June 18, 2021
By Steve Blumenthal

“Investing is the intersection of economics and psychology.
The economics, the valuation of the business is not hard.
The Psychology—How much do you buy? Do you buy it at this price?
Do you wait for a lower price? What do you do when it looks like
the world might end?
Those are the harder things.”

– Seth Klarman,
Chief Executive and Portfolio Manager, Baupost Group

“What a wise man does in the beginning, a fool does in the end.”

– Warren Buffett,
Chairman and CEO of Berkshire Hathaway, Investor, and Philanthropist

It’s been several months since we last looked at equity market valuations and what they tell us about coming 10-year return probabilities. Let’s do that today.

But first, a quick recap: In last week’s OMR, I concluded my SIC2021 conference notes. Hosted by my friend and partner John Mauldin, nearly 5,000 virtual attendees watched and listened to six days of presentations, including insights from Howard Marks, Felix Zulauf, William White, Richard Fisher, Karen Harris, Ian Bremmer, Jim Bianco, Dr. Lacy Hunt, Peter Boockvar, Barry Habib, David Rosenberg, David Rubenstein, Liz Ann Sonders, Ron Baron, Catherine Wood, Louis-Vincent Gave, Constance Hunter, and more.

Inflation was top of mind and it matters. It may just be what matters most. I believe William White and Richard Fisher stole the show. Both are retired central bank insiders. Since the Fed controls the cost of money, what it does with monetary policy directly impacts our wealth. “Don’t fight the Fed” as they say. Current policy has interest rates set at 0%. Just this month, the Fed’s balance sheet topped $8 trillion. The Fed owns $8 trillion in mostly U.S. Treasury bills, notes, bonds, and U.S. mortgages… along with a little corporate and high yield debt. $8 trillion… hard to comprehend… numbing.

If inflation gets out of the bag, interest rates will rise. The Fed is comfortable letting inflation get to 2.5%, but more than that will be problematic. Inflation is clearly in full bloom. Check out the following chart. After seeing it on Wednesday, a majority of Fed policymakers moved up projections for commencing interest rate hikes from 2024 to 2023, with two quarter-point interest rate increases projected in 2023.

William White sees inflation in the near term, deflation in the medium term, and problematic inflation in the long term (due to all the Fed’s printing of new money and government spending… MMT). Fisher didn’t disagree. Dr. Lacy Hunt and David Rosenberg both see deflation and lower interest rates ahead. Likely, maybe, watch the technical indicators.

Inflation is the kryptonite to zero interest rate policy. If rates rise, asset prices will fall. Fisher said, “If it is not transitory, and I hope it is, then the weed of inflation grows and kills the garden.” What he meant is that inflation will cause the Fed to have to raise interest rates, which will seriously hurt the stock and bond markets.

When I began my career in 1984 at Merrill Lynch, interest rates were in the mid-teens and the median P/E on the S&P 500 Index was less than 10. Paul Volker was fighting inflation. No one wanted to own stocks. That’s not the case today. Investment conditions are vastly different: interest rates are set at zero percent and the S&P 500 median P/E is 33.6. Today, we’ll look at what this means in terms of risk and probable future returns.

Valuations, Trend, and Debt
Links to Prior SIC2021 Notes
Trade Signals – All Eyes on the Fed Today
Personal Section – Whistling Straits and Chicago

Valuations, Trend, and Debt

Each month, I review valuations and (most months, at least) I share that information with you. For me, it’s about process. I do it monthly since the data refreshes after each month ends. Slow and boring, yes. But the process does help me set some targets for offense and defense. It’s been a few months since I last shared my valuation insights with you. Here’s the latest:

Median P/E

In my book, On My Radar: Navigating Stock Market Cycles, I talk about how to use valuations to help you set your own game plan. One of the charts I share tracks the median price-to-earnings (P/E) ratio of the S&P 500 Index. I like that it’s based on actual month-end prices and actual trailing 12-month earnings. Take the price and compare it to earnings and you get median P/E. Last month’s median P/E was 33.6. (“Median” refers to the middle of the set. Since there are 500 stocks in the S&P 500 Index, there were 250 P/Es higher and 250 P/Es lower than 33.6.)

Ned Davis Research (NDR) plots each month-end median P/E dating back to 1964 (tracked by the orange line in the next chart.) The average median P/E of the last 57.3 years is 17.3. Let’s call that “fair value.”

What I like best about this chart is that NDR adds standard deviation zones. To keep your head from spinning off, just think of standard deviation as a measure of the amount of variation in a set of values. Put simply, it takes an extreme increase in price relative to earnings to get to the “very overvalued” zone, and an extreme decrease in price relative to earnings to get to the “bargains” zone. Such moves to both extremes rarely happen––but they do happen.

A straightforward way to employ this chart is to buy whenever the median P/E approaches the green dotted fair value line. Lighten up and hedge when it’s in the “overvalued” zone and get very aggressive with your buying when it’s in the “bargains” zone.

Look at where we are today (the red “we are here” arrow in the following chart). Median P/E has never been this far above “fair value” since 1964, when NDR began tracking. At some point––and nobody knows exactly when––the orange line will move down. A few things to note:

A much better entry point is at the “overvalued” dotted line, or 2,858.79 in the S&P 500.
However, I suspect we’ll return to the “median fair value” line in the next bear market cycle. That is 2,160.91 in the S&P 500 Index, at which point it will be reasonable to expect returns of approximately 10% per year—the historical returns the market has provided over the last 100 years.
Lastly, a decline of 65.1% to 1,467.23, while improbable, can’t be ruled out.

Somewhat like the 2000 tech bubble market peak, much of the overvaluation extreme is tied to tech stocks. It is not that they are bad companies; it’s that the cap-weighted indices by rule overweight more and more to the stocks whose prices increase the most. Since so much money has shifted to cap-weighted index funds, we have returned to a similar overconcentration of risk. Therefore, I like smarter beta ETFs (not cap-weighted), particularly if they are hedged. There are some creative ETFs that you can find. Call me… I’m happy to share a few ideas.

The Buffett Indicator: Corporate Equities to GDP

Market cap-to-GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001, he remarked in a Fortune magazine interview that “it is probably the best single measure of where valuations stand at any given moment.”

Highest ever—enough said.

Median Price-to-Sales Ratio

The price-to-sales ratio (price/sales or P/S) is calculated by taking a company’s market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company’s total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. (Source: Investopedia.com)

Bottom line: Light blue line bottom section of chart. Note the data boxes.

Lastly, let’s take a look at what the return probabilities are for the S&P 500 Index, from today’s starting point over the coming one to 11 years.

Stock Market Capitalization as a Percentage of Nominal Gross Domestic Income

The next chart plots stock market capitalization as a percentage of nominal gross domestic income. Think of it as how much we collectively earn.

Here’s how to read the chart:

The orange line in the middle section tracks the month-by-month ratio between the value of the total U.S. stock market as a percentage of our collective incomes. NDR plots an upward sloping trendline.
The light blue line in the bottom section plots just how far above or below the current valuation (stock market to gross domestic income) is from the trendline. The long red arrow points to the end of February 2021. Simply compare it to the other peaks. (Note: the data goes back to 1925.)
Now, look at the data box in the upper left-hand corner. Considering all of the month-end data, NDR asked, What happened to the S&P 500 Index one, three, five, seven, nine, and 11 years later?Note the subsequent average returns when in the “top quintile – overvalued” and the “bottom quintile – undervalued.”

Bottom line: Expect flat to negative returns for the S&P 500 over the coming one, three, five, seven, nine, and 11-years. Said the great Warren Buffett, “What a wise man does in the beginning, a fool does in the end.” Defense wins championships.

Trend

Each week in Trade Signals, I share my favorite trend indicators. And yes, while valuations are the highest in history and euphoria is clear to see, the trend in the market remains bullish. Despite my fundamental view, I anchor to process, and the technical indicators are telling us to remain bullish. That’s been the case for the last number of years. See the Trade Signals section below.

Debt

Total domestic debt is the total outstanding debt owed by all domestic sectors (households and nonprofit institutions, financial and non-financial corporations, farms, state and local governments, federal government) and includes government bonds, corporate bonds, bank loans, other loans and advances, mortgages, and consumer credit.

Total Domestic Debt as a Percent of GDP – data as of 12-31-2021 (select countries) Source: Haver Analytics

Canada: 367.2%
Eurozone: 483.6%
UK: 513.4%
France: 589.0%
Germany: 319.9%
Ireland: 898.1%
Italy: 382.8%
Japan: 654.1%
South Korea: 384.8%
United States: 361.7%

Debt is a drag on future growth. Reinhart and Rogoff did an excellent review of history. The bottom line––plain and simple––is that economies get into trouble when debt-to-GDP is north of 100%. Debt is our number-one problem. It is why the economists I respect the most believe deflation will continue to be the dominant force. In the end, we will monetize the debt and the path to that end game will be volatile. We will solve the problem, but it will require political will, global coordination, and probable financial pain. It is why William White believes, “In the end, there will be inflation.” We do not yet know what the solution will look like. And we’ll all be fine. And our finances will be fine too if we adapt accordingly.

We’ll look at the leverage in the financial system in coming OMRs. Think swaps, derivatives, and margin debt. The investment (speculation) leverage in the system sits near its highest point in history. Factor that into your overvalued calculus too. Bad starting conditions for the traditional 60/40 buy-and-hold portfolio. Excellent conditions for active money management and opportunistic investors.

Links to Prior SIC2021 Notes

Here are a few links if you’d like to track some of the writings from SIC2020.

Trade Signals – All Eyes on the Fed Today

June 16, 2021

Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.

For new readers – Trade Signals is organized into three sections:

Market Commentary
Trade Signals — Dashboard of Indicators
Charts with Explanations

Market Commentary

Notable this week:

The trade signals are unchanged since last week. We’re currently seeing buy signals across the board – equities, fixed income, and gold. Below you will find the current charts and indicators, showing the persisting bullish trend.

Today is “Fed Day,” the day the Federal Open Market Committee (FOMC) concludes its two-day meeting and announces any changes in monetary policy and interest rates. The FOMC will issue its policy statement at 2:00 pm (ET) and Federal Reserve Chair Jerome Powell will have a press conference at 2:30 pm. Generally speaking, the markets are not expecting any major changes in policy or interest rates, however market participants and economic observers will be closely reviewing the policy statement and Chair Powell’s remarks concerning inflation, economic growth, and any potential future changes in the Fed’s market support/bond-buying program.

Trade Signals – Dashboard of Indicators follows next. Green continues to dominate the dashboard. Click HERE to go to the balance of 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.

Personal Note – Whistling Straits and Chicago

I flew to Milwaukee last Sunday evening and drove north to Sheboygan, Wisconsin. My destination? The famed Whistling Straits Golf Course. Ranked #51 in the world, the links-style golf course sits on Lake Michigan (pictured below) and is owned by a subsidiary of the Kohler Company. To say I was excited is an understatement, and the experience did not disappoint.

This year’s Ryder Cup match, which pits top U.S. professionals against Europe’s best, will be held at Whistling Straits. I’m really looking forward to that…

Steve, Lance, Gary, and Andy

Post-golf, I spent Wednesday and Thursday in Chicago for dinner with partner Kevin Malone and meetings, then returned home Thursday evening. Downtown Chicago was quiet. The airports, on the other hand, were packed.

Some more golf is in the plans for this weekend. Matt is home and we’ll be golfing together on Father’s Day. I get the strokes, as he is much better than me. I don’t think he’ll gift me a win, though. It’s usually $20 from my pocket into his. Not this week, Matt! Not this week!

Happy Father’s Day to you and your father. Wishing you a great day.

Steve

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

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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.

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On My Radar: Valuations, Trend, and Debt