May 2, 2014
By Steve Blumenthal
Valuations are flashing red. Driven higher by QE, the markets have exceeded (as measured by John Hussman) the prior bubble records achieved in 2000 and 2007. Brace yourself (and your portfolios).
This doesn’t mean markets can’t move higher; central banks have enormous staying power. It simply means that with elevated valuations comes elevated risk. The opposite of what your client may be feeling today. Past extremes have lead to remarkable declines.
So let’s take several different looks at valuation (all show a richly priced stock market) and further my research by looking at Hussman’s most recent work. I also provide a link to an excellent letter from Jeremy Grantham (who coincidentally gives praise to John). Grantham, is masterful as usual.
Included in this week’s On My Radar:
- Valuations – Flashing Red
- Looking for Bubbles – Grantham
- Trade Signals – Expect a Bumpy May to October
Valuations – Flashing Red
As you’ll see in the following four charts, valuations are rich. The first chart looks at the total value of the stock market as a percentage of gross domestic income. Stock market cap has now exceeded the lofty levels last seen in 2007. In short, this is Bubble Territory.
The second chart looks at valuation from the perspective of dividends, earnings, cash flow, sales, PE and trend. It then normalizes the five measures and compares the current level to the historical trend of those measures. Take a look at the performance when the blue line is more than 20% above the dotted black trend line. Five years out, the average percent gain for the S&P 500 Index is -0.30%.
The third chart looks at median PE of the S&P 500 Index compared to the historical median PE of the S&P 500 Index. The current median PE is 20.4 compared to a 50 year historical median PE of 16.7. The data in the orange highlighted box shows an overvalued, undervalued and fair value range for the market. A 1 standard deviation move above fair value puts an upside S&P 500 target at 2021.41. A 1 standard deviation move below fair value puts a downside target at 1066.27. Fair value is at 1543.84.
My two cents is that this pretty much shapes our current risk and reward environment.
Chart number four comes courtesy of John Hussman. Hussman takes a look at median price to revenues. He feels that this measure is a better valuation metric than PE. Here too, valuations are elevated – or as you’ll see – extremely elevated.
“The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak. The average price/revenue multiple across S&P 500 constituents is now above every point in that bubble except the first and third quarters of 2000.” John Hussman (emphasis mine)
Note that the blue line is higher than the lofty valuations achieved in 2000 and 2007.
“The danger comes when investors drive price/revenue multiples to market-wide extremes, across all stocks and industries. At bull market peaks, investors typically fail to recognize cyclically elevated profit margins, assuming that those margins are permanent and that earnings can be taken at face value. If there is one thing that separates our views here from the bulk of Wall Street analysis, it is the historically-informed insistence that investors are mistakenly banking on record-high profit margins to be permanent.” John Hussman
Ok – enough said. Valuations are flashing red!
As you’ll see in Grantham’s “Looking for Bubbles”, he sees a slightly higher potential upside of 2250 yet cautions the May – October period ahead. He sees a significant correction in 2015 (to this, I agree, as covered in past letters).
Looking for Bubbles – Jeremy Grantham
“It is a sensible expectation that reasonable long-term value investors will endure pain in a bubble. It is almost a rule.
The pain will be psychological and will come from looking like an old fuddy-duddy… looking as if you have lost your way in the new golden era where some important things, which you have obviously missed, are different this time. For professionals this psychological pain will also come from loss of client respect, which always hurts, and loss of peer group respect, which can be irritating.
In truth there is nothing much that we can do about this problem. Value investors must, as always, invest exclusively on long-term values and long-term risks. We must always build our portfolios from the best mix of these two characteristics. Therefore there is simply no alternative to standing our ground and taking it on the chin when crazy markets get even crazier. Our consolation will be in knowing that we will win in the end whereas if we start jumping around on other non-value considerations, who knows what might happen?
On the other hand, it is perhaps useful to be familiar with the various aspects of bubbles that may arrive to trouble us. It is in this spirit that this quarterly letter is written: to better prepare prudent investors for the probable future pain so that they can more easily process it and be less likely to do something foolish.” Jeremy Grantham
He concludes, “The bull market may come to an end any time, indeed as I write it may already have happened. It could be derailed by disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation, or, perhaps most dangerous and likely, an extreme Chinese slowdown. But I believe it probably (i.e., over 50%) will not end for at least a year or two and probably not before it reaches a level in excess of 2,250 on the S&P 500. Prudent long-term value investors will of course treat all of the above as attempted entertainment (although I believe all statistically accurate) and be prepared once again to prove their discipline and man-hoods (people-hoods) by taking it on the chin.
I am not saying that this time is different (attention Edward Chancellor). I am sure it will end badly. But given this regime of the Federal Reserve and given the levels of excess at other market peaks, I think it would be different to end this bull market just yet.”
Here is the link to the full piece.
Trade Signals – Expect a Bumpy May to October
Click here for a link to Wednesday’s Trade Signals.
Conclusion
I presented my thoughts on valuations at an advisor conference in Florida this past week. A value manager like Grantham is tied to an investment mandate. His management plays a role in a portfolio. You however, can expand your asset exposures and use tools to risk protect even his exposure.
I mentioned to the advisor audience that, from a portfolio construction perspective, if you move 100% of your equities to cash or bonds (not wise), how do you sit with your client if the market moves another 20% higher (and you missed)? Heads nodded in agreement. A very large career risk.
The mismatch is that emotionally, when crisis hits and markets disconnect (which will happen again), clients may (and often do) panic. “Stocks for the long haul” turns into “get me out”.
Further, meager 5 and 10 year forward projected returns of 0% to 4% are likely not strong enough to keep a client on path. Grantham is a value investor. He has a process and a way. He is one of the true greats yet lost billions in assets in 1998-2000. Supposedly, the value guys just didn’t get it. Later everyone realized they did. To change his investment process would be to change his entire business model. I believe smaller investors have an edge and combine long-term focus with equity risk management and broader portfolio diversification.
I believe the best plan is to incorporate an element of risk management into your equity exposure, over-allocate to tactical strategies that have the flexibility to risk protect (also mix in long/short and select manage futures strategies) and think entirely differently about your bond exposure (look at risk managed bond strategies and/or shorten your maturities and be patient). It’s time to reduce equity return expectations, overweight tactical strategies, adjust bond exposure and in aggregate position portfolios more defensively.
As for tactical investing (a new area for many), there is an abundance of academic research that exists on the merits of price momentum. Click here for a link to our white paper – Understanding Tactical Investment Strategies. In it I cite a number of papers.
A trip to Chicago is up next. I am attending Envestnet’s annual conference May 14 – 16. Their software allows you to put managed strategies, like ours, into your existing client accounts. It also allows you to manage various portfolios across multiple client accounts. I’ve seen some very successful advisors create a range of portfolios from conservative to moderate to aggressive. This allows them to match client goals, needs, risk tolerances, etc. to one of their managed portfolios. The leverage gained from both an operational standpoint and time perspective is significant. Envestnet is the leader in this space. There are a few others. The good news is that technology has advanced to allow you and me as advisors to be more efficiently productive. I’m really looking forward to their conference and hope to learn more.
Please let me know if you are attending or in the area. Let’s get a good beer.
Have a great weekend!
With warm regards,
Steve
Steve 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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