X-factor Report, 11 January 2015
by Lance Roberts, StreetTalk Live
Last week, I reviewed 2014 as we closed the books on the trading year. This week, I want to look at the mainstream analysis and media exuberance as we go into the year and offer some perspectives for you to consider.
Let’s start by discussing what “bad analysis” looks like.
I was sent the following chart from Bloomberg with rather a long statement about how we are beginning a new secular bull market and the secular bear market is “officially dead.”
The premise that was made is that it is clear that the markets have broken out of the secular “bear” market range of the last 14 years and have now begun a new secular “bull” market like the 80’s. Secondly, the “worst” will probably happen is a correction along the way of only 20%. So why not just be 100% stocks and “fugetta ’bout it.”
If you look at the chart, and I apologize for not crediting the author as I have no idea where it came from, you can certainly see the point trying being made. However, the reason that I say this is “bad analysis” is because simply looking at a chart of price action does not provide the underlying context within which that price action occurred. Let me provide that for you in table format below:
The 1982-2000 secular “bull” market was driven by an expansion of valuations driven by a three decade fall in interest rates and inflation. With valuations currently at levels that have historically marked secular “bull” market peaks, and with interest rates and inflation at historically low levels, the fuel needed for further valuation expansion is in extremely limited supply. (Also note that the labor-force participation rate was rising through 2000 versus falling today.)
As I wrote last week in “Analyzing The Secular Market Thesis:”
“As I discussed yesterday, valuations are currently pushing more than 27x earnings on a trailing basis using Dr. Shiller’s cyclically adjusted methodology. At the beginning of each previous secular bull market valuations were in the single digits. I have notated when valuations have exceeded 25x trailing earnings which historically marked the peaks of bull markets rather than the beginning.”
“Here is another view of valuations and secular market periods for a better perspective of future expected returns. The yellow triangles note valuations where secular bull markets previously began. Importantly, note the market’s behavior at the start of periods where valuations were 25x earnings are higher.”
Enough from me on this issue. Daniel Crosby from Wealth Management.com (courtesy of my friend Scott Bishop) had this to say.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham
Believing as I do in the sage advice of Mr. Graham, I recently set out to quantify my growing unease with the heights obtained by the bull market of the last five-plus years. As you read below, please realize that this is not a forecast or prognostication about what will happen – especially not in the short term. Timing the market on any sort of a short-term basis is a fool’s errand, as is deviating from your specific financial plan on the advice of a stranger.
Consider this more of a “Where are we at?” with respect to market valuations, secure in the knowledge that times of sensational highs and lows tend to be fleeting and that the market has a tendency to mean-revert (that is, become a weighing machine) in the long term.
Let me say that I find the market significantly overvalued and think that some sort of defensive measures will be wise for most investors in the year(s) to come.
Shiller’s CAPE Ratio
The CAPE is a poor predictor of short-term market movements (most everything is), but is much more reliable in speaking to the long term return horizon. Using Shiller’s own expected return formula (taken from value investing site GuruFocus), yields an expected return over the next 8 years of .3%. What is much more informative than a single prediction, however, is considering the range of possible distributions for the longer term, which are as follows:
It is certainly worth noting that even the “Really Lucky” scenario that might play out over the next 8 years vastly underperforms the market average.
S&P 500 P/E Ratio
Ned Davis research has done the math on times when the market has been over or under valued relative to fundamentals and has discovered the following:
According to Ned Davis and company, we are now well over 30% overvalued, comfortably above the threshold for the paltry “Overvalued” returns you see above.
The Buffett Valuation Indicator
Given historical returns from this significantly elevated level of market cap to GDP, the predicted return for 2015 is .7%, which includes dividends. Drawing on Buffett’s comments, GuruFocus considers a 75 to 90% ratio fair value, with 90 to 115% modestly overvalued and anything over 115% significantly overvalued. The only other time since 1950 that this indicator has broken past two standard deviations of overvaluation is, you guessed it, in the run up to the 2000 crash.”
Without Accounting Fudges – Current S&P 500 P/E Ratio is 67x
You get the idea? Well, let me throw one more “match on the fire” from Blackrock’s 2015 Investment Outlook:
“Corporate earnings are a key risk. Analysts predict double-digit growth in 2015, yet such high expectations will be tough to meet. Companies have picked the low-hanging fruit by slashing costs since the financial crisis. How do you generate 10% earnings-per-share growth when nominal GDP growth is just 4%?
It becomes tempting to take on too much leverage, use financial wizardry to reward shareholders or even stretch accounting principles. S&P 500 profits are 86% higher than they would be if accounting standards of the national accounts were used, Pelham Smithers Associates notes. And the gap between the two measures is widening, the research firm finds.
So assuming 126 non-GAAP, accounting-levitated 2015 S&P consensus EPS, this means the real EPS is… 67? Which in turn means that the real forward P/E as of this moment is over 30x!”
Richard Russell – Buy Stocks For The 3rd Stage Of The Bull Market
Importantly, none of this means that you should run and hide in cash. What IT DOES MEAN is that you need to be extremely aware that we are likely closer to the next major market reversion than not. This is not a “bearish call,” but simply an acknowledgement that EVERY single metric suggests that the current bull market cycle has reached historic extremes in terms of “risk.”
As I penned last week:
“However, the markets are currently on a “buy” signal which suggests that we should be increasing our allocation back to 100%.
With portfolios currently in a very healthy condition after rebalancing positions and raising cash earlier this year, it is now time to start slowing adding some equity exposure as we move into the seasonally strong time of the year. I highly suggest that you read the Sector Analysis section of the newsletter for a better understanding of what we are looking to add if the market gives us enough “safety” to do so in the days ahead.
As noted: I am not convinced about the markets at the current time, so if you choose to wait for a stronger confirmation before increasing exposure that is completely okay.”
The reality is that we are likely heading into the “expected market meltup” as the vast majority of analysts and poorly researched commentators grasp at straws to justify further market advances. It is this “bull mania” that lifts asset prices into their final bullish phase as I described previously in “Are We Entering The 3rd Stage Of A Bull Market?”
“In the final phase of the bull market, market participants become ecstatic. This euphoria is driven by continually rising prices and a belief that the markets have become a “no risk opportunity.” Fundamental arguments are generally dismissed as “this time is different.” The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks ‘rosy’ and complacency takes over proper due diligence. During the third phase, there is a near complete rotation out of “safety” and into ‘risk.’ Previously cautious investors dump conservative advice, and holdings, for last year’s hot “hand” and picks.”
“It is necessary to remember what was being said during the third phase of the previous two bull market cycles.
- Low inflation supports higher valuations
- Valuation based on forward estimates shows stocks are cheap.
- Low interest rates suggests that stocks can go higher.
- Nothing can stop this market from going higher.
- There is no risk of a recession on the horizon.
- Markets always climb a wall of worry.
- “This time is different than last time.”
- This market is not anything like (name your previous correction year.)”
Well, you get the idea.
Richard Russell recently penned for Financial Sense the following about the third phase of the bull market.
“For a month, I’ve told subscribers that I believe we’re now entering the third phase of the bull market. Strangely, most market analysts – almost all of whom are considerably younger than I am – are not acquainted with the sentiment phases of a bull market.
Normally, following the second phase, we have a deep correction followed by a continuation of the bull market into a third and final speculative phase. From here on, the character of the third phase trumps everything else. All minor ripples in the market, all dips or pops, all of these are contained within the third psychological phase.
My old friend John Magee used to say, ‘Don’t tell me what to buy. Tell me when to buy it.’ The time to enter this third phase of the bull market is now.
I expect the Fed to gradually raise interest rates. The stock market will ignore rising interest rates up to a point, and continue to push higher. But eventually rising rates will tend to halt the market’s rise. At what level will interest rates restrain the third phase? I don’t have the answer to this; it’s like the question, ‘How hot is hot?’ or, ‘How greedy and courageous can stock buyers become?’
All historic measures of valuation will be ignored as this mighty third phase heads higher.”
While I don’t have 60 years of market experience under my belt like he does, I suspect that it is quite possible that we entered into the third phase of the bull market in 2013. Regardless, I agree that the markets are indeed going to be propelled higher in the months ahead as money chases momentum, and “greed” overtakes all logic.
While there will be money made during this last phase, it is important that if you can’t recognize when it has ended you will lose everything and more when the next reversion begins.
Have a great week.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at http://streettalklive.com/index.php/newsletter-disclaimer.html.
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