Bearish predictions of a market crash are largely hyperbolic, as we noted last week, but that doesn't mean investors shouldn't be concerned about valuations. In fact, there are obvious grounds for caution, with multiple signals indicating that the US stock market – by far the biggest in the world – faces years of sub-par returns.
Buffett indicator
US stock market capitalisation as a percentage of GDP,
Warren Buffett
once said, is “probably the best single measure of where valuations stand at any given moment”. Unfortunately for investors, the current picture is not a pretty one.
Total US market capitalisation stands at 124 per cent of GDP, the second-highest reading in history, bettered only by the 153 per cent reading in 2000, at the peak of the dotcom bubble. Roughly two standard deviations above historical norms, the current reading indicates a severely overvalued market, and is comfortably above the 112 per cent level recorded at the 2007 market high.
Bulls question the relevance of this ratio, noting that it has indicated some degree of overvaluation (above 100 per cent) for almost all of the past 18 years. Nevertheless, the sheer scale of today’s apparent overvaluation must give investors pause for thought.
Shiller’s Cape
Few valuation metrics have attracted as much debate as Nobel prizewinning economist Robert Shiller’s cyclically adjusted price-earnings ratio (Cape), which averages earnings over 10 years to smooth out the ups and downs of the business cycle.
The S&P 500’s current Cape of 25 is roughly 60 per cent above its long-term average of 16 and has only been exceeded on three occasions over the past century: in 1929, 2000 and 2007, all prior to market crashes.
Now, as we noted last week, Cape is not a market-timing indicator and does not indicate that a crash is imminent. However, it does suggest poor long-term returns, with Cape advocates warning that stocks will be hard-pressed to keep up with inflation over the next seven years.
Bulls object on multiple grounds. They say the Cape reading of the S&P 500 has been at overvalued levels for most of the past two decades; that it is less relevant than it once was, due to accounting changes; that US indices deserve a higher rating due to their sector make-up, particularly the importance of the high-margin technology sector; and that the 2008-09 earnings collapse distorted the current figure.
However, tweaking the Cape, whether by stripping out the aforementioned earnings collapse, or by looking at different accounts of corporate earnings, or by adjusting for the S&P 500’s sector make-up, only reduces the level of US overvaluation; it does not erase it.
If anything, warned award-winning analyst James Montier, of GMO, earlier this year, the current Cape reading is "quite possibly too optimistic". Nor is Shiller himself convinced by the bulls' counter-arguments, warning last month that while a high Cape reading can persist for years, it has historically reverted to historical norms.
“If the mood changes again,” he said, “stock market investments may disappoint us.”
International comparisons
US money manager
Mebane Faber
habitually cites the S&P 500’s high Cape reading as evidence that the US market is one of the most expensive in the world. What if Cape is wrong, as the bulls say?
“Fine, don’t use it,” says Faber. “Let’s substitute in dividends, book values and cash flows – three totally different metrics.”
Of 43 countries analysed, the US ranked 39th, 37th and 36th in terms of valuation. That is, multiple metrics that look at long-term valuations suggest the US is one of the priciest stock markets in the world.
Profit margins
US earnings are at record highs, despite a relatively muted economic recovery. It’s not that revenue growth has been exponential – the real driver of earnings growth has been soaring corporate profit margins. US company earnings account for around 11 per cent of GDP – an all-time high, and way above historical norms of around 6.5 per cent. Bulls say the upward trend in margins is sustainable, pointing to technological advances and the fact that US firms are deriving an increased percentage of their earnings from international markets, where corporation tax tends to be lower.
Bears think otherwise. Profit margins have always been volatile. They are, as GMO's Jeremy Grantham once put it, "probably the most mean-reverting series in finance", with competition ensuring that margins do not remain elevated for extended periods. Bulls say high valuation multiples are justified by the improving economy, which will drive corporate revenues. However, revenue growth alone will not be enough to catalyse strong earnings if margins begin to revert to historical norms. In other words, continued stock market gains appear to be dependent on corporate profit margins remaining near all-time highs.
Past market tops
How do current US valuations appear when compared to those that prevailed at past market tops?
Not well, as market commentator Mark Hulbert noted earlier this year. Examining 35 market tops since 1900, Hulbert looked at six indicators: the trailing price/earnings (P/E) ratio, Cape, dividend yield, price/sales ratio, price/book ratio, and the somewhat esoteric Q ratio devised by Nobel-winning economist James Tobin.
The current Cape and Q ratios are higher than almost all of the 35 previous peaks, while dividend yields have rarely been as low as today. A higher price/sales ratio was found on just two of the bull market tops since 1955, while the price/book ratio was below today’s levels in 23 of the 28 bull market tops since the 1920s. The S&P’s trailing P/E ratio is higher than 24 of the 35 aforementioned bull market tops. Stocks have, of course, advanced further since Hulbert’s analysis, so valuations will look even more stretched today.
Rotation time?
The fact that there are concerns over valuations and profit margins, of course, does not mean investors should dump stocks and move to cash. As the well-known investor Peter Lynch once said, more money has been lost by investors preparing for corrections than in the corrections themselves.
Current valuations are nowhere near as demanding as they were prior to the bursting of the technology bubble in 2000. And if companies do manage to grow earnings sufficiently, valuations may naturally settle into more reasonable levels.
However, US markets do appear highly valued relative to history, which is why cautious investors, such as Jeremy Grantham and Mebane Faber, recommend a rotation into less expensive markets.
The US accounts for 35 per cent of global stock market capitalisation, five times that of the next biggest market. Faber argues that investors should over-weight cheap stock markets – he especially likes European market valuations – rather than merely tracking global indices. He gives the example of Japan, which accounted for almost half of global stock market capitalisation in 1989. The Nikkei tanked over the next 20 years, hitting the returns of investors who allocated half of their portfolio to Japan.
Similarly, Grantham says investors can “patch together global equities and get a semi-respectable-looking portfolio”.
Wary of bonds (“nerve-rackingly overpriced”), emerging stock markets offer the best value, according to Grantham’s latest seven-year forecast. Additionally, he likes value stocks in Europe as well as high-quality stocks in the US. In real terms, however, Grantham reckons US large-cap and small-cap stocks are likely to be money-losers over the next seven years.
