Are Valuations Really Too High?
By John Mauldin
May 10, 2014
The older I get and the more I research and study, the more convinced I become that one of the more important traits of a good investor or businessman is not simply to come up with the right answer but to be able to ask the right question. The questions we ask often reveal the biases in our thinking, and we are all prone to what behavioral psychologists call confirmation bias: we tend to look for (and thus to see, and to ask about) things that confirm our current thinking.
I try to spend a significant part of my time researching and thinking about things that will tell me why my current belief system is wrong, testing my opinions against the ideas of others, some of whom are genuine outliers.
I have done quite a number of media interviews and question-and-answer sessions with audiences in the past few months, and one question keeps coming up: “Are valuations too high?” In this week’s letter we’re going to try to look at the various answers (orthodox and not) one could come up with to answer that basic question, and then we’ll look at market conditions in general. This letter may print a little longer as there are going to be a lot of charts.
I am back in Dallas today, getting ready to leave Monday for San Diego and my Strategic Investment Conference. I’m really excited about the array of speakers we have this year. We’re going to share the conference with you in a different way this year. My associate Worth Wray and I are going to do a brief summary of the speakers’ presentations every day and send that out as a short Thoughts from the Frontline for four days running. Plus, for those who are interested in my more immediate reactions, I suggest you follow me on Twitter. There are still a few spots available at the conference, as we have expanded the venue, and if you would like to see who is speaking or maybe decide to show up at the last minute (which you should), just followthis link. Now let’s jump into the letter.
First, let’s examine three ways to look at stock market valuations for the S&P 500. The first is the Shiller P/E ratio, which is a ten-year smoothed curve that in theory takes away some of the volatility caused by recessions. If this metric is your standard, I think you would conclude that stocks are expensive and getting close to the danger zone, if not already in it. Only by the standards of the 2000 tech bubble and the year 1929 do you find higher normalized P/E ratios.
But if you look at the 12-month trailing P/E ratio, you could easily conclude that stocks are moderately expensive but not yet in bubble territory.
And yet again, if you look at the 12-month forward P/E ratio, it might be easy to conclude that stocks are fairly, even cheaply priced.
Earnings are projected to grow rather significantly. Let’s visit our old friend the S&P 500 Earnings and Estimate Report, produced by Howard Silverblatt (it’s a treasure trove of data, and it opens in Excel here.
I copied and pasted below just the material relevant for our purposes. Basically, you can see that using the consensus estimate for as-reported earnings would result in a relatively low price-to-earnings ratio of 13.5 at today’s S&P 500 price. If you think valuations will be higher than 13.5 at the end of 2015, then you probably want to be a buyer of stocks. (Again, you data junkies can see far more data in the full report.)
But this interpretation begs a question: How much of 2013 equity returns were due to actual earnings growth and how much were due to people’s being willing to pay more for a dollar’s worth of earnings? Good question. It turns out that the bulk of market growth in 2013 came from multiple expansion in the US, Europe, and United Kingdom. Apparently, we think (at least those who are investing in the stock market think) that the good times are going to continue to roll.
The chart above shows the breakdown of 2013 return drivers in global markets, but this next chart, from my friend Rob Arnott, shows that roughly 30% of large-cap US equity (S&P 500) returns over the last 30 years have come from multiple expansion; and recently, rising P/E has accounted for the vast majority of stock returns in the face of flat earnings.
What kind of returns can we expect from today’s valuations? There are two ways we can look at it. One way is by looking at expected returns from current valuations, which is how Jeremy Grantham of GMO regularly does it. The following chart shows his projections for the average annual real return over the next seven years.
If you go back to the very first chart we looked at, which showed the Shiller P/E ratio for the S&P 500, you can see that it is quite high. If you break returns down to 10-year periods for the last 86 years and rank those returns from the highest to the lowest in 10 groups, you find out that, reasonably enough, if you start out at a low price-to-earnings ratio, your returns for the next 10 years are likely to be quite high. If you start from where we are today, though, the same methodology suggests that your returns might be anywhere from -4.4% to +8.3%, or less than 1% on average, not exactly a projection likely to warm an investor’s heart.
I was talking with my good friend Ed Easterling of Crestmont Research, as I often do when I’m thinking about stock market valuations – he’s one of the most thoughtful analysts I know. We were looking at some charts on his always-useful Crestmont Research website, and he offered to modify one of the reports for this letter. You can see the updated version at Crestmont P/E Report. Here’s what he wrote to accompany the table below:
The outlook may be uncertain, but that does not make it unpredictable. The current secular bear could remain in hibernation. The inflation rate could remain low and stable, thereby sustaining P/E in the range of 20 to 25. The current secular bear could succumb to a period of higher inflation or deflation, thereby P/E declines to levels associated with the end of typical secular bears (at or below 10). Alternatively, P/E might begin to migrate along its secular bear course, only to arrive near its historical average around 15. The outlook may be uncertain, yet we can assess the range of potential outcomes using these three scenarios.
Consistent with a foggy crystal ball, the horizon is likewise variable. Some people may want to see the impact of a fast path (say, 5 years), while others may take a somewhat longer view of a decade or more.
The result is a forecast providing a matrix of outlooks based upon your assumptions. Pick your time, pick your ending P/E, and add in dividend yield for the expected total return from the stock market. Figure 7 shows that secular bear markets are periods of below-average returns. The magnitude of the annualized return (or loss) depends upon the investor’s time period. Most notably, however, is that none of the scenarios provide average or above-average returns. As history has shown, average or above-average returns cannot occur from levels of relatively high valuation without the multiple expansion of a rising P/E. From today’s lofty levels, bubble conditions would be required… and that’s not a reasonable assumption for any investor’s portfolio.
Figure 7. Crestmont Research Outlook (S&P 500 Total Return)
I think we have to admit that quantitative easing on the scale that it has been practiced by the Federal Reserve for the past few years has had a great deal to do with the rise in the prices of stocks. We’re not seeing the massive inflation that was predicted with the swelling of the money supply, except in asset prices, as the chart below shows.
The tapering by the Fed is well underway and will be completed sometime this fall. It would not surprise me if they come to October and just go ahead and take off the final $5 billion along with the expected $10 billion reduction. It would seem pretty pointless to maintain just a $5 billion QE program. (Thanks to Josh Ayers at Paradarch Advisors for the following chart.)
Bonds are beginning to get a little stretched as well. This note from MarketWatch pretty much tells the story:
If it’s not happening immediately, when will it happen? Valuations are getting pretty high, prompting junk bond guru Martin Fridson to say the asset class is in a state of “extreme overvaluation.” Credit is in such high demand right now that it’s prompting big name investors like DoubleLine Capital’s Jeffrey Gundlach to declare that the asset class is too crowded.
Citi credit strategist Matt King, who is out with an extensive report this week about the current state of the credit market, has this chart to show:
It will be interesting to see what Jeff Gundlach says at our Strategic Investment Conference this week. As well as David Rosenberg, Lacy Hunt, Gary Shilling, and others who will always opine on the bond market. As I mentioned at the beginning, we will be sending you updates from the conference, and you really should follow me on Twitter.
I leave Monday morning for San Diego to prepare for the conference (co-sponsored with Altegris) and to spend a day with my partners planning and shooting videos. I have really been anticipating this conference, not only because of the speakers but because this is the place where I catch up with so many friends and meet new ones. This really is just about my favorite week of the year. While we may have trouble finding value in the stock market, I always find that time with my friends is about the most valuable time I can spend. Right now, my daughter Tiffani is scheduled to come, as well as most of my staff. Tiffani has not been to the last few conferences, and she is looking forward to catching up as well.
I’ve been working on my presentation for about eight weeks now. The theme for the conference is “Investing in an Age of Transformation,” and I want to try to really focus our attention on the large trends in the world, both economic and technological, that are going to have rather massive implications for our investment portfolios.
Following the conference, I’ll be home for a few weeks before I take off for a working vacation in a little town in Tuscany called Trequanda. I will also be in Rome June 14-17, where I will be joined by Christian Menegatti from Roubini Global Economics. We plan to spend time with various businessmen, investors, central bankers, and politicians to get a better understanding of what is really unfolding in Italy. We are actively looking for people to visit and especially for business associations with whom we can meet. Drop me a note if you’re interested.
Then I’m home for another month before I have a speaking engagement in Nantucket, Massachusetts, in the middle of July. And of course the first Friday of August will find me in Grand Lake Stream, Maine, where I will once again be trying to outfish my youngest son on our annual fishing trip to “Camp Kotok.”
I am often asked how I can travel so much. I admit that from time to time it can be a bit physically wearing, but I have come to the conclusion that it’s early mornings and insufficient sleep that is the main culprit in travel weariness. I find that if I get enough sleep and can find a gym, then I seem to be okay. I guess it’s just important to stay away from those early-morning meetings if you’re going to be out late the night before.
It is time to hit the send button. The gym is calling. Have a great week!
Your just trying to keep up analyst,
Europe’s Political Transcendence
MAY 9, 2014
WASHINGTON, DC – This month, European citizens will head to the polls to select the 751 members of the European to represent 507 million people. The way the election campaign has unfolded marks a small but significant step in the emergence of the first transnational political space in European – indeed, world – history.
To be sure, the European Parliament elections have been bringing smaller shares of voters to the polls: 43% in 2009, compared to almost 60% in 1978-1994. Nonetheless, the participation rate over the last decade is comparable to average turnout in American congressional elections. Given the perceived remoteness of the European parliament and widespread frustration with the European Union’s bureaucracy, the level of participation and the movement toward transnational politics is remarkable.
The transnational nature of the election is stronger this time because the major pan-European political parties have, for the first time, nominated specific candidates for the presidency of the European Commission, and the candidates are campaigning, including in televised debates. The European Council, as mandated by the Lisbon Treaty, will have to take into account the election results in selecting the candidate to put forward for parliamentary endorsement.
The campaign for the Commission’s presidency may turn out to be as significant as the final selection. The first debate, held late last month, included Jean-Claude Juncker of the center-right European People’s Party (EPP), the Green Party’s Ska Keller, Martin Schultz of the center-left Progressive Alliance of Socialists and Democrats, and Guy Verhofstadt of the centrist Alliance of Liberals and Democrats. Alexis Tsipras, representing the Party of the European Left, is expected to participate in the final debate this month.
All of the candidates spoke flawless English – though the debate was translated into 16 languages. Given the United Kingdom’s reservations about European integration, it is somewhat ironic that English is playing such a critical role in facilitating the creation of a transnational political space.
The debate attracted significant social-media attention, with tens of thousands of tweets on the subject reflecting the passion that some Europeans – especially the younger generation – feel about Europe’s political evolution. More generally, while public interest in the campaign remains far below that seen in national political contests, it has become stronger than in recent pan-European elections, despite the rise of nationalism and Euro-skepticism.
In this context, it would be strange if the European Council tried to nominate the Commission president without regard for the public’s response to the campaign. And yet there is a risk that the selection process becomes no more than an exercise in political horse-trading, with Council members awarding leadership positions, including seats on the Commission, purely on the basis of national political considerations. Such an approach would deal a powerful blow to the citizens who took their European ballot seriously – and to the credibility of the EU as a whole.
Could this really happen? Or has the transnational European space – however young – already grown to the point that it cannot be ignored?
Much will depend on the election results. First and foremost, the participation rate will be critical. If it were to fall below the 43% attained in 2009, the Council could more plausibly argue that the preferences of a decreasingly interested public can be largely ignored. A substantial increase, however – say, toward the 45-47% range – would make it much more difficult to ignore the outcome of the campaign.
The relative performance of the pan-European parties will also matter. If, for example, the Socialists won 215 seats, compared to 185 for the EPP, the substantial difference would make their leader, Martin Schultz, a very strong contender, even though no party came close to an absolute majority of 376 seats.
If the outcome turns out to be closer, with a difference of only five or ten seats between the two top parties, it could be argued that neither of the leading candidates had “won.” This would give the Council more space to consider an “outside” candidate (for example, Pascal Lamy, who is closer to the center left, or Christine Lagarde, who is closer to the center right, both of whom are extremely experienced European policymakers whose names have already been raised in the media).
To bolster the legitimacy of such a move, the Council would have to select the candidate more closely associated with the party that gained more votes, however narrow the margin. Moreover, an outside candidate must be likely to generate backing by a sufficiently large coalition in the parliament. Alternatively, with neither of the larger parties able to declare real victory, they could decide as a compromise to indicate preference for one of the other leaders who had campaigned – perhaps Verhofstadt, the liberal centrist.
As Jean Pisani-Ferry has explained, despite the European Parliament’s substantial – and increasing – power, it cannot be the central actor in Europe’s economic-policy debates in the short term. Real decision-making power will remain largely national.
But, given the parliament’s position at the center of a nascent transnational European space that could, over time, transform Europe’s politics and help the continent overcome resurgent and dangerous chauvinism, this first European election with a transnational flavor should not be ignored. When they meet on May 28, European leaders would do well to encourage the strength of European institutions by choosing both competence and legitimacy.
Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Vice President of the Brookings Institution
The Fed's "Growth-Buying" Scheme Is Failing
By SHAH GILANI, Capital Wave Strategist, Money Morning ·
May 13, 2014
The numbers are in. And they are ugly...
Based on preliminary first-quarter data, U.S. GDP (gross domestic product) growth is 0.1%.
That's not much.
But then again what do you expect for $3.4 trillion dollars of Federal Reserve spending to boost the economy?
So the question is, how is it possible that we've got nonexistent economic growth, or worse, negative growth and possibly another recession looming, when the Federal Reserve since September 2008 has spent $3.4 trillion to prime the economic pump?
This could push the whole economy past the brink...
The Ugly Truth on Fed Intervention
First of all, the preliminary GDP number, which is the total output of goods and services produced by labor and property minus imports, will be revised on May 29, 2014.
A majority of economists are already revising their estimates down into negative territory.
The consensus view expects the revised or "second" GDP number will actually show the economy contracted by 0.5% to 1% in the first quarter.
Not that the second quarter is expected to be bad just because of a slow first quarter. In fact, a majority of pundits, including the Federal Reserve itself, are saying because the first quarter was so bad the economy will bounce robustly in the second quarter.
But if they're wrong and the second quarter shows negative growth, that's really bad.
It's bad because two consecutive quarters in a row of negative GDP growth is the definition of a recession.
Why has the Fed intervention failed so miserably in spurring growth? It's an ugly truth but needs to be told.
Since the credit crisis, which spawned the Great Recession, the Federal Reserve has been trying to build a bridge to growth. The truth is they've spent trillions on their bridge efforts, but they can't deliver the destination.
Here's what's frightening: What seems like misguided Federal Reserve policies to stimulate economic growth by printing egregious amounts of money was never a misguided policy of trying to stimulate the economy. It was a massive liquidity and profit-making program designed to first save, then enrich, the nation's biggest banks.
Economic growth was the expected byproduct of the Fed's "trickle-down" banking bonanza.
Why It Didn't Work
The reason we're not seeing that trickle-down growth is because the banks aren't lending as they were expected to.
They aren't lending robustly into the economy because they've had to pay out billions of dollars in fines and legal costs.
That plus their former freewheeling speculative trading gambits with depositor money are being shut down thanks to Dodd-Frank and the Volcker rule, and they are facing their worst free-market enemy, a flattening yield curve.
It's common knowledge that all the nation's too-big-to-fail banks would have all failed if the Fed hadn't bailed them out. Any one of them collapsing, after what happened when Lehman Brothers imploded, would have brought down all of them like a professional bowler throwing a 50-pound ball down an alley with gutter guards.
It's impossible for there to be any economic activity if there are no banks. So, the Fed did what it had to do to save the big banks.
It flushed them with trillions of dollars.
To get their footing back, the Fed took bad loans off their books and opened up its discount window to all comers for all they needed.
They also took in underwater mortgage-backed securities (MBS) and bad loans as collateral for the cash they lent them. To ensure their return to massive profitability, the Fed then embarked on quantitative easing, or QE.
QE is another giveaway program for the big banks. The Fed buys tens of billions of dollars a month in treasuries and MBS from the banks.
The banks in turn get cash, and they lend overnight at the fed funds rate. The Fed set the fed funds rate to essentially zero, and with their borrowed cash the big banks buy more treasuries and MBS to sell next month to the Fed.
It's a great way to make risk-free money and for the big banks to improve their capital ratios and reserves and profits. All of which makes them flush enough to raise dividends, which makes their equity stock look better to investors. And the icing on the cake is that they get to raise dividends to entice more investors. It's a great game.
Too bad the banks are the only ones benefiting directly. The whole trickle-down thing isn't working.
What Has the Big Banks Terrified
Besides hoarding money to pay ongoing and future fines for criminal activities, all the big banks are terrified of the shape of the yield curve.
The yield curve is a graphical representation of interest rates. On the vertical left axis are interest rates rising from zero to whatever height they attain. The horizontal axis is time, with one day all the way on the left and going out to 30 years on the right end of the axis.
Banks borrow from each other, usually for a day at a time, at the fed funds rate, which is a market rate but a rate that the Fed largely controls. The fed funds rate is somewhere between zero and .025% now, as that's where the Fed manipulated it to. As the line that traces interest rates moves to the right, it trends higher. That's because you pay a higher interest rate to borrow money you intend to pay back over a longer time.
Normally the yield curve slopes upward steadily, so that interest rates to borrow for a day might be .25% (on an annualized basis) and 5% or 6% or more for a 30-year mortgage.
But the yield curve is flattening, not steepening, for a few reasons.
Investors are buying 10-year and 15-year and 30-year bonds because their yield is better than what they would be paid if they bought shorter maturity bonds.
One reason that longer-term interest rates aren't as high as they are expected to be is because rates are so artificially low (courtesy of the Fed' manipulation) that investors are going further out on the "risk spectrum," meaning they're willing to lend out money for longer to get more yield.
But another reason there's so much interest in longer-dated bonds is that investors are seeking a safe place to park their cash in anticipation of falling yields because of a market crash or some global macro-event that panics markets.
In other words, investors are fearful.
One of the reasons is that they don't believe the Fed's low interest rate policies are creating growth and that the economy could fall back into recession, which would cause yields to fall even further.
So they want to lock in whatever higher yields they can get now.
The flattening of the yield curve is bad for banks.
When they lend out for a long period of time, they want to charge as much interest as they can.
But if the yield curve is flat and investors are willing to take less interest, they can't charge as much interest as they would like.
If you're a bank and you make loans, you price them according to your risk of being paid back and how long you're making the loan for.
Banks don't want to make long-term loans and not get paid; that's too much risk. That's why they're not making loans hand over fist, even though they have the money to lend.
Thanks to the Fed's QE, banks are better off doing business with each other and the Fed than the public. If there's no credit, there's no economic growth.
And that's the dilemma we're facing.
And most frightening of all, the consequences of no growth and the Fed's money printing are about to devastate equities (again), some bond investments, commodities, real estate (again), and other asset classes.
The Swiss Central Bank Conundrum: Fighting Fire with Kerosene
The currency “stabilisation” choices a central bank has
Should a central bank set prices for individual goods?
Changing foreign exchange rates do not affect an economy in uniform fashion!
Each importer or exporter has a different cost structure that cannot be addressed by setting the foreign exchange rate
All foreign exchange rate manipulation leads to losses of overall welfare
- Nothing happens, i.e. the relative price levels of your own currency and that reserve currency you just put into your “vaults” stay the same. If that were the price you aimed for, you could call it mission accomplished – now you enjoy that (lower) conversion rate that you thought was so crucial to your country’s exporters’ fate.
- The foreign currency you just bought appreciates. Now what happens? As your own central bank is judged by the assets it holds, your national currency tends to appreciate too. So you need to start selling more of your own currency, buying more foreign currency. If you buy the same currency you just bought in the first round, its price will likely even increase further. You see where we are going with this? Sheer stupidity. You cannot, not in the long run and not with the necessary precision, devalue your currency by intervening in the foreign currency markets in this way!
- Last possible case: your newly won assets, that foreign currency depreciates (against all or most other currencies of note). Now what happens: while the exchange rate between that individual currency and your national currency may stay roughly the same, your currency devalues on a more global scale. If you still want to uphold that “fixed” exchange rate the only two real choices that you are left with now are: buy more of that foreign currency you just pegged your own currency to or sell the currency you once bought to get rid of that peg you tied yourself to and stop the decline.
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Las convicciones son mas peligrosos enemigos de la verdad que las mentiras.
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
No soy alguien que sabe, sino alguien que busca.
Only Gold is money. Everything else is debt.
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Quien no lo ha dado todo no ha dado nada.
History repeats itself, first as tragedy, second as farce.
We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.
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