE back to 1964.

Here’s how to read the chart:

  • On June 30, 2022, Median PE Ratio was 21.7. The good news is that it is down from a high of over 30 during the bull market late last year.
  • The green “Better Off Here” arrow points to the 58.3-year median PE. NDR calls that level “Fair Value.”
  • For game plan purposes, Fair Value based on this metric puts the S&P 500 Index at 3,039.66. Only another -19.7% to go to get there.
  • If Michael Burry is correct, we may be halfway there.

Chart 3 Stock Market Cap to Gross Domestic Income

One of the reasons I like the Stock Market Cap to Gross Domestic Income chart is that it creates a visual of sorts for what Buffett is saying about hamburgers.

Here’s how to read the chart:

  • The “orange line” in the middle section plots Stock Market Cap to Gross Domestic Income. Think of it as the price of stock vs. gross income, except this is the total value of the cap-weighted S&P 500 index vs. total US gross domestic income. What you want to get a feel for is the level of the orange line relative to data going back to 1925.
  • The bottom section “blue line” plots how far above or below the orange line is from its long-term historical trend line.
  • I know this is getting geeky but hang in there with me. The value in looking at the data this way is what NDR calculated in the data box in the upper left-hand section of the chart. They broke the data into quintiles and looked at subsequent returns that followed 1, 3, 5, 7, 9, and 11 years later based on the actual “average % change in the S&P 500 Index” turned out to be. I plot two “We are here” red arrows and one green we’d be “Better off here” green arrow.
  • The good news is that we are nearing a much better entry point. As a general rule (not a guarantee), when the orange line reverts to the dotted blue regression line (center section), that’s an excellent entry position where stocks will work well for us again, with returns of approximately 9 to 10%. Similar to long-term historical averages.
  • The red arrow in the upper left points to the current quintile we sit on June 30, 2022. I’m unsure if the next crisis sends market cap relative to GDI to the “Bottom Quintile.” If it does, that’s when you want to go all-in risk on.

Bottom line: Valuations are better but not yet attractive.  Let’s keep our eyes on the valuation charts over the coming months.

Trade Signals: 300+ Ph.D.’s? The Fed is Guessing!!!

June 29, 2022

Market Commentary 

Notable this week:

“I think we now understand better how little we understand about inflation.”
– Jerome Powell, Federal Reserve Chairman June 29, 2022

There you have it! Yikes! From arguably the most important financial person in the world. 300+ Ph.D.’s? The Fed is guessing!!!

“In theory, theory and practice are the same. In practice, they are not.” – Albert Einstein

“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” – Milton Friedman

To this point, next is a look at the “Monetary Base” since 1959. The monetary base measures the supply of liquid money (circulating currency and bank reserves). It increased by 52%, from $3.442 trillion in January 2020, to $5.248 trillion in January 2021. The Fed continued its $120 billion per month QE bond-buying program until March 2022. They over-spiked the punch bowl.

“Always and everywhere.”

Inflation is the kryptonite to Fed policy. The Fed is raising interest rates and has removed $120 billion per month (QE) of Treasury and Mortgage bond buying. A hard economic landing lies ahead. “I think we now understand better how little we understand about inflation.” At the very least, you have to appreciate his honesty.

The Trade Signals are signaling recession. First, the high yield market signaled an economic warning, Dr. Copper followed, and the ‘economy based on the stock market’ indicator signaled ten weeks ago. The economy is slowing. The recession is either here or very near.

From a buy and holder’s perspective, it’s been a painful year for bond investors. From a trader’s perspective, the opportunities have been good. And a long Treasury bond trade appears to be set up. Here is how to read the following chart of the popular Vanguard Extended Duration Treasury ETF.

  • The red and black line in the bottom section compares two weekly moving averages. Signals occur when the faster-moving average ‘black line’ crosses the slower-moving average ‘red line.’ Green arrows reflect buy signals. Red arrows are sell signals.
  • The top section of the chart shows the change in the price of EDV.
  • Please note that this is not a recommendation for you to buy or sell any security. Talk with your advisor.

I share the above chart with you weekly in Trade Signals and several other bond market indicators. The bond market indicators signal that inflation, rising rates, and Fed QT are quickening the path to the next recession. My best guess is that we are in a recession or will be in one this year. Recessions are known in hindsight – defined as two quarters in a row of negative GDP. We must do our best to be forward-looking.

If I’m right, the Fed will reverse course by the fall (best guess: September/October). Then we are back to a risk-on move in stocks. That’s my base case working hypothesis. The bond market should lead the stock market and signal first (interest rates heading lower), which looks imminent. Stocks tend to lag bonds. Therefore, it is too soon, in my view, to get excited about stocks. The average stock market decline in recessions is more than 30%. Minus 32.5% from the high puts the S&P 500 at 3,200. That seems to be a logical target.

The Dashboard follows next. More red than green.

Click HERE to see the Dashboard of Indicators and all the updated charts in Wednesday’s Trade Signals post.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon, and risk tolerances.

If you are not signed up to receive the free weekly On My Radar letter,
you can sign up here.

Personal Note –  Stone Harbor and Dallas

I’m writing you this morning from Stone Harbor, NJ. Our summer vacation destination with the kids for many years; however, this trip is for Susan and me. Last night we celebrated our 10th anniversary with delicious scallops and an outstanding red Bordeaux. Crazy about my Susan. I’m checking in happy and very, very lucky.

A last-minute business trip to Dallas for next Wednesday – Thursday is booked. I am meeting Mauldin for dinner Wednesday evening, followed by a Thursday morning research meeting, then a flight home that afternoon. Hoping American Airlines gets its act together.

I am wishing you and your family a happy 4th of July celebration. I hope you find some time to put your toes in the sand.

Wishing you a great week!

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

If you are not signed up to receive the free weekly On My Radar letter,
you can sign up here.

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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