by Jeff Miller
Quote of the Day from Tadas Viskanta
…(Y)ou have to have a system that gets you in and out of the market based upon your own signals and not pay attention to what other people are saying.
I could not agree more! The quotation is from today’s screencast at Abnormal Returns, a brief video that I watch and enjoy every day. The cited text comes at the 2:10 mark or so, but you should really watch the whole thing. The links are also informative and fun.
[Regular readers of Abnormal Returns will notice that I have shamelessly ripped off their daily introduction to let Tadas have a turn at being the source of the “quote of the day.”]
Like Tadas, I am not a big fan of round numbers or anniversaries, but his screencast inspired me to compare today’s market with what we saw two years ago. I have done a few pieces like this in the past, but this was an occasion to be more systematic and to spend a few hours doing additional research.
The table below shows a summary of the method that I use to “have a system” and to ignore the noise. It combines value, future prospects, and risk.
There is room for improvement, but it helps me stay on the right side of the market.
I am going to discuss each of the categories in turn. The result, a doubling in stock prices, is what we seek to explain. Let me explain the other factors.
There is something about discussing market valuation that generates passionate responses. Regular readers of “A Dash” know that I have provided solid evidence that the bottoms up projections by analysts are the best predictor of next year’s earnings. I have a continuing invitation to those advocating alternative methods to provide any evidence. [Here is the article where I discussed the misinterpretation of the widely-cited McKinsey study.] So far I have no takers. This is something to keep in mind the next time you read someone assert, without evidence, that analysts are “too bullish.”
Everyone who picks stocks looks ahead, starting with what they expect the earnings to be. The sum of this individual analysis of stocks is reflected in the valuation of the market. Who knows? If Ben Graham had lived in the era of sell-side analysts he might have improved his backward-looking method of forecasting earnings. My guess is that he would have employed the best available information, had it been available.
In the table above I have also provided data for those who (mistakenly) prefer to look at past earnings instead of looking ahead. I have also added interest rate comparisons.
The forward P/E for the market is now 13.5 compared to 10.8 in 2009. The trailing P/E comparison is even worse — 15.8 instead of 10.3.
Many pundits thoughtlessly cite average P/E multiples without regard to interest rates. Since every major pension fund manager has a daily choice between stocks and bonds, the comparison is of obvious necessity.
The table shows two interest rate comparisons — the rate for investment-grade corporate bonds and the ten-year treasury note. The former provides a comparison for those willing to take the risk of corporate failures and the latter an indicator of perceived risk in the system.
By this measure, stocks are 20% undervalued now and were only 12% undervalued in 2009. Another way of looking at this is that investors in corporate bonds have also done very well in the last two years.
The valuation disparity is quite different when compared to the ten-year note. The stock risk premium is still 100%. This is large by historical standards, but only half of what it was in 2009.
The stock market is not a futures contract on GDP. Having said this, the prospects for the economy are the biggest single input for expected earnings. There is a real challenge in finding forward looking economic indicators. The Economic Cycle Research Institute has a good record and a widely followed forecast.
In 2009 their Weekly Leading Index was a meager 105.5 and the growth index a negative 23.7. Today the WLI is at 105.5 and the Growth Index a postive 6.5. While the ECRI does not look ahead more than six months or so, the economic prospects look good. This is confirmed by other professional economic surveys.
The economic future looks much better than it did in 2009.
I evaluate risk using the St. Louis Fed Stress Index. This method is objective and market-based. If a doomsday pundit is telling you to worry, and the concern is not reflected in any of the 18 factors in the SLFSI, I recommend choosing the data over the anecdotes.
In 2009 the SLFSI was at 3.88. This is measured in standard deviations, so it was a true black swan. The chance of this happening is about 0.5%. An intersting comparison is the maximum stress from the prior 90 days, which I show in the change in the level. The prior high was at a 3/1000 percent extreme.
The current readings are quite normal — very close to the middle of the distribution with a mild decline from the high in the last three months.
The future also looks less risky than it did in 2009.
The overall conclusion from this analysis is pretty clear. This is a better time to invest than it was two years ago. The valuation is a little lower, but the risk is much, much lower. Risk-adjusted return is our goal.
I realize that most readers will disagree with this conclusion, but that is only because they already know what happened to an investment in 2009, and they are skeptical about the future.
Many would also have been skeptical in 2009. This is the challenge of looking ahead. Investors need an objective, data-based method for cutting through the noise.
You might want to consider my Value+Economy+Risk approach. I write about this method nearly every week in my “Weighing the Week Ahead” series. I also have a risk-adjusted program for clients, where I pay special attention to what might go wrong. You can do the same at home by following the indicators I have outlined..
One More Thought
One more factor that I cite is the need for a list of widely publicized worries. Most investors are big losers because they react to market “headwinds” by selling. The gradual meeting of worries has been the story of the last two years. We continue to have a long list of worries, highlighted every day. When this is no longer true, it will be a warning of a market top.
As compelling evidence the Abnormal Returns article provides a link to an entertaining article on Clusterstock, reviewing the bearish punditry of the last two years. As you read through the past predictions, you might well notice that most of those cited are offering the same advice now as they did then. A little research will show that they are often hailed as “early” predictors of the financial crisis, which means they were bearish as early as 2005 or so….
What better evidence can there be for the quote of the day?
You need your own approach.
Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts. He has worked for market makers at the Chicago Board Options Exchange, where found anomalies in the standard option pricing models and developed new forecasting techniques. Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin. He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade. Jeff writes at his blog, A Dash of Insight.