What are Stocks Worth?

Over the ten days between January 29 and February 8, the world’s stock markets  decided that equities were actually worth about 10% less than they were at the close on January 26. Of course, on that date markets priced equities more than 20% higher than they were immediately before Trump’s election. So prices have varied plus-or-minus about 25%, as shown in the chart of the S&P 500 below.

SP500 Election - Feb18

In terms of market history, there is nothing unusual about the recent price action. On Thursday February 8 we had the largest-ever single-day point decline in the Dow Jones Industrial Average, but nowhere close to the greatest percentage decline. At the end of trading on Thursday, February 8 we were officially in a correction, defined as a 10% decline from a prior market close. Since the Second World War, the US stock market has seen a correction about every 14 months. Nothing much to see here, then, in terms of unusual market action. But there may be an opportunity for increased understanding in examining the stated reasons for the decline.

The main driver of the decline was a rise in inflation fears. About one-third of the commentators noted that higher inflation will cause the Fed to raise interest rates, and those elevated rates will choke off economic growth, thus the decline has a legitimate economic basis. Another third of observers agree that the fear of inflation is causing a fear of rising rates, but think both fears are premature, and should not distract us from the current bullish reality–a strong world economy and a solid near-term corporate earnings forecast.

Both the bull and bear cases are based on the theory that economic growth drives stock prices. That theory is mostly wrong. To understand this, consider the stock market’s performance during the Obama years. By all accounts, economic growth during the years 2009-2016 was slow, especially after a deep recession. Yet the US stock market was up about 300% during Obama’s watch.

Here’s my take on the drivers of valuation:

Growth in GDP is almost irrelevant, unless the economy collapses into recession. More directly consequential is…

Growth in corporate earnings, which has been much stronger than overall economic growth, as corporations have used pricing power in labor markets to increase their margins. Corporate earnings are at unprecedented levels as a fraction of GDP. Earnings are the denominator in the pricing calculation, but the future streams of earnings and dividends we buy as stock investors are actually less important than…

The price we pay for them. There are three principal determinants of the price/earnings ratio. The least important is…

The prospective returns on competing investments. If Treasury bond yields were to rise to 6.5%, utility stocks (for example) would need to decline in price to remain competitive. This mechanism (direct and immediate competition for investor dollars) is way more important than the delayed, indirect, and hypothetical effect of higher interest rates on future economic growth, but still less important than…

Sentiment. Greed can drive markets upward much further and faster than any underlying change in the real economy, while fear can crater prices out of all proportion to actual economic declines. Earlier this month, stock prices fell by 10% in less than a week, but the US economy hasn’t seen a year-over-year decline in GDP of 10% since the 1930s. Sentiment-driven pricing changes can be abrupt and significant, but they are not structural. Which brings us to the most powerful driver of stock valuations…

Inflation. Contrary to the discussion in recent weeks, inflation is not an indirect driver of future earnings, mediated by the long-term effects of Fed policy on the availability and price of credit, and relevant only once it eventually results in changes in economic growth rates. In reality, inflation is the most direct component of the price we are willing to pay for future earnings.

Consider a company with $5.00 per share of future earnings. Assume the earnings grow by 5% per year. Within ten years, the EPS will be $8.14. (In the long run, growth in earnings that handily outpaces growth in GDP is nice work if you can get it, but that is a subject for another post.) In an environment of low inflation and corresponding low intermediate-term interest rates, prospective earnings a decade away can have substantial current value.

But what if inflation were 10% a year? In that case, those future earnings would be worth much, much less. Higher inflation makes future cash flows less valuable for two reasons–first, because the future dollars we’ll receive will be worth much less when we get them, and second because a high-inflation environment is more essentially uncertain and unstable. If I lack confidence in the magnitude of future benefits, I will give greater weight to current availability. I’ll have my dessert right now, thank you, rather than wait for something better tomorrow evening.

Corporate earnings, measured by the S&P 500, have grown from $13.30 in 1979, when I started work as a stockbroker, to over $105 today. That is an increase of just over 8:1. But the price of the S&P? That has gone up by more than 25:1. The price we are willing to pay for each $1.00 of earnings has tripled over almost forty years. That rising tide has lifted almost all boats, so much so that the inflation-adjusted trailing price/earnings ratio we pay for the median stock in the S&P 500 was recently the highest ever.

Over the decades since the cyclical market low of August 19, 1982, the principal driver of rising stock prices has been falling inflation. For 90% of my career, starting in 1981, the inflation rate has either been declining or low and static. Most people working in the financial sector have never worked during a rising inflation environment. Quite a few have never actually experienced a bear market.

If inflation picks up, we won’t need to wait for a delayed and indirect effect on GDP growth and corporate earnings some years in the future. The effects will be felt much more quickly, as markets rediscover the pain of a less valuable future, manifested in the form of a lower structural P/E ratio.

What should we do about all of this? Two things. First, operate from a more-informed understanding of the true potential risks, which are about much more than hypothetical economic growth years from today. Our stock and bond portfolios contemplate higher inflation, along with other risks. Second, diversify internationally. Higher inflation in the US does not necessarily imply higher inflation worldwide.



The Election and Your Money

In past years, I’ve written on this topic once the results of the Presidential election are known. This year, I’m posting prior to the election, because some of the potential short-term effects of the election results are worth considering, so as to be ready if market dislocation follows next Tuesday’s vote.

This is my eleventh presidential election, and surely the most contentious. I won’t tell you how to vote, or even touch the arguments against the two major-party candidates. Good luck to all of us when we step into that booth and confront the duties of our citizenship.

What I will comment on is the investment implications of this election. You can also watch a recording of our recent webinar, The Markets & The Election Season. How will the results affect our portfolios? Is there anything we should do in advance of the election, either to protect ourselves or to maximize our opportunities? Are there actions we should be prepared to take after the election, depending on the result?

As always, let’s start by examining the data. We have really good data going back to the presidential election of 1952 about how U.S. financial markets have reacted in the short-term, over the two months on either side of presidential votes, to different election outcomes.

Here’s a summary of some of the key points:

  • Markets usually go up slightly in the two months bracketing the presidential election.
  • They go up more if the election is close.
  • If the election is a landslide, they go down a bit.
  • If the party in the White House changes, they go down. If the White House remains with the same party, they go up.
  • If a Democrat wins, markets decline, while a Republican victory sends markets up by exactly the same margin.
  • None of these historical moves averages as much as 2% in either direction.

So the best scenario for the markets is if the Democrats retain the White House by a slim margin, and a Republican wins the presidency. Which is clearly self-contradictory, and thus no help at all.

Does either party have a longer-term advantage? Yes, there is a slight advantage for Democrats in long-term returns. But if you deduct the market crash of 1929-1932, the Republicans have a slight edge. As investors, we really have no reason to prefer either candidate based on historical market reactions to partisan outcomes.

Is there a more reliable metric we could apply?

As we often do, we fall back on valuation. Economist Robert Shiller of Yale University won the Nobel Prize in Economics for his insight, captured in the Shiller CAPE (Cyclically-Adjusted Price Earnings ratio), that when stock market valuations are high, future returns are lower, and when valuations are low, future returns are higher.

The last two times the presidency changed hands, in 2000 and 2008, we used Shiller CAPE to inform our broad perspective on the markets.

In 2000, when George W. Bush finally won, valuations were high, and we warned that risks were high and prospective returns likely to be low. We took a defensive posture. As the tech crash continued through 2003, our portfolios largely avoided the market decline.

In 2008, when Barack Obama won a compelling victory in the midst of the worst stock market decline since the Great Depression, we observed that stock prices were below average. With risks lower and opportunities higher, we pounded on the table in favor of buying stocks. At the market bottom in 2009, our stock holdings were the highest ever. We were ultimately well-paid for owning stocks, as Barack Obama’s first term was one of the most profitable for U.S. stock market investors in a generation.

Today, market prices are high. With Shiller CAPE at 26.5 times trailing earnings, we are in the top 7% of historical valuations (93.6th percentile). Our portfolios are defensive, just as they were in 2000 when Bush 43 was elected.

A little more than a week ago, a Hillary victory with limited “coattails” appeared to be priced in.[1] A sharply different result—either a Trump victory or a Hillary victory with big coattails, giving the Democrats control of the House and Senate, would have been surprising, and thus likely to lead to a short-term market decline. (For what little it is worth, historically market returns have been highest with a Democrat in the White House and Republicans in control of Congress, just as we have now.) As Trump closed the gap, the U.S. stock market declined for nine straight sessions, the longest losing sequence since 1980. We have done limited buying during this decline, mostly for clients who were over-weight cash.

There is an aspect of our portfolio strategy that may intersect in interesting ways with the election results. While U.S. valuations are very high, all foreign stock markets are cheaper as measured by CAPE, without exception. We are overweight foreign equities.

To evaluate how this positioning might perform after the election, let’s examine the reaction of markets to the British vote on whether to leave the European Union (Brexit). Immediately before the vote, the final polls predicted Brexit would fail and Britain would remain in the EU. Markets rallied sharply. But Britons actually voted for Brexit, against polling predictions. Markets fell sharply, both in the U. S. and in Great Britain. But within weeks, markets fully recovered in both the U.S. and overseas. So far, so unremarkable.

But one market fell sharply and has continued to fall in reaction to Brexit—the currency market for the British pound, which fell by 6.0% the next day and has fallen another 10.4% since, with no sign of recovery.

What is the similar scenario in the U.S.? It would be a Trump victory, against the indications of the majority of polls. If we followed the Brexit path afterwards (no guarantees of that at all), we would see a sharp decline in the S&P 500, followed by a full recovery in stock prices, but we would also see a sharp and persistent  decline in the value of the U.S. dollar.

That single, entirely speculative scenario would actually benefit our target portfolios, because we are strongly over-weight foreign equities. A falling dollar increases the price of foreign stocks. Of course, there are multiple other scenarios under which we would not benefit.

Our advice is to exercise your franchise in line with your moral, political, and philosophical convictions, and to expect markets to react to the election results in unpredictable ways. Know that our portfolios are defensive and diversified, that we have cash available to invest in the event of a large market decline, and that we remain committed to a global perspective on investing. As always, we are devoted to your lifetime financial success, and none of our personal political perspectives will ever deflect us from making decisions solely based on what we believe to be your best long-term interests.

[1] A President’s election is said to have “coattails” when it also results in large gains for down-ticket candidates for Congress, Governorships, or state-house races. Examples during my lifetime were Johnson in 1964, Reagan in 1980, and Obama in 2008.

Prediction vs. Valuation

Two weeks ago we hosted a quarterly investor call, discussing our strategy and our viewpoint on the financial markets. Afterwards we took questions.

The first question we got was, “When will the Fed raise rates and what will happen when they do?”

Our answer was to quote Warren Buffett’s observation: as investors, we are better at valuation than prediction. We can’t know what will happen in the future, no matter how badly we wish to, but even if we could confidently predict a future event, we would still be unable to reliably forecast its effects.

This past week, events demonstrated Buffett’s acumen yet again, and our borrowed wisdom in aping his viewpoint. With many investors publicly worried that the Fed would raise rates, and that the end of free money would hurt the markets, instead the Fed chose to stand pat on rates.

So the market went up, right? No, the market went down, concerned that the Fed’s restraint proved the world economy was in worse shape than we thought. (We are not the first to observe that the Fed is trapped in a Catch-22 of its own making.)

There are two takeaways here. First, forget about predicting. Second, markets that want to go up will interpret most news as bullish, while markets biased toward decline will go down on a similarly broad span of news. Right now the markets see the glass half-empty. Which helps us not at all, since sentiment can swing from greed/bullishness to fear/bearishness with shocking speed and unpredictability.

This leaves us with valuation. U.S. stocks remain very expensive by the long-term measures we find most persuasive, though another week or two of declines would change “very expensive” to merely “quite expensive,” with some limited implications for asset allocation. Foreign stocks are, relatively speaking, unusually, even extraordinarily cheap. That we can act on, never mind the Fed.

Last Bear Standing?

Over the last few weeks, there has been a steady trickle of headlines about formerly-bearish money managers and commentators who have jumped (or slunk quietly) onto the bull-market bandwagon.

One such is Hugh Hendry, a hedge fund manager who shorted financial stocks in 2008, earning a 31% return in a year when most investors lost big. As is all too usual in the hedge fund space, this made him a rock star, got him lots of exposure, and attracted millions to his fund. Which, somewhat predictably, did nothing much for the next five years, as Hendry maintained his prediction that worse was yet to come. Referencing the possibility of a Greek default in 2010, Hendry commented, “I suggest you panic.”

Last month, Hendry announced that he has now become a trend-follower, and is going long stocks. This after a 160% advance in the markets since the March 2009 low, all of which he missed.

Another perma-bear has been Paul Farrell of MarketWatch, who I singled out as an especially worthless analyst in a prior post. After years of advising individual investors that the game is rigged against them, even predicting the collapse of the capitalist world system and suggesting buying a farm in the mountains and stocking it with canned goods, he suddenly turned bullish in late October. A recent headline tells the story of Farrell’s conversion: 12 get-rich sectors for a hot 2014 bull market.

Of course, Farrell is an idiot. But some of the others advertised as new bulls are not. Of particular interest is Jeremy Grantham of GMO, who we at TGS regard as one of the world’s smartest asset allocators.

Grantham has recently been advertised as a bear-turned-bull, with a Barrons headline pretty typical: Jeremy Grantham’s Bullish Two-Year Outlook. (The Barrons article is behind a paywall, but GMO’s quarterly newsletter, from which Barrons and others conclude Grantham is now a bull, is not.)

Given that Grantham is on our very short list of investors too savvy to ignore, this would be a huge change in viewpoint, and would certainly cause us to question our own cautious investment stance. Even a cursory reading of GMO’s recent newsletter, however, suggests Grantham’s opinion has hardly changed.

GMO’s newletter actually starts with Paul Inker’s analysis, titled Breaking News! U.S. Equity Market Overvalued! Hardly bullish. Grantham then discusses the reasons he believes the U. S. stock market is significantly over-valued, but suspects that irrational investors, emboldened by easy money, are likely to drive it higher before the bubble inevitably pops, finishing the three-time cycle of easy money leading to asset bubble leading to market bust (2000, 2008, and perhaps 2015).

We pretty much entirely agree. This is why we have increased our cash position, and tilted our sector choices so heavily toward managers running lower-volatility portfolios and owning higher-quality stocks.

As John Templeton pointed out, bull markets usually “die amidst euphoria.” We’re not there yet, but we are already past the point where further gains will be based primarily on economic fundamentals. As usual, we remain long stocks, but we are no longer over-weight, as we were from October of 2008 through summer of 2013.