April 10, 2006
Rich Valuations and Rising Yields are a Dangerous Combination
Stocks aren't cheap. It would be one thing if valuations were only moderately above normal and market action was uniformly strong – particularly if the economy was being driven by some sort of investment boom with strong leadership. That description more or less fits the period up to mid-1998. Market returns to that point were strong and ultimately enduring. Since then, of course, stocks have actually lagged even the depressed returns on Treasury bills, though thrill-seekers can take solace in the fact that stocks have delivered those lousy returns in a very exciting way.
It's entirely another thing for stocks to be roughly double their historical norms of valuation, being led primarily by speculative garbage stocks, in an economy driven not by booming investment but excessive leverage and over-reliance on foreign capital, with no particular leadership – medical, pharmaceutical, technological, manufacturing, or otherwise – and importantly, with interest-sensitive groups such as bonds and utilities breaking down. Bonds and utilities aren't always the groups that break first, but both the 1987 and 1990 declines were preceded by just that sort of action. That's not a forecast about near-term market direction, but my concern about potential market weakness is admittedly elevated here.
As I've noted in recent weeks (see in particular the March 27 comment, my assertion that stocks are about double their normal historical valuations also applies to earnings-based measures like P/E ratios. S&P 500 earnings are presently right at the 6% line that connects historical earnings peaks across economic cycles going back cleanly over the past century. At that elevation of earnings (indeed, even when earnings have been within 20% of that 6% trendline), the P/E ratio for the S&P 500 has historically averaged just 9 or 10, compared with the current level of 18.
According to some neat supporting research from James Montier, the global equity strategist at Dresdner, Kleinwort, Wasserstein in London, the U.S. is hardly alone in these rich valuations. John Mauldin included this bit from Montier in his latest issue of Front Line Thoughts:
“As with the US , European earnings have not managed to grow by more than 6% measured peak to peak since 1970. Current earnings are rapidly approaching the top edge of this earnings growth channel. Yet the European ex UK market is trading on a 17x peak cycle earnings. Normally (again excluding the bubble years) when earnings are within 5% of the top edge of the 6% channel, the European market would be trading on a Hussman PE of 11.5x.
“Both the US and Europe look expensive relative to peak earnings. They also look expensive on a broader range of valuation measures. For instance, across our nine measures of valuation (none of which include bonds) the US appears to be 54% overvalued. In the past when we have done a similar analysis on Europe, it has appeared to be 33% overvalued. However, this is flattered by a much shorter data set for Europe. If we take the average European valuation discount to the US since 1970, and apply it to the US long run averages we can proxy a ‘long run' benchmark for Europe. When we conduct this exercise, we find that Europe is on average 63% overvalued!”
If stocks are richly valued both in the U.S. and abroad, the situation can only be compounded by the fact that interest rates are rising everywhere. As a rule, the most dangerous conditions for stocks are always when stock yields are low (stock valuations are high) and competing yields (primarily interest rates) are rising.
The history of market plunges is not primarily a history of earnings shortfalls or economic disasters. It is mainly a history of low yields being pressured higher – of thin risk premiums being pressured to widen – of rich valuations being pressured lower.
I won't bother mincing words. Given rich global stock market valuations, slumping quality of internal market action, and rising global interest rates, this is not an appropriate time to accept significant market risk. There is no assurance that stock prices will fall, and no assurance that they might not instead rise further. But from the standpoint of a long-term investor, it's useful to look over the past 7+ years of profitless excitement in the stock market and ask whether tracking every fluctuation in the market – even participating in periodic, marginal new highs – is a necessary objective. 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.
On average. On average. Nothing in that phrase implies an ability to forecast specific movements or “time” market peaks and troughs with great accuracy. What matters is that different combinations of observable conditions, on average, have produced much different profiles of return and risk. If a portfolio loads market risk when the likely return/risk profile is favorable, and hedges market risk when the likely return/risk profile is unfavorable, it's possible to achieve a very satisfactory return/risk profile over the full market cycle without ever making a specific short-term forecast.
Go to Vegas, and the odds are against you, on average. The gamblers at the roulette table will scoff at that, as will the ones at the slot machine. Some of them will even win here and there. Specific outcomes aren't predictable. But on average, the gamblers in Vegas will walk out with less than they walked in with. When taking market risk requires a gambler's mentality – a faith that all will work out despite the fact that it hasn't on average – it's appropriate to hedge those risks.
Rich global valuations, predominantly thin risk premiums, and uniformly rising global interest rates haven't rewarded investors historically, on average.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and unfavorable market action (a deterioration from the prior week, primarily on the basis of interest-sensitive securities such as bonds and utilities, as well as measures of breadth and distribution). Aside from a tiny “contingent” position in S&P 500 call options representing a small fraction of 1% of Fund assets (which gives the Fund a small “local” exposure to short-term market fluctuations), the Strategic Growth Fund is fully hedged. The Fund remains invested in a widely diversified portfolio of individual stocks in a broad range of industries, with an offsetting hedge of equal value in the S&P 500 and Russell 2000 indices.
In bonds, yields are slightly more interesting given that the 30-year Treasury is above 5%., but the most likely merits are short-term since the Market Climate remains unfavorable. Given that Treasury yields broke through levels that have been a fairly reliable barrier for several years now, it wouldn't be surprising to see bonds stage a “relief rally” here, but both yields and market action remain unfavorable overall, holding the Strategic Total Return Fund to a roughly 2-year duration, primarily in Treasury inflation-protected securities.
Based on particular strength in the precious metals market mid-last week, I reduced the exposure of the Strategic Total Return Fund in precious metals shares, from close to 18% of assets down to just over 10%. That's not a “bearish call” on precious metals shares, but does reflect somewhat richer valuations for precious metals than we saw a few weeks ago when those stocks were declining notably.
... and despite being something of a stick-in-the-mud when it comes to market conditions here, wishing you a wonderful Easter, full of good news.
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