And if so, is it time to put them away too?
Current stock valuations – or cost per unit of economic value – are not something I usually want to devote a lot of space to as they don’t change that significantly month to month and their short run influence is rather limited. This certainly shouldn’t imply that value isn’t high on my list as an investor, because it is. Further, valuation input is pretty well established and not subject to a ton of disagreement (if you are in the business, just check your twitter stream). However, as we move from one market environment and calendar year to the next – here are a few thoughts on the topic.
Two Considerations for Expensive Stocks
The view that US stock valuations are elevated is certainly not a new one and merits little dispute. Yet, I am a firm supporter of the notion that stock valuations shouldn’t be analyzed in a vacuum that only considers past stock valuations and ignores other basic factors like interest rates. Most families for whom my role supports need some combination of growth and income to support them during retirement, with our job at the Financial Enhancement Group being to find that best combination. So, it absolutely matters that the lower forward return expectations that accompany high valuations is accompanied by extraordinarily low bond return expectations as well. That is the first notion to consider when using equity valuations as an investment input.
The second notion accompanies what has now probably become the most popular method of looking at stock values; the Shiller cyclically adjusted price-earnings ratio (CAPE). The CAPE’s concept of not being overly influenced by the booms and busts of a cycle carries a lot of appeal. Applying the concept though to publicly-traded US equities has one big problem: the way we measure earnings was significantly adjusted in 2001. For a much better explanation, follow this link to a brilliant piece in 2013 by Philosophical Economics: http://www.philosophicaleconomics.com/2013/12/shiller/. To put the problem simply, before 2001 was apples and post 2001 are oranges.
Proprietary Solution
My answer to both of these notions was taken into account by what I call the “rule of 25”. It is built on the framework of Shiller’s CAPE but takes into account these two factors of consideration described above. For this post’s purposes, I won’t fully describe the methodology (and thereby give away too many secrets). What I will tell you is that as we close out this year, this internally calculated measure now suggests a more balanced view of stocks and bonds than we had as late 2013/early 2014. In 2009 and 2010 as the cycle turned upward, the extremely low stock prices produced very cheap valuations that suggested equities should be very heavily over weighted due to a favorable 5 year forward outlook compared to bonds. As we lifted off those levels, stocks continued to be favored on a 5 year forward basis but not by as much and increasingly because interest rates kept moving lower. Where we stand today in this internal rule is a more balanced and neutral view of the allocation to stocks (whatever that means to you). Again – this is only looking discussing valuation and only one part of the investment input.
Deeper view of current valuation levels
Goldman Sachs recently put out a simple, but rich perspective on current valuations. It was meaningful because they look beyond one or two measures of value and instead compare across 7 as shown in the table below.
Looking at a composite view is very helpful in looking past any anomalies that can skew one indicator or another. In this case, however, the message across the board is pretty clear that stocks are historically expensive. The one holdout on these is free cash flow yield – which in my role as an analyst has a lead role. While the initial thought is that is a nice silver lining, another perspective merits strong consideration.
One of the main restraints we have seen in the economy over these past few years is a reluctance of corporate America to invest in their future through capital expenditures (chart below). Keeping Cap-Ex low has been a boost to free cash flow (which keeps free cash flow yields high). If corporate America jumps on board with the current economic optimism and invests their cash flows – this one silver lining goes away. If they don’t, the lack of investment will further restrain their growth. I can’t tell you which one is better for next couple of years’ stock market, but a release of the cash flow would take away the one hold out from the table above and leave a unanimous view of high historic valuations.
Valuation context and what it means for you
Valuations are most helpful (at least to me) when simply thought of in the context of how markets move from point A to B. The move from point A to point B will always comprise of a change in earnings and a change in the price for earnings (P/E) multiple investors are willing to pay for those earnings. For example, the S & P has moved from 1,518 at the end of 2011 to now over 2,200 – an increase of 45%+. Over this time frame, earnings on the index have increased 13% from 77 to 87. Meanwhile, the (P/E) multiple – investors were willing to pay which has moved up from 16.3 to now over 26 (trailing basis). That expansion in P/E to a very high historical level has served as a major tailwind for stocks – a tailwind we should assume is now likely behind us after having accounted for the majority of the move over the last 5 years. Of course, it can march on higher but it is most wise to assume that any surge to higher valuation levels would not be permanent and likely quite short lived.
In that sense, it may be helpful to think about the market as a 4 engine plane. Sure, the “multiples engine” is probably gone – but that doesn’t mean the plane is destined to crash. One of the biggest mistakes I’ve seen investors make (speaking from experience here) is avoiding equities under the risk that stock prices could fall and return valuations to normal. High valuations, in isolation, shouldn’t mean you drop equities all together. Valuations can just simply hold here near these levels through the rest of this cycle. If we couple that scenario with something like steady 4-6% growth stemming from earnings growth through the rest of the cycle….is that the worst outcome?
At the same time, we have to recognize that we are clearly running with less power with the “multiples engine” offline. If storms pop up (which, for us, include other pieces of our risk barometer), the valuation piece means we have less engine power to get around those storms. Our sell signals need to be closer by under nosebleed valuations. If we lose another engine – that’s when we are looking for an emergency landing. High valuations will be corrected, but it’s foolish to think we can know how or when.