This is where the market's current valuation provides significant insight, particularly
when those valuation measures reach historical extremes.
Put simply,
when valuation measures are steeply elevated but investors remain inclined to speculate, as evidenced by very broad uniformity of market action and the absence of internal divergences, rich valuations often have little effect on market outcomes.
Not exact matches
Because
when you actually look at the relationship across sectors, and you look at their
valuations based on return on equity, or other
measures, all sectors seem to be about fairly valued.
So if we look at a range of market
valuation measures, whether it's Shiller CAPE, whether its price - to - book, whether it's price - to - trailing earnings, price - to - peak earnings,
when we look at these
measures, they look like they're in the, what we would call, the 10th decile, meaning generally,
valuations are cheaper 90 % of the time.
Given that
valuations were already rich
when the VIX, a commonly used
measure of S&P 500 volatility, was at 10, a doubling of volatility suggests stocks should be trading closer to 16 or 17 times earnings, not 21.
When you look back on this moment in history, remember that spectacular extremes in reliable
valuation measures already told you how the story would end.
When valuations exceeded even 12 times normalized earnings (on our most comprehensive
measure discussed above), seemingly «favorable» market action was followed by profound losses averaging -69.8 % on an annualized basis (generally reflecting a few weeks of vertical losses until enough damage was done to kick the market action
measures negative).
The problem is
when investors adopt theories and models that embed the most optimistic assumptions possible, run contrary to historical evidence, or embed subtle peculiarities that actually drive the results (see, for example, the «novel
valuation measures» section of The Diva is Already Singing).
As always, the best opportunities are likely to emerge
when a material retreat in
valuations is joined by an early improvement in our
measures of market action (which, following our stress - testing earlier in this half - cycle, are robust to every market cycle we've observed across history).
At the surface,
when we look at
valuation measures and other fundamentals and compare them to historical precedents, there is a case to be made that stocks (in particular in the US) are above fair value, if not rich.
Our actual expectation is that the completion of the current market cycle is likely to wipe out the entire total return of the S&P 500 — in excess of Treasury bill returns — all the way back to roughly October 1997; an outcome that would require a market retreat no larger than it experienced in the past two cycles, and that would not even carry historically reliable
valuation measures to materially undervalued levels (see
When You Look Back On This Moment In History).
Instead, they've run their finances conservatively enough that they can sit on depressed
valuations for years at a time, knowing that they are still earning a good rate of return
when measured as the cash flow that belongs to them relative to the price they paid for their ownership stake.
In my view, the necessary objective is to accept market risk
when the likely return / risk profile is attractive, based on observable
measures of
valuation and market action, and to avoid, hedge, or diversify away those risks that don't carry attractive return / risk profiles on average.
Given that
valuations were already rich
when the VIX, a commonly used
measure of S&P 500 volatility, was at 10, a doubling of volatility suggests stocks should be trading closer to 16 or 17 times earnings, not 21.
On long - term
measures of value (for example, Graham's 10 - year trailing P / E ratio and corporate profits as a proportion of GDP) market prices are well below average and approaching all time lows (See Future Blind «s post Market
Valuation Charts prepared in October last year
when the S&P 500 was around 1160).
That brings us to the next potential risk — the risk that the largest companies in the S&P 500 Index also tend to be overvalued
when compared with their 10 - year average price / earnings (P / E) ratio.2 According to our research taking these
valuation measures into account, 70 % of the 10 largest stocks in the S&P 500 Index were overvalued, as of December 31, 2015 and 56 % of the top 25 stocks are overvalued, the very same ones that make up a third of the index allocation.
Generally, we observe stronger correlations with future returns
when we use aggregate relative
valuation measures compared to using P / B alone.
The results of our analysis are generally a bit stronger
when the aggregate
valuation measure is used, but three of eight factors (value blend, momentum, and investment) and two of eight smart beta strategies (Fundamental Index and dividend index) show a stronger correlation
when the P / B
valuation measure is used.11 The aggregate
valuation measure is likely stronger because it captures differences in profitability that can be missed by P / B.
When relative
valuation is gauged using the aggregate
measure (reported in the right-most column of Tables 1 and 2 for both aggregate and P / B
valuations), we find that the cheapest stocks based on B / P are no longer cheap.
Our actual expectation is that the completion of the current market cycle is likely to wipe out the entire total return of the S&P 500 — in excess of Treasury bill returns — all the way back to roughly October 1997; an outcome that would require a market retreat no larger than it experienced in the past two cycles, and that would not even carry historically reliable
valuation measures to materially undervalued levels (see
When You Look Back On This Moment In History).
This is what I mean
when I often state that
measuring performance without simultaneously
measuring valuation is a job half done.
Further, some
valuation measures may be backward - looking
when the market is pricing the future.
This represents what I mean
when I say that
measuring performance without simultaneously
measuring valuation is a job half done.