September 6, 2019
By Steve Blumenthal
“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 the ‘Hallelujah Chorus’ in the Buffett household.
When hamburgers go up in price, we weep. For most people, it’s the same 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, Fortune Magazine (December 10, 2001)
“I must say, after more than 30 years in this business, the stock market remains as manic as ever.”
– David Rosenberg, Chief Economist & Strategist, Gluskin Sheff + Associates Inc.
Today, let’s take a look at what the latest valuation data are telling us and zero in on what it means in terms of coming 5- and 10-year returns. Let’s also review my five favorite recession watch charts. In short, the hamburgers remain expensive and recession clouds are forming, but the weight of evidence remains mixed.
There are times in the investment game when it makes sense to play more offense than defense and times when defense should be the focus. I like to think of it as “Investing Fast or Slow.” (It’s the title of my soon-to-be-published book.) When stocks go down in price, love them. When stocks are extremely overvalued (like today), protect them. Faster active risk management – more defense. The best opportunities present in recession. Then, with forward returns in the mid-teens, slower passive management. Thus, the focus on both the forward return and recession watch data.
The current data suggest coming 5- and 10-year returns for the S&P 500 Index in the 1% to 3% range before inflation. Here is a look at the current data.
Coming 5- and 10-year Returns
The first chart looks at the long-term trend of the S&P 500 Index. It looks busy but hang in there with me. Here’s how to read it:
- Ned Davis Research (NDR) plots the long-term trend line of returns since 1928 (red dotted line in the middle section of the chart).
- They measure each month-end price and compare it relative to the long-term trend line (again, since 1928). They sort the data into five quintiles ranging from “Top Quintile” (most overpriced relative to the long-term trend) to “Bottom Quintile” (most underpriced).
- They then look at each data point and calculate what the actual subsequent 5- and 10-year total return turned out to be. Then they calculate the average return in each quintile.
- The data box in the upper left shows the difference. I’ve added the data box in the upper middle so you can see both the total return after 5 and 10 years and what that means in terms of annualized gains.
- Bottom line: Buffett is correct. Best to buy when the price of hamburgers is lowest. The average annual gain is just 1.80% when in the top quintile (see 8/31/19 “We are Here” arrow) and it is greater than 15% per year when in the bottom quintile (see green “We’d be better off Here” arrow).
The yellow circles in the middle section of the chart highlight prior periods when the market advanced well above its long-term trend. Note that it can stay above trend for a period of time. So it is not a good trading indicator but it is an excellent indicator to help us gauge different risk and return regimes — probable coming 5- and 10-year returns. This and other valuation measures help me know when to play more offense than defense or more defense than offense.
My valuation dashboard contains 52 different charts covering many different markets (U.S. and global). There is no need to look at all of them. I would like to focus in on a few of my favorites.
The next chart shows that by most measures, especially key factors, such as “Price to Sales,” “Price to Book,” Price to Cash Flow,” “Median Price to Earnings,” “Dividend Yield,” and “EBIT to Enterprise Value”, the stock market is “Extremely Overvalued.” Here is a small dashboard of select valuation indictors. NDR ranks the data for each valuation metric in terms of quintiles that range from “Extremely Undervalued” to “Extremely Overvalued” (red is bad, green is good):
As you can see, there is a lot of red.
Warren Buffett is on record saying that his favorite valuation metric is the total value of the stock market relative to gross domestic income. In this next chart, NDR sorts the Stock Market Capitalization to Gross Domestic Income into quintiles looking at the data from 1925 to present.
Here is how to read the chart:
- The bottom section plots the ratio of Stock Market Capitalization to Gross Domestic Income to its long-term trend line. Above the top dotted green line is the “Top Quintile – Overvalued” zone. You can see that the current level (8/31/19) is in the top quintile. Other periods were 2015, 2007/08, 2000 and 1929.
- Next look at the data box in the upper left-hand side of the chart. It shows the subsequent total returns that occurred 1, 3, 5, 7, 9 and 11 years later. In the “Top Quintile,” returns were negative with the exception of 11 years. The 2.19% positive return was essentially a return of about 0.10% per year for 11 years.
- Finally, compare the returns for the same periods when one invested when in the “Bottom Quintile.”
Below I share a few more charts and an interesting one that plots how much households have invested in stocks and what that means in terms of coming returns.
So grab that coffee and find your favorite chair. We’ll also take a look at what my favorite recession watch charts are telling us about timing of the next recession. And I’ve added a bonus chart with permission from my good friend, Lakshman Achuthan, with a hat tip to Ned Davis Research. I love how NDR sorts the data. Lakshman heads the Economic Cycle Research Institute (“ECRI”) and was on CNBC a few days ago saying, “The moment to take recession risk off the plate has past.” ECRI’s popular recession indicator just fired a warning signal. You’ll find that chart along with my fab five recession watch indicators in the Trade Signals section below. Finally, do you remember the movie “The Great Short”? Michael Lewis wrote about hedge fund manager, Michael Burry, who made a fortune shorting the subprime mortgage market. Burry was featured in Bloomberg this past week – “The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs”. Worth the read. You’ll find that article with source link below. Thanks for reading!
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Valuations and Coming 5- and 10-year Returns
- Bubbles – The Great Short, Part II
- Trade Signals – The ECRI Recession Indicator Signaling Recession (Recession Watch Update)
- Personal Note – Old Friends
Valuations and Coming 5- and 10-year Returns
Shiller PE = 29.87
Simply note the current level relative to 2007, 2000 and 1929.
NDR took the month-end P/E data back to 1881 and sorted the month-end P/Es into quintiles. Then they calculated the average return achieved 10 years later. It is summed up in the next chart.
Bottom line: Expect low single-digit returns…
If an investor were to consider raising cash and earning 3% to 4% in a liquid way (there are ways to do this with certain low-fee insurance products) and patiently wait for better opportunities in equities, I think that is a good plan.
The last point I’d like to make is that risk is greatest when valuations are in the “Most Expensive” quintile and least when in the “Cheapest” quintile.
I’ve probably charted you out for the day… So let’s come to a close.
Finally, when investor capital is heavily invested in stocks, there is less fuel in the tank to drive prices higher.
Here is how to read the chart:
- The blue line tracks the percentage that households have invested in equities. The latest data is as of 3/31/19 and shows that households have 53.9% of their money invested in equities relative to bonds and cash.
- The dotted black line shows the returns achieved 10 years later. Note how highly correlated the subsequent 10-year returns were to how much households had invested in equities.
- Bottom line: The current reading is for 2% annualized returns in the coming 10 years. Maybe the “Magic Money Tree” can change the outcome but I don’t like the odds.
Bubbles – The Great Short, Part II
From Bloomberg:
For an investor whose story was featured in a best-selling book and an Oscar-winning movie, Michael Burry has kept a surprisingly low profile in recent years.
But it turns out the hero of “The Big Short” has plenty to say about everything from central banks fueling distortions in credit markets to opportunities in small-cap value stocks and the “bubble” in passive investing.
One of his most provocative views from a lengthy email interview with Bloomberg News on Tuesday: The recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations, the complex securities that almost destroyed the global financial system.
Burry, who made a fortune betting against CDOs before the crisis, said index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do.
“Like most bubbles, the longer it goes on, the worse the crash will be,” said Burry, who oversees about $340 million at Scion Asset Management in Cupertino, California. One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.
Here’s what else Burry had to say about indexing, liquidity, Japan and more. Comments have been lightly edited and condensed.
Index Funds and Price Discovery:
Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies — these do not require the security-level analysis that is required for true price discovery.
This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.
Liquidity Risk
The dirty secret of passive index funds — whether open-end, closed-end, or ETF — is the distribution of daily dollar value traded among the securities within the indexes they mimic.
In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those — 456 stocks — traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different — the index contains the world’s largest stocks, but still, 266 stocks — over half — traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.
It Won’t End Well
This structured asset play is the same story again and again — so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools — they make up for it in scale.
Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.
Click here for the rest of the article.
I remember watching “The Big Short” while on vacation. Living through that experience just can’t be learned in a book. I wrote often about subprime and what I believed would follow. I knew it would be bad (or good depending on how your investments were positioned). It turned out to be far worse than I imaged. Susan was next to me and fortunately for her, she fell asleep. As I watched the movie, my blood began to boil. I mean really boil and I had a hard time falling asleep that night.
As much as we’d like to believe human behavior will change, I just don’t believe it will. Greed isn’t going away. Nor is fear that leads to panic that creates opportunity. You can use it to your advantage.
No one knows when the current bubble will burst. My best two cents: Put risk management processes in place, underweight your equity market exposure, overweight companies with history of increasing dividends and other value like strategies, reallocate from cap-weighted indices to better beta indices and diversify to trading strategies.
And get yourself mentally prepared to overweight back to equities when the hamburgers go down in price. The day will come when we sing the “Hallelujah Chorus.” It will take guts and discipline to act.
Trade Signals – The ECRI Recession Indicator Signaling Recession (Recession Watch Update)
September 4, 2019
S&P 500 Index — 2,924
Notable this week:
Market Commentary: My good friend Lakshman Achuthan heads the Economic Cycle Research Institute (“ECRI”). Lakshman was on CNBC a few days ago saying, “The moment to take recession risk off the plate has past.” ECRI’s popular recession indicator just fired a warning as reflected in the following chart.
There are several things to note in looking at the chart:
- First, it has historically done an excellent job at signaling oncoming recessions. Red down arrows. There were several other signals so the process is not perfect but historically very good.
- Ned Davis Research plots the ECRI index and compares the index to a 98-week smoothed moving average line. Think of the darker red line in the chart as the trend in U.S. economic activity as measured by the ECRI Weekly Leading Index. A signal is generated when the 98-week long-term smoothed trend line rises or falls by 0.1%. The contraction signals are in red. If you look closely at the dotted red 98-week moving average line, you can see when it turns higher and lower. Note the trend higher post recessions (“Expansion” signals).
- Prior to 2009, there were few false signals. This process has had a tougher time (a number of false signals as indicated by the small yellow circles) since the Great Financial Crisis. I attribute them to the unprecedented determination of global central bankers to stimulate economies and become indiscriminate buyers of bonds and equities (the Japanese Central Bank, the European Central Bank and the Swiss Central Bank). Recall Mario Draghi’s promise, “Whatever it takes…”. But one must question the sanity of $17 trillion in negative yielding sovereign debt. Everything cycles; therefore, I would look at the data. I just don’t believe that 17 Fed members (10 voting members) and their global central bank friends have the ability to prevent recessions.
- Bottom line: ECRI’s model has just flashed a recession signal. Heed the warning.
Source: Ned Davis Research
Sam Zell appeared on CNBC this morning and said, “it’s hard to have recession when interest rates are at zero.” He added that his favorite recession indicator has given more false signals than at anytime in his long career. Perhaps similar challenges to what we see in the chart above. At the end of each calendar month, I update my favorite recession watch indicators. You’ll find the updated indicators when you scroll down. Two are flashing red, three remain green. I favor a disciplined process, especially given the high probability for low coming 5- and 10-year returns for equities. More on current valuations in forward returns in this Friday’s On My Radar. Stay tuned.
Market Trends: Despite the aged cyclical bull market (the longest on record), all equity market trend indicators remain bullish. Both of our investor sentiment indicators show “Extreme Pessimism.” While it may seem counter-intuitive, extreme pessimism readings are short-term bullish for the stock market. Also, Don’t Fight the Tape or the Fed indicator moved back to a bullish +1 reading. Bottom line: the equity market uptrend, while weakening, remains intact. As for the bond market trend indicators: the Zweig Bond Model remains in a buy signal, suggesting higher bond prices and lower yields. The trend in the High Yield bond market is bullish. The trend in Gold remains bullish. The indicator dashboard section is next, followed by the updated charts with explanations.
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.
Click here for this week’s Trade Signals.
Personal Note – Old Friends
“Beautiful memories are like old friends.
They may not always be on your mind, but they are forever in your heart.”
– Susan Gale
“New friends may be poems but old friends are alphabets.
Don’t forget the alphabets because you will need them to read the poems.”
– William Shakespeare
“We need old friends to help us grow old and new friends to help us stay young.”
– Letty Cottin Pogrebin
“Forsake not an old friend, for the new is not comparable to him.
A new friend is a new wine; when it is old, thou shalt drink it with pleasure.”
– The Bible
I’m in NYC next Tuesday and Wednesday and on to St. Louis September 24 to 26 for a meeting with one of our advisor teams with some good fun mixed in. Penn State plays Pitt on September 14. I’m heading up to meet with a few of my fraternity pledge class brothers. Brother Smoyer and his beautiful wife have a second home in State College and I have a couch reserved with my name on it… and coming with several bottles of fine red wine. The plan is to arrive in time for the Friday evening men’s soccer game against Villanova. Then, after what I’m sure will be a very late night, it’s up early Saturday morning to tailgate with my fraternity brothers and sons, Matt and Kyle. The boys will be after the good food. I’ll be enjoying the time with my dear friends. Pictures to follow. Go Lions!
Have a great weekend! Raise a glass of fine wine (or your favorite beverage) to your old friends! Cheers!
Best regards,
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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