MacroView: Rationalizing High

Valuations Won't Improve Outcomes

Jun. 6, 2020 10:14 AM ET 

Lance Roberts

Summary

When discussing valuations, it is important to maintain a proper perspective.

Valuations are NOT a market-timing device to tell you to buy or sell stocks.

What valuations do provide is a framework for understanding forward returns over

long periods of time.

Rationalizing high valuations today will likely lead to ultimately "losing the war."

This idea was discussed in more depth with members of my private investing
community,Real Investment Advice PRO.

Rationalizing high valuations won't improve future return outcomes.

The reason I say this is because of a tweet from Tom McClellan recently:
While I have an immense amount of respect for Tom, the exercise of manipulating
valuation measures can lead to false conclusions. Take the following chart:
The dark blue line is Shiller's CAPE measure as compared to Tom's M2 measure and
our CT measure. Clearly, both measures show the market is substantially cheaper
than Shiller's smoothed price to earnings model. Moreover, both the M2 and CT
measures have a very high correlation of nearly 90%.
Therefore, investors can rationalize that by using either M2 or CT, stocks should
have higher return rates in the future.

The problem is that the CT model has nothing to do with asset markets. It's a
measure of "College Tuition" expenditures. So, while there is a spurious correlation
to both Shiller's CAPE and M2, the measure has little to do with forward return
expectations or current valuations.

Why is this important?

While valuations can seem passive over short periods of time, and they are indeed
horrible market timing measures, they have everything to do with future outcomes.

"Price is what you pay, value is what you get." - Warren Buffett.
Measuring Valuations The Correct Way

When discussing valuations, it is important to maintain a proper perspective.

Valuations are NOT a market-timing device to tell you to buy or sell stocks. What
valuations do provide is a framework for understanding forward returns over long
periods of time.
Despite the market's outperformance over the last 10 years, such was due to the
unprecedented monetary interventions by the Federal Reserve. Regardless,
markets have a strong tendency to revert to their average performance over time,
which is not nearly as much fun as it sounds.

As investors, our job is not only to invest for today, but also to understand the
potential of long-term impacts.

When considering stock valuations, one should only use the past 12 months of
reported earnings, known as GAAP earnings, which include "all of the bad
stuff." The reason is that all analysis uses trailing GAAP earnings as the
denominator. These are "known" earnings and makes valuation analysis more
reliable.

Conversely, Wall Street analysts use operating earnings, or "earnings without all
that bad stuff," to deflate multiples using forward "guesses." This method provides
the rationalization for overpaying for assets during periods of excess valuations.

Importantly, using operating earnings also provides a faulty comparison between

valuation models which are largely based on "known" trailing earnings.

However, this is where we must make an important distinction.

Starting Valuations Matter Most

When discussing valuations, the starting level when you begin your investment
journey is the most critical. Such was a point discussed previously:

"The chart below shows the history of secular bull market periods going back to
1871 using data from Dr. Robert Shiller. You will notice that secular bull markets
tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend
to end around 23-25x earnings or higher. (Over the long-term valuations do
matter)."
The two previous 20-year secular bull markets begin with valuations in single digits.
At the end of the first decade of those secular advances, valuations were still
trading below 20x. Currently, valuations are still hovering near 30x.

But that is just today. Over the next couple of quarters, the "E" will drop markedly
as the impact of the economic shutdown settles in. While it is hoped there will only
be a mild-reduction in earnings, historically, they have reverted past the long-term
exponential trend.
Given 13% unemployment rates and a recession of nearly 20%, earnings will likely
revert toward $60/share. Such a decline will push current valuations to historically
high levels assuming prices remain elevated.

The 1920-1929 secular advance most closely mimics the current 2010 cycle. While
valuations started below 5x earnings in 1919, they eclipsed 30x earnings 10 years
later in 1929. The rest, as they say, is history. Or rather, maybe "past is
prologue" is more fitting.

High Valuations & Low Returns

Another confusion when discussing future low rates of returns is misunderstanding

each year will be a low return. That assumption is incorrect. What high valuations
tend to dictate is the return for the entire period will be low.

The chart below shows 10-year rolling REAL, inflation-adjusted returns in the
markets. (Note: Spikes in 10-year returns, which occurred because the 50%
decline in 2008 dropped out of the equation, have previously denoted peaks in
forward annual returns).
(Important note: Many advisers/analysts often pen that the market has never had
a 10- or 20-year negative return. That is only on a nominal basis. Inflation must be
included in the debate).

Even on a 30-year rolling return basis, high "starting valuations" suggest lower-

than-expected rates of returns in the future.
 There are two crucial points to take away from the data.

1. There are several periods throughout history where market returns were not
only low but also negative. (Given that most people only have 20-30 functional
years to save for retirement, a 20-year low return period can devastate those
plans).
2. Periods of low returns follow periods of excessive market valuations and
encompass the majority of negative return years.

"Importantly, it is worth noting that negative returns tend to cluster during periods
of declining valuations. These 'clusters' of negative returns are what define 'secular
bear markets.'"
The Mistake Investors Make

The mistake investors repeatedly make is dismissing the data in the short-term
because there is no immediate impact on price returns. As noted above, valuations
by their very nature are HORRIBLE predictors of 12-month returns. Investors avoid
any investment strategy which has such a focus. In the longer term, however,
valuations are strong predictors of expected returns.

It isn't just trailing valuations suggesting markets are overpriced and expensive.
The chart below shows Dr. Robert Shiller's cyclically adjusted P/E ratio compared
with Tobin's Q-ratio. The Q-ratio measures the "replacement cost" for the firm's
assets in the broad Wilshire 5000 index. (This measure has nothing to do with
earnings).

Unsurprisingly, Tobin's Q is also at historically expensive valuations hitting the

highest level since the peak in 2000. Furthermore, note forward 10-year returns do
NOT improve from historically expensive levels, but decline sharply.
Warren Buffett's favorite valuation measure also supports current valuation
concerns (which may explain why he is sitting on $137 billion in cash). The
following measure is the price of the Wilshire 5000 market capitalization level
divided by GDP. Given the stock market is not the economy, asset prices should
reflect underlying economic growth rather than the "irrational exuberance" of
investors.

(The analysis below includes the latest Atlanta Fed estimate for Q2-2020 GDP)
Lastly, one figure that is hard to fudge or manipulate is sales. Such is where
corporations derive earnings and profitability. Given the coming drop in sales over
the two quarters, the price-to-sales ratio will surge to historic heights. Like
valuations, overpaying for revenue tends to have less desirable outcomes.
No matter how you analyze the data, the potential future outcomes for investors
are likely to be less desirable than many hope.

Bull Now, Pay Later

In the short-term, the bull market continues as the flood of liquidity and
accommodative actions from global central banks has lulled investors into a state of
complacency rarely seen historically. As Richard Thaler, the famous University of
Chicago professor who won the Nobel Prize in economics once stated:

"We seem to be living in the riskiest moment of our lives, and yet the stock market
seems to be napping. I admit to not understanding it. Nothing seems to spook the
market."
While market analysts continue to come up with a variety of rationalizations to
justify high valuations, none of them hold up under real scrutiny. The problem is
while central bank interventions boost asset prices in the short term, over the long
term, there is an inherently negative impact on economic growth. As such, it leads
to the repetitive cycle of monetary policy.
1. Monetary policy drags forward future consumption leaving a void in the
future.
2. Since monetary policy does not create self-sustaining economic growth,
ever-larger amounts of liquidity are needed to maintain the same level of activity.
3. The filling of the "gap" between fundamentals and reality leads to economic
contraction.
4. Job losses rise, wealth effect diminishes, and real wealth reduces.
5. The middle class shrinks further.
6. Central banks act to provide more liquidity to offset recessionary drag and
restart economic growth by dragging forward future consumption.
7. Wash, Rinse, Repeat.

If you don't believe me, here is the evidence.

"Through the end of the Q1-2020, the stock market has returned almost 127.79%
from the 2007 peak using quarterly data. Such is more than 3x the growth in GDP
and 6.5x the increase in corporate revenue. (I have used SALES growth in the chart
below as it is what happens at the top line of income statements and is not AS
subject to manipulation)."

Unfortunately, the "wealth effect" impact has only benefited a relatively small

percentage of the overall economy.
The Risk Of Overpaying

While it is "bullish" to come up with reasons to justify overpaying for assets in the
short-term, outcomes are quite different long-term.

If this wasn't the case, then "riddle me this."

If investing works like the media suggests, then why are 80% of Americans living
paycheck-to-paycheck? Why is it just the top 10% of income earners own 88% of
the stock market?

The reality is that investing long-term is hard. Short-term exuberance tends to lead
to poor, long-term returns.

Let me conclude with this key quote from Vitaliy Katsenelson, which sums up our
investing view:

"Our goal is to win a war, and we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the
market continues to mount even higher, we will likely lag. The stocks we own will
become fully valued, and we'll sell them. If our cash balances continue to rise, then
they will. We are not going to sacrifice our standards and thus let our portfolio be a
byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the
war. Timing the market is an impossible endeavor. We don't know anyone who has
done it successfully on a consistent and repeated basis. In the short run, stock
market movements are completely random - as random as you're trying to guess
the next card at the blackjack table."
Rationalizing high valuations today will likely lead to ultimately "losing the war."

Technically Speaking: Defining

The Market Using Long-Term
Analysis
May 26, 2020 9:33 AM ET
Lance Roberts

Real Investment Advice PRO

Unique, unbiased and contrarian real investment advice

Summary

This past weekend, I asked if the decline in March was a bear market or just
a big correction.

The debate that ensued was polarizing, to say the least.

However, defining the market using long-term analysis is essential in

determining the current trend, potential outcomes, and portfolio
assumptions.

This idea was discussed in more depth with members of my private investing
community,Real Investment Advice PRO.

This past weekend, I asked if the decline in March was a bear market or just
a big correction. The debate that ensued was polarizing, to say the least.
However, defining the market using long-term analysis is essential in
determining the current trend, potential outcomes, and portfolio
assumptions.

The Recap

Let's start with the analysis from "Was March A Bear Market?"

"Such brings up an interesting question. After a decade-long bull market,

which stretched prices to extremes above long-term trends, is the 20%
measure still valid?

To answer that question, let's clarify the premise.

 A bull market is when the price of the market is trending higher over a
long-term period.
 A bear market is when the previous advance breaks, and prices begin
to trend lower.

The chart below provides a visual of the distinction. When you look at price
"trends," the difference becomes both apparent and useful."

"This distinction is important.

 "Corrections" generally occur over very short time frames, do not

break the prevailing trend in prices, and are quickly resolved by markets
reversing to new highs.
 "Bear Markets" tend to be long-term affairs where prices grind
sideways or lower over several months as valuations are reverted.

Using monthly closing data, the 'correction' in March was unusually swift but
did not break the long-term bullish trend. Such suggests the bull market
that began in 2009 is still intact as long as the monthly trend line holds.

However, I have noted the market may be in the process of a topping

pattern. The 2018 and 2020 peaks are currently forming the "left shoulder"
and "head" of the topping process. Such would also suggest the "neckline" is
the running bull trend from the 2009 lows. A market peak without setting a
new high that violates the bull trend line would define a "bear market."

Defining Long-Term Market Cycles

That analysis brings up an interesting question.

What if the secular bull market that began in 1980 is still in process?Before
you adamantly deny this possibility, we need to consider the context of both
long-term investor psychology cycles and valuations.Let's start with the
following chart of investor psychology.

This chart is not new, and there are many variations similar to it, but do not
dismiss the importance. Throughout history, individuals have repeatedly
responded to market dynamics in the same fashion. At each delusional peak,
it was always uttered, in some form or variation, "this time is different."

Valuations Matter
I have often discussed the importance of full-market cycles.

"Long-term investment success depends more on the WHEN you start

investing. Such is shown in the chart of valuation cycles."

"Here is the critical point. The MAJORITY of the returns from investing came
in just 4 of the 8-major market cycles since 1871. Every other period yielded
a return that lost out to inflation during that time frame."

However, by looking at each full-cycle period as two parts, bull and bear, it
obscures the importance of the "full cycle." What if instead of there being 8-
cycles, we look at them as only three?
Note in the chart above that CAPE (cyclically adjusted P/E ratio) reverted
well below the long-term trend in both prior full-market cycles. When viewed
in this manner, we see the full-market cycle encompasses many bull and
bear market cycles, but only completes when valuations are reset.

While valuations briefly dipped below the long-term trend in 2008-2009,

they did not revert to previously low levels. Given valuations have remained
elevated since 1982; it suggests the full-market cycle has yet to complete.
Such a reversion would align the fundamental and psychological
underpinnings seen at the beginning of the last two full-market cycles.

Long-Term Analysis - Is The 80's Bull Still Running?

We can further examine the idea of long-term market cycles if we overly the
psychological and time-frame analysis. The first full-market cycle lasted 63-
years from 1871 through 1934. This period ended with the crash of 1929
and the beginning of the "Great Depression."
The second full-market cycle lasted 45-years from 1935-1980. This cycle
ended with the demise of the "Nifty-Fifty" stocks and the "Black Bear
Market" of 1974. While not as economically devastating as the 1929-crash, it
did greatly impair the investment psychology of those in the market.

The Running Bull Market

 The current full-market cycle is only 38-years in the making. Here is a short-
list of what prices are pushing up against:

 Elevated valuations
 Collapsing economic data
 Declining earnings and corporate profitability
 Weak economic growth
 Surging debt levels
 Deflationary economic pressures
 Suppressed wage growth
 Weakening demand from consumption

Even this short-list of headwinds makes it worth questioning whether the

current full-market cycle has completed. Such is particularly the case when
Central Banks are required to maintain ever-increasing levels of monetary
interventions to keep financial markets functioning.

The idea of the "bull market," which begin in 1980, is still intact is not a new
one. As shown below, a chart of the market from 1980 to the present
suggests the same.
The long-term bullish trend line remains, and the cycle-oscillator is only half-
way through a long-term cycle. Furthermore, by the time the market
resolves itself, a 61.8% retracement would reset markets back to the 1999
levels. Such is based only on the assumption that the long-term full market
cycle has not yet completed.

I am NOT suggesting this is the case.

Instead, this is a thought-experiment about the potential outcome from the

collision of weak economics, high levels of debt, valuations, and
investor's "irrational exuberance."

Yes, this time could entirely be different.

It just never has been before.

Using Long-Term Analysis To Measure Potential Outcomes

Regardless of whether you agree with the premise, do not completely

dismiss the importance of long-term price cycles. Currently, it is "in
vogue" to believe it is only monetary policy driving markets now. Over the
long-term, there have been many excuses for rising prices, which eventually
gave way to "fundamental gravity."
One of the most interesting emails I received in response to my monthly
analysis above was from Jim Colquitt, President of Armor Index, Inc. To wit:

"If we draw the 'Head & Shoulders' pattern you described above, we find an
interesting symmetry. The distance from the beginning of the left shoulder
(September 2017) to the end of the left shoulder (December 2018), is the
same distance (15 months) from the end of the left shoulder to the end of
the head (March 2020).

If we assume this symmetry remains intact, it will allow us to complete the

right shoulder of the head and shoulder pattern 15 months later in June
2021. Such would be somewhere in the price range of ~2,030 or roughly
~31% lower than current levels."

Where Do We Go From Here

What does this analysis suggest if the market breaks below the neckline? Or,
what if markets bounce off of the neckline as support?.

'Head & Shoulder' pattern theory suggests a move to the downside would
put the target price at the equivalent of the distance from the head to the
neckline as measured from the neckline. A break would equate to roughly
~840 on the index, or ~72% lower than current levels (see "Chart 2").

Conversely, if the neckline is rejected, pattern theory suggests the distance

above is used but is added to the top of the right shoulder. Such would
equate to an index level of roughly ~4,160 or ~41% higher than current
levels (see "Chart 2"). However, such a rise would likely come after testing
the neckline (~2,030) and would equate to more than a 100% return from
that point.

It is also interesting that current market levels are almost perfectly in line
with the left shoulder peak in September 2018, the resistance/support levels
from April through July 2019, and February through April 2020. Such could
be the top for the right shoulder.

Should we test the lows of the worst case scenario, pattern theory puts the
target range at levels, which are almost perfectly in line with the lows of the
2002 and 2008 recessions (see "Chart 3").
Jim is correct in the analysis. We certainly hope markets don't revisit the
lows of the previous two bear-markets. For investors that is the worse
possible outcome. However, such an outcome does have historical
precedents within the context of completing a full-market cycle.

Conclusion

There is a sizable contingent of investors, and advisors, today who have

never been through a real bear market. After a decade long bull-market
cycle, fueled by Central Bank liquidity, it is understandable why mainstream
analysis believe markets can only go higher.

Bear market cycles rarely end in a single month. There is much "hope" the

Fed's flood of liquidity can arrest the market decline. However, there is still a
tremendous amount of economic damage to contend with over the months
to come.

When analyzing the markets using monthly data, it certainly appears as if

the long-term bull market that began in 1980 remains intact currently.
However, we have roughly a decade of potentially hard times ahead of us if
we are early in the process of completing the second half of the full-market
cycle.

If you are a short-term market trader, this analysis likely has little
importance to you. It also doesn't mean market returns over the next
decade are negative every single year. What it does suggest is that investors
will face increased volatility and low average rates of return.

For most investors, a "buy and hold" investment strategy will likely leave
you far short of your goals.

That is just what this particular set of analysis suggests. There is an

unlimited number of potential outcomes that can occur over the next
decade. Some of them good, some of them bad. Such is why it is important
to measure the amount of risk being taken to achieve financial goals and
manage that risk accordingly.

Or, you can disregard the analysis entirely and continue hoping for the best.

However, if investing worked as the media tells you, then why, after three
major bull markets in the last 30-years, are 80% of Americans still broke?