For six years, the macro trend has largely driven asset valuations and price multiples as investors have weathered crisis after crisis, from the burst of the housing bubble and the collateral damage to the financial system and leverage, all the way to the European Sovereign Debt Crisis, Tidal Waves, and the Fed Taper — all of which plagued investor sentiment. Last year, with macro risks abating, and the return of housing prices and sales, investors finally moved out along the risk curve – some even jumping into small-cap stocks where the majority of earnings are domestic. As we begin 2014 after a 422 rally in the S&P 500, with a trailing price-to-earnings ratio that has risen near 3 points in the last year, focus has shifted finally to the micro world of valuations and earnings. But don’t get too complacent about the macro, as there are a few catalysts that still abound that could capture attention once again.
Source: Bloomberg
The Federal Reserve Bank released the minutes of its December meeting yesterday. At first glance, the minutes were hawkish with a lot of talk about the efficacy of QE, as well as limited support from the various members to cut guidance on the unemployment threshold (currently 6.5%). One must first always note that the minutes are released to the public after the statement — 2-3 weeks later — and are used to justify the policy decision in more detail. As such, the Fed’s minutes for the September meeting were less hawkish as the Fed delayed the start of taper a while longer, while the Fed’s December minutes were hawkish as they finally justified why they began the taper. But the one item that stuck out the most was the following:
“Several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans” December 2013 Fed Minutes
The biggest road block to this market over the next couple of quarters — even from the Fed’s perspective — is rising valuations and risk appetites. That tends to happen when you have healthy expansion of the economy and falling macro risks. Of the many analyst forecasts and outlooks for 2014 that I’ve read, the two re-occurring themes are elevated valuations and better economic results to justify them ahead.
From some of the statistics I’ve seen on valuations, they’re not a very effective tool if used alone to raise or lower equity exposure. Goldman Sachs did a study on valuations and, according to their statistics from 1945-2013, the probability of a 10%+ gain, either at some point during the year or by year end, is much higher than the probability of a 10% loss in the highest 9th and 10th deciles. In English, the factors that keep valuations high will likely continue to support high valuations — unless the macro changes.
We have found that valuations tend to affect expected returns over the long-term. When valuations are high, expected returns are lower as opposed to what expected returns may be near low valuations. Again, in English, expect lower returns when valuations are high. But high valuations aren’t a sole reason to decrease equity exposure, especially when the economy and earnings are expanding.
Source: CrestmontResearch.com, “Secular Cycles”
Warren Buffet said, “Price is what you pay. Value is what you get.” So what is fair value and what is expensive? The historical average for the normalized P/E ratio is 16.3 which is based upon reported 10-year trailing real earnings – a method established by Robert Shiller at Yale. If you take out the outlier years of the late 1990s, that ratio is even smaller, near 15.5. So at 17.33 currently, the S&P 500 is overvalued, if your definition of overvalued is a P/E above the historical average. The more pertinent question now is: is 17.33 the top, and should we all go to cash? Historically speaking, 17.33 isn’t the upper band on valuations. See the chart below:
Two Parts of a Whole
Let us remember that price and earnings are two parts to the same ratio equation. So, now that we’ve looked at the ratio as a whole, let’s look at the two parts. Price is never debated; nobody ever argues over the price of the S&P index. The index is a sum of its weighted parts and what we get is what we get. The second part of the ratio is earnings. If the economy is expanding, then earnings should follow suit. It’s a simple idea that doesn’t take a lot of explanation. The correlation is high between the change in earnings and the business cycle as depicted below by the ISM’s manufacturing index. As my brother, Chris, showed last month, corporations are likely to see a pickup in sales and earnings heading into next year, as suggested by the ISM Manufacturing PMI, which tends to lead earnings growth for the S&P 500 by six months. He showed that the decline in the PMI that occurred from 2011-2013 ended last year with a sharp move to 57.3 — suggesting slow earnings growth should be a thing of the past and higher earnings growth a thing of the future.
Source: “The Time to Be Bearish Is When Breadth Is Weak, Which Clearly Isn’t Now” accessed January 9, 2013. Data source: Bloomberg
With all of the downgrades on valuations lately, it wouldn’t surprise me in the least to see the P/E ratio fall in the first quarter of 2014. Sentiment continues to be negative on the market despite what the Investment Surveys show (AAII shows 43.6% bullish and only 25.0% bearish for the week ending January 8th); I say this because primarily the members that vote on the AAII sentiment are “do-it-yourself” investors, as they put it, and only hedge funds and private investors got the market right. According to Bank of America and Merrill Lynch Client Flow Trends, January 7th 2014, institutional investors were net sellers of the market all year long and it looks like hedge fund managers are turning in their chips more recently.
Conclusion
The focus of analysts has turned from the macro to the micro, and the most important factor seems to be the topic of valuations. I’ve shown that valuations are above the historical mean, but that alone isn’t justification to make the long-term decision to get out of equities. Valuations can remain high or low for extended periods of time. Valuations are, however, a good determinant of expected returns over a long period of time. Better to begin investing when valuations are low than when high. And we’ve looked at charts to show us what is high.
There are two parts to the P/E ratio. I’ve shown there’s a high correlation between earnings and the change in the economy as viewed through the ISM Manufacturing PMI; however, there’s a lag of typically six months before results show up in earnings. As such, I expect to see the turn in the economy that we saw last year in housing and manufacturing, with the addition of cheap energy and falling commodity prices, to have a positive effect on earnings in 2014. Valuations will be made justified. Next week, I’ll take a look at the macro and possible areas of opportunity and/or risk. For right now, the macro will have to defer to investors’ thoughts on valuations.
