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Don’t Kid Yourself: Stocks Are Just As Overvalued Today As They Were In 2000

As the Nasdaq approaches its 2000 highs people are talking about the similarities and the differences between the market then and now. Most seem to be focusing on the differences, on how much more attractively-priced stocks are today than they were then. From Barron’s:

“What was propelling the Nasdaq in the year 2000 was a dream. What’s driving the Nasdaq today is reality,” says Gavin Baker, who runs the Nasdaq-focused Fidelity OTC Portfolio fund (FOCPX). “The current valuation is very well supported by earnings and cash flows and if those earnings and cash flows continue growing, the Nasdaq should continue going up.”

ON-BI695_NasThe_G_20150220201918

The article continues by predicting the index not only surpasses the 5,000 mark but surges as far as 7,000 in “coming years.” This is certainly possible but using the table above to make the case that the Nasdaq, or stocks generally, are cheaper today than they were then is just faulty.

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The internet bubble was characterized by incredible euphoria and unbelievable valuations in just one group of companies. What investors fail to recall is that at the same time there were incredible values to be had in other sectors. The “old economy,” “bricks and mortar” companies had been left for dead as investors believed the internet revolution would put them out of business.

We don’t have a sector today that is nearly as overvalued at the tech/internet sector was in 2000 but we also don’t have any sector that is significantly undervalued:

In fact, virtually every sector is historically overvalued. This is why active managers and value investors are pulling their hair out right now:

Rather than prove that stocks are cheaper today, that first chart above from Barron’s merely demonstrates why the stock market appeared to be more expensive back then even if it wasn’t. Because the indexes are market cap weighted, that relatively small number of incredibly overpriced companies in 2000 skewed the overall valuation of the market much higher than was true for the majority of stocks in the market and obscured the segments of the market that were actually cheap.

If we look at median valuations of the market then and now we see a completely different story. The median number, rather than the aggregate number, is a much better indicator of the valuation of the average stock in the market because it eliminates the bias of market cap weighting toward only the biggest companies. Whether you look at price-to-earnings or price-to-cash flow, the average stock in the market has never been more highly valued than it is today:

Screen Shot 2015-02-24 at 1.12.15 PMScreen Shot 2015-02-24 at 1.12.32 PMCharts via Wells Capital

So don’t kid yourself. Stocks aren’t any cheaper today than they were at the height of the internet bubble. What’s truly “different this time” is that, rather than seeing incredible overvaluation confined to just one segment of the market, it is far more pervasive than it was back then. In my view, this also makes it far more insidious.

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Why Today’s Ultra-Low Interest Rates Are Actually Bearish For Stocks

There are plenty of pundits out there arguing that today’s record-high valuations in the stock market are validated by ultra-low interest rates (see Fed Model). The problem with this idea is it really only tells us how we got here. What investors should really care about is where we’re going and ultra-low interest rates are not at all bullish for future returns in the stock market.

In some respects, the idea that low rates should mean higher equity valuations makes perfect sense. If the 10-year treasury bond only pays 1.7% and the dividend yield on the S&P 500 is closer to 1.9% why wouldn’t I be more inclined to buy stocks? Good question! And this is probably why investors bid stocks up to astronomical valuations in the first place.

The major problem with this line of thinking is that it is backward-looking and it is no justification for valuations to remain high going forward. I’ll let Cliff Asness explain:

It is true that all-else-equal a falling discount rate raises the current price. All is not equal, though. If when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates.

In fact, over time corporate earnings growth tracks very closely to the rate of inflation. This is why so many people like to say stocks are a good inflation hedge because they can typically raise prices to combat rising costs in an inflationary environment. But if that’s true then they also make a very poor deflation hedge as their earnings also must also fall when the rate of inflation does. And right now the bond market is pricing in the lowest levels of inflation since the financial crisis:

fredgraphChart via FRED

This would suggest that earnings growth going forward should also be very weak. In fact, we are already seeing this reflected in companies’ fourth quarter earnings reports and in the forward guidance they are now giving. Goldman Sachs reports that guidance is now the worst ever recorded. Forward earnings estimates are beginning to reflect this as they have been falling for almost as long as long-term interest rates have been:

Screen Shot 2015-02-02 at 1.02.58 PMChart via Humble Student

From this perspective, it’s very hard to make the case that low-interest rates are a valid reason to be bullish on equities. It may be true that low rates encourage increasing risk taking when investors compare alternatives to the “risk-free rate” of the 10-year treasury bond. This is where the Fed’s interest rate lever and quantitative easing have obviously been successful. But at some point, plunging interest rates like we have seen over the past year, are a sign that earnings growth could be rapidly slowing if not turning negative, a development not at all supportive of risk assets.

Historically, this may be represented by the fact that low interest rates have led to the worst forward returns for stocks. The chart below separates the market into five distinct buckets ranked by the level of interest rates. Bucket 1 reflects the lowest month-end 10-year treasury rates on record during the 1965-2001 period. It’s clear that the 10 year periods leading up to those low-rate environments were fantastic for stocks. The subsequent 10 years were not nearly so kind, as investors suffered losses after adjusting for inflation.

Screen Shot 2015-02-02 at 11.36.14 AMChart via Fight The Fed Model

There is also recent evidence in other countries that the idea of low interest rates supporting stock prices is faulty. Just take a look at Switzerland. This Swiss 10-year bond yield is now negative. Based on the idea that low rates justify higher valuations, one could make the case that an infinite price-to-earnings multiple for stocks would not be unreasonable in comparison. But what did the Swiss stock market do while their long bond yield recently plunged? It also plunged!

tumblr_nialaheKOR1smq3o4o1_1280Chart via JLFMI

The point is investors like to use low rates as justification for higher equity valuations. At some point, however, really low rates go from being benign to malignant for risk assets. No doubt low rates have supported risk assets in our markets for the past five years or longer. But the rapid decline over the past few months is now being reflected in company earnings. And investors may soon begin to question whether it still makes sense to pay record-high valuations in light of this.

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By Some Measures This Is The Most Overvalued Stock Market Of All Time

Not so long ago I wrote, “this is probably the second worst time to own stocks in history.” However, when you look at the market a bit differently you can make the case that this could be THE worst time ever to own stocks.

Most broad valuation measures are market capitalization-weighted simply because the major indexes are cap-weighted. The S&P 500, for example, currently trades at a price-to-earnings ratio of about 19. However, the p/e of the Russell 2000 small cap index is closer to 80!

Screen Shot 2015-01-13 at 9.28.35 AMChart via wsj.com

This disparity between the two is hidden from the valuation discussion most of the time because it usually focuses on the stock market as represented by the largest 500 companies. When you look at the broader market, though, it’s clear there’s much more to the story.

So how do we reconcile the small cap p/e that is off the charts with a large cap p/e that is elevated but not nearly as ridiculous? Looking at the median p/e (the valuation of the company in the exact middle of the pack) should do the trick. Fortunately, Jim Paulsen of Wells Capital has already gone to the trouble of putting this together:

Screen Shot 2015-01-13 at 9.32.03 AMChart via wellscap.com

There you have it: the most overvalued stock market of all time, based on median price-to-earnings. (For what it’s worth, Paulsen also demonstrates in the paper that on a price-to-cash flow basis stocks have also never been as highly priced as they are today.)

Here’s what I think you should take away from this. The first thing I think about when I see a chart like this is my potential reward versus the potential risk I’m assuming. The best possible situation would be for valuations to remain elevated for the foreseeable future. Then my gains should be roughly equivalent to corporate earnings growth, probably in the low to mid-single digits. However, in a worst case scenario, valuations return to the bargain bin and I’m facing steep losses (possibly 50% or more). All in all, I’m risking half my capital to make a single digit return.

The second thing I think about when looking at the chart above is my long-term rate of return is determined by the price I pay. If I’m fortunate enough to get a below-average price then over time I can reasonably expect an above-average return from stocks (10% per year or more). Pay a high price and I guarantee myself a mediocre return. Pay a record-high price and I’m essentially locking in one of the worst long-term returns in history (probably somewhere close to 0%).

Now I have to say that I believe price-to-earnings ratios are not the best way to value individual stocks or the broader market. There are other methods that are much more valuable for forecasting long-term returns like Warren Buffett’s favorite yardstick, total market cap-to-GNP. See “everything but the US stock market has already peaked” for my latest update on it and other indicators crucial to long-term equity performance.

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My Favorite Investment Idea Since Apple

I’m in the process of creating a premium version of “The Felder Report” that focuses on actionable investment ideas including general market commentary, a model ETF portfolio and individual investment and trade ideas. This is in response to demand from readers like you who have appreciated my thoughts on index funds, buy and hold, long bonds and, of course, Apple.

My first idea over at the new site is Herbalife, which is getting hammered today (on sale!). To see why I like as much as I liked Apple at $70 (if not more) subscribe to the premium site here:

http://members.thefelderreport.com

For a limited time subscribers will get a $100 discount from the regular annual subscription rate of $300 as the site is really still in the beta stage.

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Everything But The US Stock Market Has Already Peaked

The new Z.1 report came out today so let’s update many of the indicators I’ve been sharing here over the past few months. What should be worrisome to market watchers here is that we now have a host of significant indicators that look like they may have formed important peaks and begun to roll over. We will need to see at least a couple more quarters worth of data to be sure but this is certainly something to keep an eye on.

First let’s take a peek at Warren Buffett’s favorite valuation yardstick. (See “How To Time The Market Like Warren Buffett” for a look at one way I use this indicator.) It actually peaked last quarter and saw a small retracement in Q3. This indicator is 83% negatively correlated with future 10-year returns in stocks (the higher the reading the lower forward returns) and its current reading implies a -0.88% annual rate of return over the coming decade. The 10-year treasury at 2.2% looks fairly attractive in comparison.

fredgraphNext we can take a look at the household percentage of financial assets allocated to equities. This indicator is even more negatively correlated to future 10-year returns at about 90%. It has also pulled back just a bit from the peak it made in Q2. Its current reading implies a forward return of about 2.8% per year over the coming decade, slightly better than the 10-year treasury.

fredgraph-2

Finally, comparing the current level of the S&P 500 to its long-term regression trend we can see that the only other time in history stocks were this overbought was at the height of the internet bubble. This measure is not quite as highly correlated to future returns as the other two but at 74% it not that bad, either. It also looks at the largest data sample of any of them so I believe it’s worth including. At its current reading it suggests stocks should return just 0.74% per year over the coming decade.

Screen Shot 2014-12-11 at 1.35.10 PMBlending the three forecasts together we get a 0.89% annual return forecast for the stock market over the coming decade. A straight comparison to 10-year treasuries at 2.2% shows them to be the more attractive of the two asset classes right now. Hell, even 5-year treasuries are paying 1.6%, nearly double our model’s forecast.* All in all, this looks to be the second worst time to own equities in history.

Still, the stock market’s uptrend remains in tact as all of the major indexes currently trade above their 200-day moving averages. But as I’ve noted recently there are plenty of signs that the trend is not as healthy as bulls would hope. The advance/decline line, new highs-new lows and the percentage of stocks trading above their 200-day moving averages are all diverging fairly dramatically from the new highs recently set in the indexes. This is a serious red flag.

And now that our market cap-to-GDP and household equities indicators have possibly peaked, along with high-yield spreads (inverted), margin debt and corporate profit margins, there seems to be a very good possibility that the uptrend could be tested in short order. In fact, when I go back and look at the times when all of these indicators peaked around the same time over the past 15 years or so they coincide pretty neatly with the major stock market peaks:

Stock Market Peak Q1-2000 Q4-2007 ???
Market Cap-GDP Peak Q1-2000 Q4-2007 Q2-2014
Household Equities Peak Q1-2000 Q2-2007 Q2-2014
Margin Debt Peak Q1-2000 Q3-2007 Q2-2014
High Yield Spreads Peak (Inv) Q3-1997 Q2-2007 Q2-2014
Corporate Profit Margins Peak Q3-1997 Q4-2006 Q3-2013

So the uptrend may still be in tact but I think we have a plethora (yes, a plethora) of evidence that suggests its days may be numbered. Foreign equities have mostly given up their uptrends over the past few months and commodities, led by the oil crash, look even uglier. How much longer can the US stock market swim against the tide?

Note: I’ve received many questions over the past few months since I first posted, “Seeing The Forest For The Trees,” about just how to go about doing this and here’s my recommendation if you don’t want to own stocks right now: Hold cash. It’s not sexy but it’s dry powder.

Now if you want to earn something rather than nothing on your cash and you’re worried about interest rates rising (and it seems everyone is) you can easily build a ladder of individual bonds rather than just buying a bond fund. The difference between owning a fund and owning bonds individually is when you own bonds directly you can decide exactly what maturities you are comfortable owning and you can always hold them to maturity if interest rates move against you. A bond fund, on the other hand, doesn’t give you that sort of flexibility.

Here’s how I would consider setting up a bond ladder right now if your goal is wait for a better buying opportunity in the stock market. Simply divide your investable funds into five equal buckets. Then invest each bucket into 1, 2, 3, 4 and 5-year treasuries, for example (you may want to choose shorter or longer durations based on your own goals). So if you have $50,000 in our example you would just buy $10k of each maturity. If the 1-year bonds mature before you find a better place to put the money then reinvest the proceeds into 5-year bonds again (as your original 5-year bonds will now be 4-year bonds and so forth). This way your blended yield on the bonds should come pretty close to the 0.89% our model suggests stocks should return without any of the heightened risk in owning equities right now.

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