U.S. Stocks Reach Valuations Rarely Seen, Making Material Earnings Growth A Requirement For Strong Future Returns

In the face of the current highly ebullient stock market, close watchers of valuation metrics are frequently dismissed as ignoring the prospect for accelerating GDP growth and lower corporate tax expense, but I will step onto that turf anyway. It may make me look foolish, as Warren Buffett recently played down concerns about the market’s valuation, even though his often-preferred metric in years past (total stock market value relative to annual GDP) is dangerously high, but that’s okay.

Here is a look at my preferred valuation metric; a variant of the P/E ratio that uses “peak earnings” (the highest level of corporate profits ever produced in a 12 month period) instead of trailing 12 month earnings (impacted solely by the current economic environment) or forward earnings estimates (usually overly optimistic). We’ll go back more than 50 years, not only to get an idea of historical trends, but also because that is the data I have.

When people ask me about my view of the market, I tend to give a tempered response because it is hard to argue that we should really get any earnings multiple expansion. After all, we now sit above 20 times “peak earnings” and that has only happened once in the last 55 years. As you can see, that one time (the dot-com bubble of the late 1990’s) is not exactly a time we probably want to emulate this time around.

It is important to note that high valuations do not guarantee poor future returns. There is a high correlation, but you can map out mathematical scenarios whereby P/E ratios mean-revert and stock prices don’t crater. Simply put, it requires extraordinary earnings growth that can more than offset a decline in P/E ratios (which we should expect if interest rates continue to increase). Right now the U.S. market is banking on this outcome, so earnings and interest rates are probably the most important things to watch in coming quarters and years when trying to gauge where the market might go from here.

Author’s note: The use of “peak earnings” is not common, so it is worth offering a brief explanation for why I prefer that metric. Essentially, it adjusts for recessions, which are temporary events. If investors use depressed earnings figures when they value the market, they might conclude stocks are not undervalued even if prices have declined materially. This is because they inherently assume that earnings will stay low, even though recessions typically last only 6-12 months and end fairly abruptly.

As an example, let’s consider the 2008 recession. The S&P 500 fell 38% that year, from 1468 to 903. S&P earnings fell by 40%, from ~$82 to ~$50. If we simply use trailing 12-month earnings, we see that the P/E multiple on the index was 18x at the beginning of 2008, and was also 18x at the end of the year. So were stocks no more attractively priced after a near 40% fall? Of course they were, but using traditional P/E ratios didn’t make that evident.

If we instead used “peak earnings” (which were attained in 2006 at ~$88), we would have determined that the market was trading at ~17x at the outset of 2008 and had fallen to just 10x by the end of the year. By that metric, investors would have realized that stocks were a screaming buy when the S&P traded below 1,000.

 

Dow 20,000: Just A Number

How about that? Dow 20,000! What a hugely important milestone! Right? Well, not really.

Sure it will make for a good front page story in USA Today tomorrow, and those few humans who are still needed on the trading floor of the New York Stock Exchange (they’ve been largely replaced by machines) will unpack the Dow 20K hats for sure, but Dow 20,000 is no more important than Dow 18,763.

When the Dow Jones Industrial Average is this high, we actually would expect new milestones to be reached on a very regular basis. An average stock market year (+10%) would actually see us break through another 1,000 point level every six months. Even if we stretch the milestone interval to 5,000 points, it will only take two and a half years on average.

In fact, it only took 18 years from 10,000 to 20,000. That might sound like a long time for the index to double (it’s only a 4% average return during that time), but that period includes the massive dot-com market collapse of 2000-2002, as well as the Great Recession of 2008-2009.

Here is a calendar breakdown of Dow Jones milestones:

As you can see, every milestone from Dow 3,000 through Dow 20,000 has occurred since the 1990’s. Dow 1,000 — now that was a milestone… it took 76 years from the index’s creation in 1896 for it to pierce the 1,000 level!

Also of note is how the Dow itself has become less and less relevant over time for investors. Most of us use the S&P 500 index since it represents more broadly diversified group of public companies, versus just 30 for the Dow. This is also because the S&P 500 is value-weighted, meaning that a company worth $10 billion comprised twice as much of the index as a $5 billion company.

The Dow, on the other hand, is share price-weighted. So while Bank of America (market value $235 billion) is ~2.5 times larger than Goldman Sachs (market value ~$95 billion), it actually makes up far less of the Dow’s composition than Goldman does. In fact, BofA’s share price is only 1/10th that of Goldman, so a $1 increase in GS stock (which is a gain of 0.4%) adds the same amount of points to the Dow as a $1 increase in BofA stock (a gain of 4%) does. It’s really a bizarre methodology.

Despite all of that, I’m glad we are getting 20K out of the way so we can stop hearing about it. That is, of course, until we hit Dow 25K, which history suggests is most likely to happen in just a few years.

 

Keeping Perspective: S&P 500 Corrections Since 2010

Has January 2016 been rough for stock market investors? Absolutely. One of the most important things to do, in my view, is to keep perspective and not make swift, emotional changes during times like these. With the help of the media, many investors see this kind of drop in such a short time (10% in a few weeks) and immediately think back to 2008. That financial crisis was the worst recession in 80 years. It is not a common occurrence. What is common are regular market corrections triggered by some macroeconomic event that are characterized by stock prices reacting far worse than underlying economic and corporate performance would indicate is rational. That is very likely what we are seeing right now. In fact, it might surprise people that we have actually witnessed many such events just since 2010.

SPX-drops-2010-2016

For long-term investors (time horizon of 3-5 years or more), these are almost always opportunities to buy rather than sell.

Market Volatility Is Back, And That’s Okay

You might be freaking out now that the U.S. stock market has dropped more than 8% during the first two weeks of 2016. With only nine trading days under our belt (including today) it has been a rough start to the new year. It has not helped our mental conditioning that from 2011 to 2015 we had a four-year stretch of no market corrections. Over the last six months we have now seen drops of 10% or more on two separate occasions. It also does not help that the national news typically only covers the stock market on days when the Dow drops 300 or 400 points, rather than giving equal time when it rebounds.

All of this is going to be okay. The shift from human to electronic trading has allowed computers to take over the process, which means much faster transacting. The result is that moves up and down now happen much more quickly. Market shifts that once took week or months can now come and go in a matter of minutes or hours. A 10% market correction might have taken three months a couple decades ago but now can take three days.

The ever-changing global economy also contributes to the volatility. We never heard much about China twenty years ago but now our financial markets can react violently to swift declines in Chinese stocks, even when their impact on American companies is minimal. As the United States matures and other countries grow faster and contribute a higher portion of global economic output, we become less shielded from international markets and therefore we will feel more ripple waves. And that’s okay.

Advances in technology more generally have also had consequences for those of us who are investing for our futures. Information can now be transferred across the globe in a matter of milliseconds. While that is great for a level playing field and means we can research our investments more quickly, easily, and cheaply than ever before, it also means that there is more to react to. More information and quicker dissemination of that information has its drawbacks; namely volatility. Engineers are now even programming computers to automatically place buy and sell trades based on information delivered online. So not only do we get information faster, but we can act on in it much faster too.

And then there are new financial products being created all of the time. More ways to “play” means more money flowing in different directions, which also increases volatility of the underlying prices for assets. As the great new movie “The Big Short” conveys so well, financial derivatives allow more money to be wagered on various outcomes than ever before. As the analogy goes, you used to be the only one who could buy insurance on your own house or car, but now an unlimited number of people can do so. Imagine how volatile the price of insurance will be when it trades daily and anyone can buy it on practically anything.

By now you are probably thinking that I have changed my mind in a few paragraphs and everything will not be okay. Nope. The saving grace is that business profitability does not swing nearly as much as asset prices do. And over the long-term asset prices are going to track the underlying fundamentals of a business. As long as we are willing to not panic and sell when things turn south for a little while, the near-term price gyrations should not matter. And no matter how hard it is to accept this fact and not panic, that is what investing requires. I try to do the best job I can reinforcing this with my clients, but it is a tough job. Emotional reactions are natural and difficult to ignore.

My focus right now is on fourth quarter earnings reports and 2016 commentaries which are getting under way. Doing so will allow investors to separate what is going on daily in terms of asset prices and how the underlying fundamentals of companies look. After all, five years from now stock prices will reflect underlying earnings more than anything else. Five days or five weeks from now they can reflect anything at all.

PS: Some people may argue with that last point. After all, if markets get wacky five years from today what is to say that the underlying profits of the company will matter? That is a fair statement, to some extent. I think it is important to point out that history has shown that stock prices, while volatile, do not have an unlimited range of outcomes. The S&P 500 has traded as low as 7-8 times earnings during periods of double-digit interest rates and as high as 25-30 times earnings during bubbles. But it has never traded for 3 times earnings or 100 times earnings.

Why is this important? Let’s say you buy a $100 stock today that trades for 10 times earnings and pays a 5% annual dividend. Your underlying investment thesis is that it will grow earnings per share by 10% annually for the next five years and continue to pay the dividend, which will be increased at the same rate as the underlying earnings grow.

If your fundamental analysis of the company turns out to be accurate, and you do not sell the stock (even during times of market panic), five years from now you will have collected more than $30 per share in dividends and the company’s earnings will have grown from $10 to $16 per share. Assuming this plays out, what is the worst case scenario in terms of investment return? Even if the stock trades at only 7 times earnings, the stock will still trade at $112 per share. Add in the $30 of dividends you collected and your total return would be more than 40% over a five-year period, or about 8% annually.

Simply put, you are not going to lose money on that investment, as long as your thesis about earnings and dividends is right. This is important because we could not say the same thing if we only look out five weeks or five months into the future. If the stock drops to 7 times earnings in the short-term you would lose 30% on paper even if the company’s fundamentals were on track. As long as you do not overpay for something, being right on the fundamentals and holding for the long-term becomes a winning proposition. That is why I spend the bulk of my time researching companies and hammering home the long-term nature of my investments.

This Market Correction In Perspective

One of my jobs as a financial manager for individuals and families is to put things into perspective, especially during times of short-term market distress, which can be quite stressful for the average person. In recent years I have tried to regularly remind my clients that normal stock market corrections of 10% or more occur about every year or so over the long term. Since we had not seen one since 2011, it had been four years since investors felt a near-term shock to their portfolios, which made being prepared for the next one especially helpful.

Given how much day-to-day stock market activity is computerized these days, one thing that is different now is that market moves happen more faster than they used to. What previously had taken weeks and months to take shape now can come and go in a matter of days. As I write this, the S&P 500 index is trading at 1,912, which is 10.4% below the all-time high made back in May. Amazingly, 8.8% of that decline has come in the last 4 trading days.

So what is important to keep in mind as computers send the market into a new world of volatility? Keep things in perspective. This  can often most easily be accomplished with graphics, so below I present three charts of the S&P 500 index:

Here is a year-to-date chart for 2015 which shows the current, sharp 10% decline:

SPX-YTD

 

Granted, that might look and feel kind of scary on its own.

Now, to see how far we have come and how much we have declined on relative terms, here is a 5-year chart:

SPX-5yr

I would guess that this second chart is far less scary to most people. It shows the market having more than doubled over a five-year period, includes the last major correction in the market (August 2011), and the most recent period appears to be no more than a standard, run-of-the-mill correction in stocks.

The last chart might be the most interesting, as it goes back 10 years. I included this one because it includes the last market peak before the “Great Recession” decline of 2008:

SPX-10yr

 

Even after the last week of declines, the U.S. stock market is still considerably above the peak it reached in 2007, just before the second largest economic collapse in United States history.

None of these charts can predict how the market will fare over the coming days, weeks, or months. Hopefully it does put the last decade in perspective and show that what we are experiencing right now, while not fun, is neither out of the ordinary, nor overly disconcerting. If you are retired, the plan you have in place with your financial manager is likely unchanged, as it should have incorporated the likelihood (or certainty, more precisely) of normal, periodic market declines. If you are still in the “work and save” phase of your career, times like these are a great time to add to your investment portfolio, as great companies are on sale.

Bargains Are Everywhere For Long-Term Investors, Even With S&P 500 Losses Contained Thus Far

Based solely on the number of new stocks I am finding to be priced at bargain levels, one would think the U.S. stock market has broken its years-long streak of avoiding a 10% correction. My potential buy list of stocks has not been this full in a long time, even though the S&P 500 (trading at 2,050 right now) has only dropped 4% from its all-time high. The reason is that as the current bull market continues to age, it is being led by fewer and fewer companies. Take out some high fliers like Amazon (AMZN) and Netflix (NFLX) and the underlying performance of the market overall has been pretty weak this year, and this is causing individual stock pickers to have ample choices when allocating fresh investment capital.

Take Disney (DIS), as an example. Down $6 today alone, the stock now fetches $100 per share, versus the $122 new high it reached on August 4th, just 16 days ago. For a blue chip company like Disney, which was a market darling just weeks ago, to be down 18% from its high is pretty remarkable. These are the kinds of moves we typically see when the market indices are really taking it on the chin.

It is impossible to know if the high-fliers are going to keep the S&P 500 fairly buoyant, or if we really will see a normal correction in the market (which would have to take stock prices materially lower from here), but as a long-term investor I do not especially care either way. I tell my clients that I invest in companies with every intention of holding them for at least five years. There are certainly times when I sell before that, but when you are searching for contrarian bargain opportunities you want to have time on your side since investors’ daily emotions are so unpredictable and oftentimes irrational. So when I find great investment opportunities, as I am more and more these days, I do not hesitate to start accumulating shares, even though the market is overdue for a correction and only down 4% from its high. If my investment thesis is correct, and I am willing to hold the stock for five years, the short-term noise becomes irrelevant.

As you consider whether to add fresh money to your investment accounts (and when), keep that in mind. Buying a good company at a great price usually pays off very well for long-term investors, in any market environment. Assuming that environment is similar to today when I write my next quarterly client letter in early October, I am likely to encourage my long-term investor clients who are still regularly adding cash to their accounts to prepare a plan of attack. That might mean putting some money to work now and leaving some on the sidelines in case we get a bigger market drop, but at the very least I think we should be shaping our plans around what we are seeing out there right now. And I would characterize the market today as getting very interesting on a stock specific level, provided one has patience and is focused on company fundamentals and not day-to-day market noise.

Full Disclosure: Long AMZN, DIS, and NFLX at the time of writing, but positions may change at any time.

U.S. Stock Market Approaching Attractive Levels

The U.S. stock market has finally rolled over, after going 3 years without so much as a single 10% decline. We are not quite there yet (at today’s S&P 500 low of 1,837 the index is down 9% from its peak reached last month), but for all practical purposes this is what a correction looks and feels like. So does it matter? Are stocks down to a point where investors should consider adding to their stock holdings? Let me share some thoughts as to how I am viewing the market’s current position.

Entering 2014, the S&P 500 sported a price-earnings ratio of about 17 based on trailing 12-month earnings (1,848/107). While this was justifiable given how low interest rates were, it was at the high end of historical norms and did not provide a lot of room for multiple expansion. The best that bulls could hope for was that earnings would continue to grow and rates would stay low, allowing for stable P/E ratios. And up until a few weeks ago, that is exactly how things played out. Earnings for 2014 are slated to come in around $119 (+11% year-over-year) and the S&P 500 index reached a high of 2,019 in September, up about 9% for the year excluding dividends of 1.5%.

While everybody has been worried about when interest rates will rise, and by how much, I think it is far more important to look at P/E ratios relative to those rates. If the average P/E ratio over the long term has been 14-15x, in a low rate environment a 17-18x P/E ratio would be fair but not compelling, assuming you expected rates to trend upward in the intermediate term. However, if stocks were trading at 15x earnings with low rates, it changes things.

Let’s assume the 10-year bond normalizes to a 4% yield (vs 2% today) over the next 3-5 years, which is the consensus view. If U.S. stocks would be likely to fetch a 15 P/E in that scenario (average rates, average P/E’s), then stocks would be attractive if I could pay 15x earnings when yields are just 2%. Essentially, even if rates doubled, there would not be any P/E multiple compression. If, however, I pay 17-18x earnings and rates rise/multiples fall, then I should expect that P/E compression will offset corporate earnings gains, and my stock returns will be muted.

Why is this important? If the S&P 500 index were to drop to 1,800 (about 2% below current levels) and earnings for the index are $119 for 2014, the trailing P/E ratio for the S&P 500 would be 15x at year-end and interest rates would be near record lows. That would make me want to add fresh capital to my stock market investments. If rates stay low for longer than people expect, then multiples could go back to 17x and equity gains will result. If rates rise and we only see average P/E ratios of 15, then stock returns will largely track corporate profit growth, which continues to be strong.

Paying above-average prices in a low rate environment is justifiable but offers minimal upside. Paying average prices for stocks in a low rate environment offers you some downside protection if rates rise and solid upside potential if they are steady. As a result, I think U.S. stocks look attractive at around 1,800 on the S&P 500. And many people would suggest starting to buy even with the index at 1,840 because it’s “close enough.” Bottom line: it’s time to make a shopping list because stocks are on sale.

 

The Average Investor Can (And Should) Ignore the 60 Minutes Story About “Rigged” Markets

The piece on 60 Minutes this past Sunday has ignited a discussion about high-frequency electronic trading systems and undoubtedly has spiked sales of the new Michael Lewis book entitled “Flash Boys: A Wall Street Revolt” which digs deep into the topic. Since I have yet to read the book, I am not going to get into many details here, but the big issue is that technology has become so advanced these days that certain people are now able to get insights into what orders are coming in for a particular security, and jump in front of those orders to make a few pennies per share on the backs of smaller investors. It’s gotten so bad (read: unfair) that a company called Virtu Financial Inc, which recently filed documents to go public, disclosed that it has only lost money on one day out of the first 1,238 trading days it has been operating.

Since I work with regular retail investors, the most salient question my readers might want to ask is “Does this affect me?” I would say “No, it doesn’t.” There are definitely counter-arguments to be made, but for the typical investor (who is investing in the stock market and planning on holding a stock for months or years) the existence of high-frequency trading firms should not even be a blip on their radar. The market is not “rigged” against the types of investments they are making. If you want to invest in Company A, you have done your research, and you feel as though paying $20 per share for that stock is an attractive price, then all you have to do is enter a limit order to buy Company A at $20 per share. In that scenario, you know what you are getting, you know what price you are paying, and you feel good about your odds of success. Over time if your investment thesis proves accurate then you will make money, and vice versa. Nothing else really should matter to you.

Now, it is hard to argue that we should embrace or even accept a system where certain groups of people with more money and better technology should be in a position to game the system and earn a profit 1,237 out of every 1,238 days the market is open. Hopefully regulators will do everything they can to close these loopholes in the system. That said, the discussion around whether regular investors should change how they save and invest based on this new book or the 60 Minutes segment are focusing their coverage and attention on the wrong headlines, in my view. Carry on.

Does Sales Growth Really Matter That Much?

“Sure, earnings are going to be fine this quarter, but sales growth has been tepid.”

I am hearing this line a lot in the financial media lately and frankly, it is a theme that is being given way too much airtime. All else equal, would earnings grow faster if sales were also growing faster? Sure. But that does not mean that earnings growth this quarter (tracking at 5-6%) is somehow bad news for investors. All too often it seems that people forget that stock prices are based on earnings, not sales. Why? Because shareholders in public companies are entitled to a proportional share of the firm’s free cash flow. Sales have nothing to do with it.

Don’t buy that argument? Think about the dot-com bubble. Why did the internet stocks tank beginning in March 2000? Because the companies were not making any money and after a while investors refused to pay 20 time sales when they were used to paying 20 times earnings. I could set up a web site that sells dollar bills for 95 cents and it would be hugely popular. Think of how fast I could grow the site’s sales! But an investor would never give me any money because the business model does not work. Stock investing is all about placing a value today on profits to be earned in the future. Sales growth is irrelevant in that context.

Consider a real world example. IBM has doubled its stock price from $100 to $200 since 2009. IBM is expected to book sales of $102 billion this year, versus $96 billion in 2009. If sales growth really mattered, IBM’s stock would not have doubled in four years because it only grew sales by 1.5% annually. Earnings per share, on the other hand, have risen by 70% during that time. That fact, along with some P/E multiple expansion, explains the stock’s performance. Don’t get caught up in the revenue growth debate. Earnings are what matter.

As The Dow Jones Industrial Average Hits A Record High, Is The Stock Market Overvalued?

How can we tell if the U.S. stock market is getting too pricey? Well, if you watch CNBC long enough or read enough stories in the financial media, you are likely to learn dozens of ways people will try and answer that question. There is not one right answer. If there was, successful investing would be easy and it is far from it.

I decided to dig into the numbers and present one way we can evaluate the stock market at today’s levels relative to prior market peaks, in order to see if we are nearing a point where we should start to get worried. I chose five of the most noteworthy market peaks over the last 25 years or so. After each of these peaks, the S&P 500 index fell at least 20% peak-to-trough. Some of the corrections were relatively normal, mild bear markets (the 1990 recession; -20% and the 1998 Asian financial crisis; -22%). Others were more pronounced (the 1987 crash; -33% and the dot-com and housing bubble bursts of 2000 and 2007; -50% and -58%, respectively).

I have graphed the P/E ratio of the S&P 500 index at each of these five market peaks. At one extreme we have the 1990’s bull market led by internet stocks, which saw equity valuations easily reach record-high levels, but at other peaks the results are more uniform, with markets typically topping out with P/E ratios in the high teens or low 20’s.

market-tops-peratios

As you can see, today the S&P 500 sits at 16x earnings. While we are approaching levels that should be considered elevated, one can argue that another 10-15% upside in P/E ratios would not be out of line with historical data. That said, making a large bet that valuations will reach the high end of the historical range is not something I would take to the bank. To me, this data says that the market is starting to get pricey, and although we could very well squeeze more upside out of this bull market (largely because with interest rates so low, equity investors are willing to pay more for stocks), I would still be cautious. As a contrarian, ever-higher stock prices only increase my preference to raise more cash and wait for the next correction, even if we don’t know exactly when it will come.