Wed, MAY 7th, 2014
Valuation is a very complex financial topic. Too many people, especially the media, oversimplify it. So let’s dial back up the complexity [I know, you’re really excited now!]. I understand that this particular blog is very dense; there’s a lot information below. I have bolded areas of notable merit.
My views on valuation.
David Leonhardt of the New York Times paints stock market valuation with a very broad brush using but a single metric. And while he is correct that the Shiller P/E [AKA. CAPE] is presently at elevated levels, historically speaking, this alone is a woefully incomplete analysis in attempting to gauge the stock market. At Albion, we are continuously taking the temperature of the financial markets from a variety of angles. My view is that, on balance, when looking at general price-to-earnings ratios [despite Mr. Leonhardt’s contempt for this metric], earnings yield, equity risk premium, dividend discount, price-to-book, “the rule of 20” [20x subtract current inflation] and the general level of earnings, the market is not presently in a bubble. Additionally, net debt at companies [as measured by net debt/ebitda] is roughly half of what it was in the prior cycle and household balance sheets are in a state of great repair.
Sniffing out market tops can be more art than science, and in this qualitative vein there just doesn’t seem to be any excess of excess like in prior bull phases. More plainly, in 2000 too many people were day trading stocks and valuations hit over 100x on the Nasdaq and over 30x on the S&P 500. In 2007, everyone was financing frivolous consumption with credit and unfettered risk taking was alive and well on Wall Street. From my perch there is nothing like that out there today. What we actually have is an abundance of bubble watchers, crisis worriers, market-top-callers and a healthy dose of general skeptics. When stocks are truly bubbly virtually no one is looking to call the top; the party is just too much fun to leave.
For a further framework into thinking about how market tops often form, please check out this blog I recently wrote on Albion’s website.
I also reason that due to record highs in both the Dow and S&P 500 and two deep bear markets inside of a single decade, talks of a bubble are natural. I recently blogged about Investing at Market Highs.
On macroeconomic metrics the market doesn’t look overvalued either. Indeed, key items like GDP & GNI, retail sales/consumption, the relative health in U.S. banking, record levels of household net worth, low inflation, an improving labor economy and expanding energy and factory production all suggest that the economy has moved up enough to support equities at their current quotation, particularly given the flattish market over the past ~14 years [referred to as a secular bear market]. There are, of course, soft patches in the economy that haven’t fully recovered – namely jobs and housing, though both are on the mend. I think these two powerful sectors can drive the economy and the market higher over the medium- and longer-term. Other places like capital spending and general sentiment levels also remain tepid. Though, again, any pick-up here – which I believe is likely as the recovery lumbers along – provide incremental tailwinds to growth.
Finally, and perhaps most imperative, interest rates remain considerably lower than in any of the prior peaks meaning that equity valuations vs. bonds and cash look especially compelling. This valuation, a variation of the “Fed Model”, is one that is too often overlooked by people who currently see stretched valuations for stocks. History suggests that when rates are at extreme lows [conversely, bond prices are high] a trailing P/E [not CAPE, standard P/E] of >21x is not unusual. Indeed, market behavior since 1954 shows a mean of ~19x when long-term interest rates are below ~8%. We currently stand at ~17x on the S&P 500.
A study of long-run stock market data tells us that protracted bull markets – those that extend 5 years or more – generally do not end simply because valuations are perceived as overstretched. Valuations often stay elevated for a lot longer than people realize. What usually ends the party is a recession, a brawny Fed tightening cycle [no, tapering QE does not qualify] or some black swan event [i.e., exogenous shock].
At present, I don’t see a recession given the economic data, nor do I expect any time soon for the Fed to embark upon a classic tightening of monetary policy by violently raising the federal funds rate target *though, as I’ve stated many times before this would become a greater risk if we suddenly get money velocity in the economy*. As for black swans, by definition these are events that are completely unknowable so I will not venture a guess as to the likelihood of one swooping down and upending the market.
Some Considerations on CAPE.
Let us revisit what we began with, the NY Times piece on CAPE. At first blush this valuation tool does indeed suggest reduced returns looking out over the next few years. Given the run-up in stocks over the past five years this baseline is quite reasonable. That said, Robert Shiller himself has noted on many occasions that – except in extreme cases, like when it’s at say 35-50x – CAPE should not be used to as a tool to predict market tops. Bob doesn’t use it this way, so I won’t use attempt such a feat either.
To balance the landscape, this high CAPE argument isn’t the only game in town. Consider this CAPE counterpoint from Wharton school finance professor Jeremy Siegel, a market maven whom I have much respect for. He penned a compelling article in the Financial Times. I happen to agree with Mr. Siegel’s view. He also explained his views in an interview with Advisor Perspectives:
“The CAPE has been a powerful predictor of long-term equity returns, forecasting strong returns in the early 1980s and poor returns from the market peak in 2000. But for many years its predictions have been very bearish. In fact, in all but nine months in the past 22 years the Cape ratio has been above its long-term average, and the ratio currently predicts well below-average stock returns.
I wrote a paper last summer, “The CAPE Ratio: A New Look.” I presented it at a Q-Group conference in October. Bob Shiller and I debated it the day after he won the Nobel Prize. (Because of all the media coverage he appeared by video-conference rather than in person)
The bottom line of the paper is I have a lot of problems with the CAPE predictions using S&P data, but not with the CAPE methodology. The CAPE methodology is brilliant and works. The data are the problem. I showed that the S&P 500 earnings data over the last 15 to 20 years, particularly in recessions, have been much different that prior to that, primarily due to the change in accounting conventions and the forced write-downs of assets. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. When I looked back at the historical data, S&P earnings compared to the business cycle, it was like night and day. You are not dealing with the same series.
I used the corporate profits from the National Income and Products Account (NIPA) data and plugged them in. Guess what? The Shiller overvaluation almost completely disappeared. And the cyclical behavior of the NIPA data is very consistent with the business cycle over the last 85 years. When you normalize for the data, the market is not overvalued by much at all. Because Shiller’s CAPE is based on the average of the last 10 years, the crash in earnings during those recessions really pumped up the CAPE ratio, and that is a major, major reason for today’s over-valuation.
Bob Shiller is my best friend. He invited me to the Nobel ceremony in Stockholm. I’m thrilled that he won. We have certainly a friendly back-and-forth on the direction of the market, but he is very well-deserving of his award. It’s not the CAPE methodology; it’s the fact that S&P 500 started dishing him a very different series from the one that he had constructed back at 1871. It was very interesting is that the S&P 500 series used to be more stable than the NIPA profit series but over the last 15 years has become less stable because of the new FASB guidelines. That’s the major problem.
The editor of the Financial Analyst Journal was at that Q-Group meeting. He came up to me afterwards and asked me to publish this. Bob acknowledged that there may be some marked inconsistencies with the series over time.”
Before you use the lone nut theory to explain away Siegel’s notion, consider that he isn’t the only one taking issue with modern CAPE data. This is from chief strategist David Bianco at Deutsche Bank:
“Shiller method uses GAAP EPS for the entire time series. We use GAAP EPS from 1900 to 1976, S&P Operating EPS from 1977-88 and IBES pro-forma EPS from 1989 onwards. SEC was not created until the Securities Exchange Act of 1934 and it took decades for US GAAP to develop and many changes have been made to the accounting standards. Since 2000 goodwill and asset write-downs increased owing to the elimination of pooling accounting for mergers and there are now regular impairment tests of acquired goodwill. This causes GAAP EPS to understate true EPS as high value assets are never written up.
The current Shiller PE is usually compared to its 100+yrs average of 16.3x. This includes the WWI EPS cycle, when companies benefitted tremendously from supplying Europe. Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war recession. This exceptional profit swing distorts the long-term average 10yr PE a full point.
We advise comparing the current PE to its average from 1960 onwards as the S&P 500 didn’t exist until 1957. From 1926-56 S&P Index data is based on the S&P 90 composite which comprised of 50 Industrial, 20 Railroad and 20 Utility stocks. Prior to 1926 the data is based on Cowles Commission Index data. Considering all this, where does this put Bianco’s CAPE? Bianco’s CAPE is 17.0 now. The Shiller PE is 24.9. The 1960-2013 average for these PEs are 15.6 and 19.6, respectively. Shiller PE suggests that S&P is overvalued, Bianco PE is reasonable.”
Barclays, BofA/Merill and DoubleLine Capital all are beginning to look at a more modern CAPE through a similar lens.
Mr. Leonhardt of the Times says “be skeptical of ‘this time is different’ arguments.” I think David is a good journalist and a sensible guy, and there is some truth to this statement. But I would also enoucrage folks to be skeptical of folks who believe things can never change. While we at Albion certainly recognize that stocks are no longer cheap, we also posit that they are not wildly expensive either as the Times piece implies. Indeed, we believe valuation to be closer to fair value on known information. Looking out into the balance of this year and next we trust that as long as corporate earnings and the economy hang in there stocks will do just fine. This is presently our base case for the market.
For supplemental charts please see the attached images from Deutsche Bank, BofA/Merrill, Albion Financial Group, Thomson Reuters/Credit Suisse, and Strategas, respectively.
Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200