August 15, 2014
By Steve Blumenthal
There is an argument being made that the currently high valuation measures (PE, dividends, price to book, price to sales) are really not so high when you consider that today’s interest rates are so low. The thinking is that today’s ultra-low interest rates make the stock market undervalued.
The good news is that we have a great deal of historical information telling us what forward returns will likely be. The bad news is that we find ways to justify why “it is different” today.
Today, let’s take a look at the probable forward returns from both a fundamental perspective (hint: 0% to 4%) and a really interesting chart on forward returns from a technical perspective. This chart, in particular, is one that really caught my eye this week.
I share the following in this week’s On My Radar:
- Forward Expected Returns – Low Interest Rates Do Not Justify High Valuations
- JPMorgan Joins Goldman in Designing Derivatives for a New Generation
- Trade Signals: Short-term Sentiment Says Buy
Forward Expected Returns – Low Interest Rates Do Not Justify High Valuations
“What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision.” John Hussman
One of the biggest problems I have with the ‘interest rates are low so valuations should be justified higher’ argument is that the low rates drove the valuations higher. Low rates are one of the main reasons profits have risen so much as falling rates cut corporate debt service; with the savings falling directly to the bottom line. Also, the ultra-low rates make it easy for corporations to borrow money to buy back more of their stock, which immediately increases earnings per share (higher profits and fewer shares outstanding).
I would argue that the low rates are one of the main reasons for high valuations and their affect has largely been realized and not the other way around. There also exists the reality of the business cycle that shows profit margins do not last indefinitely – they have a nasty habit of profits mean reverting. The next chart shows gain per annum when profit margins are high (shaded area in the upper left box). Current profit margins are at their highest ever with data back to 1955.
Next is another take on valuation calculated by looking at six independent valuation measures (dividends, earnings, cash flow, sales, P/E and trend). As of July 31, 2014, the market is 34.69% overvalued vs. its historical valuation trend line. Also note the returns ½, 1, 2, 3 and 5 years following high valuations. This data says to expect 5% over five years.
Finally, here is the special chart I referenced at the top of this week’s missive. The blue line shows the Equity as a Percentage of Household Financial Assets (this is the current percentage of household assets allocated to equities).
This is a supply and demand way of looking at the markets. When investors are more fully invested in equities, there is simply less available cash to buy and pushes stock prices higher. Ten-year subsequent returns have been very poor when the percentage of household assets invested in equities is high (as it is today). When investors have avoided stocks, they have more buying power and 10-year subsequent returns have been very good.
Take a look at the how closely the return performance of the S&P 500 Index Total Return has correlated to the percentage of equity households own. The forward 10-year expected return from this measure says to expect just 3.5% per year from equities (yellow circle).
Whether it is Hussman’s mix of measures showing actual subsequent S&P 500 Index Total Returns of 0% to 4% or NDR’s Household Equity Percentage vs. Rolling 10-year S&P 500 Index Total Returns of just 3.5%, the message is that equity markets are richly priced.
My best guess is 3% – 4%. That’s how I’m handicapping it. It is better to be a buyer when valuations are low. Today, valuations and profit margins are too high. Tread forward carefully.
JPMorgan Joins Goldman in Designing Derivatives for a New Generation
“The true sign of a top is when you have these new structures piling up,” said Lawrence McDonald, a chief strategist at Newedge USA LLC, and author of the book A Colossal Failure of Common Sense, about the 2008 demise of Lehman Brothers Holdings Inc. “At the top of the market in 2007, there were these types of innovation and many investors didn’t realize about it at that time. These products are a clear risk indicator.”
I mentioned last week that I had just done an interview with a reporter from Bloomberg. A link is provided below. The first sentence sets the stage for the article,
“Derivatives that helped inflate the 2007 credit bubble are being remade for a new generation.”
At the top of my ‘what keeps me up at night’ worry list is the pure size and interconnected web of counterparty risk in the Wall Street created and bank traded derivatives market. The size of which is more than double where it was just prior to the last crisis.
I’d feel a lot better if the derivatives were traded on exchange regulated public futures markets instead of the small network of “too big to fail” private banks like Goldman, JPMorgan, Merrill Lynch and a few others. Alas, the banks are in the pockets of the legislators and it will likely take another crisis to get the derivatives off of the bank’s books and moved onto the public exchanges.
Many might argue that a meaningful percentage of the total derivatives exposures are positions designed to hedge other investment exposure. I argue that deeper review of the legal agreements will show how banks have structured the agreements in a way that allows them to hypothecate investor collateral for their own purposes. It is a ‘leverage on top of leverage’ situation where the failure of one counterparty dominos down other seemingly unrelated and unsuspecting parties including the large banks. Liquidity that previously existed will vanish. We will look back at the word hypothecate and say “what were we thinking?”
My point made to Bloomberg was that if you trade in high yield CDX, various SWAPs or other similar bank created structures, the risk is that you may be right on your hedge or bet but you may never get paid should one (and then likely more) of various unrelated counterparties declare bankruptcy. One weak link in the collateral chain, especially the failure of a large player, might just blow down this whole house of cards. This is what can make “too big to fail” actually fail.
Following is the link to the full piece: http://www.bloomberg.com/news/2014-08-12/swaps-reincarnate-boosting-debt-bets-in-new-era-credit-markets.html
Trade Signals: Trade Signals: Short-term Sentiment Says Buy
Price momentum (as measured by Big Mo) remains bullish and don’t fight the Fed or the Tape remains the important theme.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains (as measured by Big Mo)
- 13/34-Week EMA Trend Chart: Cyclical Bullish Trend for Stocks Remains
- Weekly Investor Sentiment – NDR Crowd Sentiment Poll: Neutral (Not Yet Bullish)
- Daily Trading Sentiment Composite: Extreme Pessimism (Bullish for Stocks)
- The Zweig Bond Model: Cyclical Bullish Trend for Bonds (supporting bond investment exposure)
Click here to go to this week’s Trade Signals.
Conclusion
The problem is that timing a top is nearly impossible. My personal view is that the market will spike even higher, topping in September 2015. My target is 2250 (approximately 15% higher than today’s 1950 level) but it is really just a guess (based on market cycles and standard deviation extremes). The problem is that a 3.5% expected return over 10 years will likely come to us in a choppy and potentially violent way. Imagine a 15% gain followed by a 40% bear market decline followed by yet another recovery. Can your client stay the course? If so, will your client be happy with just 3.5% annually from equities?
What I do know is that the equity markets are richly priced and risk is elevated. I also believe that when the market cracks, it will be too late to put your hedges in place. There are a number of liquid ways to hedge your long-term equity exposure and there exists tactical and alternative strategies that are unconstrained from traditional buy-and-hold that enable you to build broadly diversified portfolios. Forward thinking today will put you in the favorable position to be able to take advantage of the opportunities the next crisis creates. At that point, the risks will be lower and forward return potential much higher.
I’m sure your business and family world is about to ramp back up again soon. Enjoy your last few weeks of summer – hopefully spent with some down time with those you love most. As I close today, I appropriately hear a Dave Matthews Band song coming from the other room:
“You And Me”
Wanna pack your bags, Something small
Take what you need and we disappear
Without a trace we’ll be gone, gone
The moon and the stars can follow the car
and then when we get to the ocean
We gonna take a boat to the end of the world
All the way to the end of the world
Oh, and when the kids are old enough
We’re gonna teach them to fly
You and me together, we could do anything, Baby
You and me together yes, yes
We are down at the beach in Stone Harbor for one last weekend getaway before school kicks into high gear. Brie departs next week for her final year at Penn State and soccer training begins for our five boys (two a days and a ton of driving begin on Monday). Susan gladly handles the brunt of the logistics. Our kids are getting older and I sure hope we are teaching them to fly. This morning it was the third reminder to my oldest son, “Matt, shave and wash that face, and brush… now.” Ugh.
Teach Them to Fly… I sure hope so! I am going to miss it all when it is gone.
Pack your bags, something small, and disappear. Here is a link to the song.
Wishing you a wonderful weekend!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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