Stock Market Valuations
It’s been a couple weeks since my last post. I spent much of that time engaging in a bit more economic research then is good for me. Days and days spent staring at GDP statistics and bond yields is not the best for one’s health. This post is going to be a bit long because we have a ton to cover. I think it’s necessary. But before we dive into anything too boring I’d like to start with a little story.
A sailor is about to set out on a great journey. Our sailor is a student at one of the finest schools of navigation. An institution both renowned and ancient. It’s marble halls have trained the finest sailors the world has ever known. He is an expert at reading star charts, skilled in the operation of the sextant, and has a photographic memory for nautical charts. One beautiful spring day he says goodbye to his instructors and fellow students learning the craft of navigating the high seas. He prepares his small ship as best he can – storing supplies, preparing sails, caulking any leaky joints. He raises anchor with a warm wind at this back and sets out across the wide blue sea for destinations unknown.
Adventure is his only goal. He discovers lands never before seen by men, fights off wretched pirates, encounters creatures both benign and terrible, and befriends all manner of folk across the great sea. After many years, he grows weary of his adventure and decides that it is time to return to his home and to the school that taught him so well, instruct a new batch of intrepid sailors. He plots a course for home, once more with a favorable wind at his back. He returns to those marble halls of his youth expecting to find the same renowned institution that he left so many years ago. However, upon returning he finds something terrible – Everyone he used to know has gone insane. They shuffle around the now decrepit halls speaking gibberish, stopping only occasionally to argue with one of the now dead potted plants. All blind to the outside world. And meanwhile, far out at sea but coming quickly a tsunami rages towards shore.
The story above is a fairly apt description of how I feel about the current state of financial markets. A little ancient history on Grizzly Dad is probably in order. My background and first love have always been economics and finance. It’s what I studied at a very fancy school when I was young. My first introduction to that world was under the tutelage of folks like Ben Bernake, Burton Malkiel, and Dan Kahneman (these were my actual freshman/sophomore year econ professors). I learned the theory of efficient markets and portfolio theory and all sorts of economic facts and figures with the best of them. I then took a detour through the US Army, but my love of markets and the weird movements of money through an economy never really left me. I didn’t have time to pay attention to the craziness that erupted in 2007-2009; I was living at a patrol base in Iraq through most of the chaos. I watched the slow climb back into a state of relative normalcy over the last decade but never had time to dig back into the weeds of the market.
Unfortunately, now I find myself with a great deal of time on my hands. Enough to take a deep look at the discipline I used to love so much. And unfortunately what I find is very similar to those marble halls filled with lunacy. In this post, it appears that I’m going to earn my name Grizzly Dad. I’m going to come out as an outright bear on the current state of financial markets today. In more normal times I would temper my statements. In the past, I have simply said, “Put it in index funds and wait.” However, that was before I’ve gone into the data as deep as I have over the last few months. I can no longer in good conscience recommend that path. My metric is if I would recommend it to my mother at current prices – I would not.
We have never seen a point in the history of our country in which such high market valuations were coupled with such poor fundamental drivers of productivity and growth. I’m not an oracle, and I cannot say exactly where everything goes from here or on what timeline, but the only emotion I have to describe what I currently feel when looking at the stock market (and MANY other related assets) is a pure unadulterated terror.
First, let’s talk about some basics of stock market valuation. Traditionally, when we talk about stock market valuations we’re talking about some sort of multiple. A price to earnings multiple is the most commonly used and referenced. Just take the current value of all the stock in a given company and divide it by the earnings for that same company. The long-run average PE multiple for the SP 500 is around 15 with a range anywhere from 5 to >120. Currently, it sits at about 23 – high, but not unprecedented. The full series going back to 1900 looks like this:
The massive spike going off into infinity is right after the last financial crisis. Earning dropped significantly faster than price, leading to a massive spike in the multiple. The large spike right before that is the dot-com bubble in the late 1990s when PE’s reached their previous all-time high. PE ratios are a frequently used shorthand by finance talking heads on the news. Unfortunately, they are not actually a very good gauge of true valuation levels. More reliable statistics paint a much more concerning picture.
Before we go further we need to talk a little bit about WHY anyone should actually care about a valuation multiple. What does a value of 20 or 50 or 10 even mean? The simple answer is absolutely nothing by themselves. We care about valuation multiples because they are a shorthand for estimating the long run stream of cash flows that will be delivered by a security. That’s ultimately what we care about.
Every stock, bond, T-Bill, etc. is simply a claim on some long run stream of payments to investors. In the case of stocks, these cash flows are the dividends paid over time. If you know the exact schedule and amount of payments in the future along with the current price, you can calculate the exact return you should expect to receive. However, no one knows the future, and it’s a time intensive (and error prone!) exercise to estimate future dividends from the entire SP 500 from the ground up. Hence why we try to use some sort of multiple to estimate those future payments and the future return we can expect from investing.
The important thing to keep in mind from this is that a multiple is only a good a measure of value and future returns if it is an accurate and stable predictor of long-term (30+ years) cash flows – what academics like to call a sufficient statistic. Basically, a measure that is highly correlated with what you are trying to assess. In this case, we are trying to determine future cash flows and through them future expected returns from current valuation levels.
This is where simple PE ratios fail. Year to year earning fluctuate wildly. Even at the highest aggregate level, corporate earnings vs. US GDP, we see somewhat random and large swings from year to year.
As a result, their predictive ability for long-range cash flows and subsequent returns is rather weak. It is useful as a rough estimate, but it is a blunt instrument at best.
As a result, we have to turn to more stable metrics to get an accurate sense of value and future returns. One measure I’ve talked about before is Robert Shiller’s cyclically adjusted price to earnings (CAPE) multiple. Essentially, it’s the current price compared to a 10 year average of earnings. It smooths out all the ups and downs of earnings cycles and does a significantly better job of predicting long-run returns. However, we can do even better.
One problem with using current (or even smoothed) earnings to predict future cash flows and future returns is profit margins tend to follow economic cycles. Often you will find the highest corporate profit margins at the hight of bull market cycles, making the pure earnings multiples somewhat under-representative of the actual valuation being given to stocks. As a result, the accuracy of the prediction is enhanced dramatically if we adjust for the prevailing profit margins. Once we make that adjustment we can develop a measure highly correlated with the returns and cash flows we should expect over time.
The graph below shows just that relationship. This is Shiller’s CAPE model adjusted for the prevailing profit margin vs. the subsequent 10-year total return (price changes + dividends) of the SP 500. These measures have an almost 90% correlation with each other. If you know the margin-adjusted PE you can very reliably predict the future returns you should expect.
Here is the same relationship over time.
The red line is the projected return based on a simple linear model with margin adjusted CAPE as the input and an expected return as the output. The blue line is the actual total 10-year returns observed from each date – ending in 2007. We are currently at a level seen only once before in US history – immediately prior to the stock market crash of 1929. This model agrees with a host of other metrics that also have a >90% correlation with subsequent market returns (Market Cap/Non-financial gross value added being the most accurate) and has held through the most recent market cycle for which we have complete data. This is one of the most accurate predictors we have of future returns from any given valuation level.
Bottom line – any suggestions that we should expect near historic rates of return in the stock market from this point forward is delusional. The expectation should be for very low, likely negative returns, with a very high chance of a significant loss in intervening years. I myself in a more naive state have suggested higher returns were possible. This was a mistake. As recently as a few years ago we could have at least expected stocks to outperform US treasuries or cash over the next 10 years. That is no longer the most likely outcome.
Fundamental Growth Drivers
These extreme valuations would be less worrisome if they were driven by dramatic improvement in economic fundamentals – rapidly growing labor force, dramatically increasing productivity, massive investment surges. This is not the case.
The drivers of the US economy, while complex, can be decomposed into simple components. At its most basic growth in GDP is controlled by two things: 1) growth in the number of workers driven by population growth and improvement in employment rates and 2) growth in productivity per worker driven by investment in education and technology. Currently, both of these factors indicate a dim view for future GDP growth.
The chart below shows the 10-year average growth rates of the US labor force over time. Employment is fairly straightforward – everyone with a job. The labor force is the subset of working age adults either employed or looking for work. Finally, the working-age population is everyone between the ages of 15-64. Employment is a subset of the labor force which is a subset of working age adults. Unfortunately, all of these metrics are trending down. The growth of the most fundamental – working age population – hit zero this past year and is unlikely to rise. We are likely to see zero, or even negative, growth in working-age population going forward which will flow through to the other labor force metrics.
Worker productivity paints a similarly dark picture. The chart below shows both 10-year average productivity growth and the domestic investment net of depreciation as a percent of GDP. That investment will ultimately drive future improvements in productivity, but unfortunately, both are at historic lows with productivity growth dipping well below 1% in recent years.
At current levels of labor force growth and productivity improvement, even 1% GDP growth per year requires a dramatic improvement in either of these metrics. We are unlikely to see such improvement given the historically low level of investment and extremely low unemployment rate currently prevailing. It is likely to get worse from here, not better.
Another fundamental narrative that is often thrown around when justifying the current runup in prices over the past year is tax reform. Unfortunately, this is largely a pipe dream. Even if some sort of corporate tax reform is passed, the narrative around extremely high corporate tax rates in the US simply is not true. Effective corporate taxes in the US are already near historic lows. Any tax reform plans, even if they were to drop this still lower, would never come close to justifying the valuations we see today. There’s just not enough room to cut.
One final argument that is raised by numerous supposedly knowledgeable people is that the current low-interest rate environment justifies the extremely high valuations we currently see. The problem with this statement is quite simple. There is no historically verifiable link between interest rates and valuations. Market valuations and the subsequent returns delivered by the stock market have no relationship with prevailing interest rates on bonds. Any relationship that does exist is actually in the opposite direction from what we would hope – with low-interest rate environments actually leading to LOWER subsequent returns in stocks over the next 10 years.
There is a great deal of truth in the statement that the current low-interest rate environment may have caused the runup in stock prices and valuations. But once those valuations are established vs. measurable fundamentals the future returns we can expect are set largely independent of the prevailing rates on treasuries. And those returns are likely below zero over the next 10 years.
Record high valuations and subsequent returns and very poor fundamental growth drivers would be enough to worry me. Unfortunately, the US has maintained and continues to build a record-breaking pile of debt across all sectors of our economy. Any deleveraging that should have been expected after the last great meltdown simply has not happened.
The only reduction has come from the finance sector – but this has largely been swapped (intentionally?) for a massive increase in US government debt. The bottom line is that that overall economy is as highly leveraged as it was prior to the last major crash. We have learned almost nothing. And the US is hardly alone in this. Around the world debt ratios are soaring. The two most egregious examples are China and Japan. But the entire world is gorging itself on debt with total debt to world GDP ratios reaching over 300% this year and continuing to rise.
Finally, in addition to a glut of debt across the world, investors have taken out record amounts of margin debt to fund positions in the currently overvalued stock market.
All of this debt buildup simply means that when market valuations retreat even slightly there will be many people and countries that are currently leveraged to their ears caught off-guard. This could, in turn, lead to even more selling with things spiraling out of control from there. Bottom line – good things do not come from these combinations.
The final and most baffling thing for me about all of this is how complacent the world seems to be about what could potentially be a looming crisis equal to or greater than the great recession.
There is a well-followed metric on Wall Street called the VIX or Volatility Index. The best way to view it is simply the price of downside insurance for an investor in the SP 500. If the VIX is lower, insurance is cheaper, higher and insurance is more expensive. If it’s lower more people are selling insurance and fewer people are buying. Who needs downside insurance if the market just keeps going up? A more complicated explanation of the VIX index is that it is a measure of the implied (or projected) volatility in the market. Higher VIX means a higher expected variance and greater uncertainty in stock prices going forward.
Intuition would suggest that with all the relative chaos in the world over the last year that folks would want a little insurance. There are mounting risks – from NAFTA negotiations to N. Korea, to Catalan and Brexit uncertainty. However, the VIX has NEVER been cheaper. Insurance against big market changes is selling for bargain basement rates. Apparently, no one is concerned about what might happen over the next several years.
Finally, I end with a quick look at what average American’s are thinking about the market today. The University of Michigan runs a regular survey asking American’s a number of questions about their own economic outlook for the year. According to Michigan, those regular American’s are once again giddy about the prospect of future market gains. Generally, this has been a very bad sign for actual market performance.
We’ve covered a lot of ground today. The bottom line is that after sequestering myself in a room for several months I have come out with a very dim view of future market performance over from our present positions. The number of things that disturb me about the present state of the market are numerous – I’ve simply gathered the most salient here. I haven’t even mentioned things like the inability of the market to price risk – with European junk bonds trading at parity with US treasuries.
The Grizzlies have already made some adjustments to our portfolio to potentially mitigate the worst of the fallout. I still believe that it is difficult to impossible to time markets correctly, but one can and should exercise prudence when faced with what could be one of the worst financial crisis in history. I’ll detail a few of those changes in my next post.