Published December 25, 2020
Investors cannot help but be amazed by the stock market’s performance this year. What began as a promising continuation of a decade-long bull run quickly turned into one of the sharpest plunges in market history as Covid-19 upended economies worldwide. Shocking as that plunge was, the subsequent rebound was even more surprising, with stocks going on to record highs despite unemployment remaining extremely high and other economic indicators remaining well below their pre-pandemic levels. The record level of stock prices in the face of still-weak economic data suggests a stock market that might have run too far too fast. A couple of notable writers on investment topics in major publications have recent tackled that topic, concluding that stocks are indeed at extremely rich prices.
Before we look at their conclusions, we must point out that our models are trend-following. They are based on price and volume market information having no basis in fundamental economic or market indicators. Why? Because whether a market is over- or under-valued is a matter of opinion. Markets are made of millions of inputs with investors pursuing a multitude of objectives on innumerable assumptions. The result is that markets are a combination of economic facts, expectations, and investor emotions. Those emotions can produce wild swings where stocks go to extreme valuations – both high and low. The articles below come to the same conclusion, coming from much of the same contextual history. Whether something has changed with the Federal Reserve maintaining ultra-low interest rates, investors having become much more passive in their investing (e.g. lots of money flowing automatically into market index funds and ETFs), and the influence/impact inherent in the rise of fintech investment gateways like Robinhood; all of these may or may not alter the current level of stock market valuation compared to times in the past.
One of the articles below notes that for decades investment theory focused on the dividend yield of the market as dividends were a major portion of the investment thesis and expected return. But newer companies stopped paying out dividends along the way, viewing reinvestment of capital as a better use of funds, and the resulting rise in share prices being the only source of investor returns. Investment theory had to change, reducing reliance on dividends, in order to explain what was going on. So, here we are today with, perhaps, another shift in underlying investment theory. How do we value stock prices when bond yields (e.g. interest rates) are extremely low? Doesn’t the ultra-low level of bond yields push investors into riskier assets like stocks, thereby rendering market valuations somewhat obsolete? Time will tell. We would note that many of the indicators discussed at the bottom of this piece are very high-level having told followers for many years that markets were overvalued. In short, they are blatantly unhelpful, in our opinion. Nevertheless, the authors below have decades of market experience and research expertise. We don’t know any more than anyone else where stock prices are headed. Our models will continue to follow the market’s price trends with, we hope and expect, continued good results.
Here are some excerpts from recent articles on stock market valuation, first from Justin Lahart at the Wall Street Journal:
“The only way to argue that stocks aren’t wildly expensive is to say that something fundamental has changed about the market environment. Thanks to the Federal Reserve, such a change might actually have occurred—but investors could pay a heavy price if they turn out to be wrong.
It has been an odd year with the Covid-19 crisis hammering the economy, but stocks recovering from sharp losses and then powering to new highs. As a result, standard measures show valuations are at rarely-seen levels that have typically ended in tears. The S&P 500 trades at 22 times analysts’ expected earnings—its most expensive level since the dot-com bubble. It also trades at its richest multiple to its inflation-adjusted earnings over the past decade—the valuation method popularized by economist Robert Shiller —in nearly 20 years. The total value of U.S. stocks as a percentage of the U.S. economy, which Warren Buffett once called “the best single measure of where valuations stand at any given moment,” is now higher than at any point during the dot-com years.
One argument for stocks may not be as expensive as they seem is that interest rates are extremely low. When the 10-year Treasury note yields just 0.95%, today’s P/E multiple looks less outlandish than it would at a 5% yield. There is a problem with this sort of thinking, however. The 10-year Treasury largely reflects investor expectations of what the overnight rates set by the Fed will average over the next decade. The Fed responds to what is going on with the economy, setting rates higher when it is trying to cool things down, lower when it is trying to heat things up. So low yields are tantamount to a low-growth, low-inflation economy—one in which profit growth would be low, too. Why pay up for stocks under that scenario?
But the Fed this year revamped how it sets policy, abandoning its practice of pre-emptively raising rates to head off inflation. In its efforts to help the economy recover, it has committed to hold short-term rates near zero until inflation reaches 2% and “is on track to moderately exceed 2% for some time.” That means that rates over the next several years will be lower than they would have been under the Fed’s previous policy. Perhaps stocks can carry higher multiples and still be reasonably valued.
The rules of investing have changed in the past, after all. Investor and financial historian Peter Bernstein noted how veteran Wall Streeters blanched when the dividend yield on stocks fell below the yield on the 10-year—a sure sell signal, they told him. What they missed was the phenomenon of companies reinvesting more of their earnings rather than paying them out. It would be a half-century before dividends surpassed Treasury yields again.
But embracing new paradigms can get investors into trouble. In the early 1970s, investors believed that the “Nifty Fifty” group of big companies that had registered years of steady growth would be able to keep growing for years to come—and got burned for it. The dot-com era rested on even more improbable expectations. Maybe the Fed’s actions this year have changed how investors should think about valuations, but it is early going and that hypothesis has yet to be put to the test.”
And now we hear from Mark Hulbert, longtime publisher of his eponymous newsletter tracking investment performance.
“Every month I track a suite of stock market valuation indicators. A month ago, most of these indicators were already indicating that the market was more overvalued than at any time in recent U.S. history. So, this month’s update hardly seems noteworthy. Equities have been overvalued for several years running, and yet the market averages keep on rising.
How boring, even if dangerous.
I am therefore devoting this month’s valuation update to the most common comeback I get when I report the market’s extreme overvaluation: If I only took interest rates into account, I’d discover that the market is not overvalued.
This is a convenient story for the bulls to tell themselves since interest rates are at historically low levels. Unfortunately, there is precious little historical support for it.
Consider what I found upon measuring the predictive power of each of these valuation indicators, calculating a statistic known as the r-squared (which ranges from a low of 0%, or no explanatory power, to 100%, or complete explanatory power). In each case I calculated the r-squared in two ways: Once when focusing on the indicator by itself, and then a second time in conjunction with prevailing interest rates.
It turns out that none of these indicators’ r-squareds significantly changed upon taking interest rates into account. To illustrate, consider the so-called Buffett Indicator, which is the ratio of the total market cap of the U.S. market divided by gross domestic product. Its r-squared is 47% when used to predict the S&P 500’s 10-year inflation-adjusted total return, which is higher than the r-squared of any indicator in the table below. When adjusting the Buffett Indicator by the real interest rate (the 10-year Treasury’s yield minus the CPI’s change over the last 12 months), its r-squared is essentially unchanged, at 48%. But that’s not even the half of it: In an econometric model that includes both the Buffett Indicator and real interest rates, lower rates are associated with lower subsequent 10-year returns — not higher. Upon including just the Buffett Indicator in this econometric model, for example, the S&P 500’s projected 10-year inflation-adjusted total return is minus 9.3% annualized. Upon including real interest rates in the model, the projection worsens to minus 10.4%.
Are you surprised by this result? You shouldn’t be. Persistently low interest rates indicate that the markets expect future economic growth to be anemic at best. Far from celebrating what today’s low interest rates mean, the bulls should be worried.
How could the bulls be so wrong when arguing that low rates justify higher valuations? My hunch is that, either consciously or unwittingly, they are guilty of a sleight of hand. They in effect are confusing two very distinct historical tendencies:
• What happens to stock market valuation ratios as interest rates decline
• What is the stock market’s future return when interest rates are low
Notice that the first is referring to a coincident tendency while the second refers to a forward-looking tendency. Yes, valuation ratios tend to rise as interest rates fall. But that is entirely distinct from what happens in the years when interest rates are already low. Another way of appreciating this subtle point: In order to exploit the first tendency for market-timing purposes, you’d have to know where interest rates are headed. Good luck with that.
The bottom line? The stock market is overvalued, period. Far from allowing us to wriggle out from underneath the bearish weight of that overvaluation, today’s low interest rates add fuel to the fire.
Here are the status indicators I follow, most all of which are at or approaching their most bearish readings (meaning they are at their most elevated, riskiest state).”
Market Update
Stocks opened this week sharply lower on fears of a rapidly spreading new Covid-19 variant in England. By Monday’s end, however, stocks had substantially pared their losses, ending the day down -0.4%. A strong earnings report from retailer Nike (NKE) offered some good news. Tuesday brought another dose of losses with the broad market dipping -0.2%. Tuesday’s offsetting good news came from Apple (AAPL) which rose +3% on optimism the consumer giant would enter the self-driving car market. Stocks spent Wednesday in positive territory before a late-day swoon left them almost flat. Investors appeared to shrug off President Trump’s concerns about the congressional stimulus deal. Further evidence of that came in Thursday’s shortened session as stocks tipped higher by +0.4%. Chinese consumer tech behemoth Alibaba (BABA) plunged -13% on news the company faces further pressure from the Chinese government.
For the thinly traded Christmas holiday week, the S&P 500 (SPY) held flat at -0.05% while the Nasdaq 100 (QQQ) posted a breakeven +0.02% result. The smallcap Russell 2000 (IWM) added +1.88% for an eighth straight weekly gain. The index has now hit overbought status on some technical indicators for the first time in almost three years.
Warm wishes and until next week.