Cart (0)
business newsThe Outlook for Equities
By
Minyanville Staff Jan 28, 2010 8:15 am
The view from the top points to something potentially bigger than the correction we've had since March.
PRINT
Editor's Note: This article was written by Damien Cleusix (damien (at) www.clue6.com). It is the fourth part of a five-part series on Global Tactical Asset Allocation. To read the first part, click here; the second part, click here, the third part, click here; and the fifth part, click here.
Valuations -- A Repeat
Valuations aren't useful for short-term market projections but are essential in forecasting long-term returns. They become informative in the shorter term when they reach extremes. When they're very high one shouldn't allow the other indicators in one’s arsenal to deteriorate too much before pushing the exit button, the reverse is true when they reach very low levels.
The perpetual question is what constitutes high and low and which valuation ratios to look at. I look at normalized price-to-earning ratios (normalized using a trailing reported-earnings moving average, average margins, or peak earnings) and price-to-book value. I like to look at a historical data set as long as possible. It's also important to consider the quality of the data. One often hears that valuations should be higher because the markets are less risky.
I disagree.
Main Street has clearly been less volatile in the past 30 years (well up to now), as has inflation. The consequence is that companies have increased their leverage dramatically. In the process, earnings volatility has increased rapidly in the past 10 years (Chart 1). From the mid-50s to the mid-80s, real annual earnings were rising or falling by 3.8% for every percent change in annual real GDP growth. In the past 10 years it was 22%.
This has been aggravated by a substantial deterioration of the assets where:
1. Intangibles have become legion in some countries (Table 1) (ask a bondholder of a bankrupt high-intangibles company what intangibles are worth). Goldman Sachs has calculated that the S&P 500 constituents asset/equity ex-goodwill has risen from 2.5 in the '80s to 4.4 today.
2. Financial assets have proportionally increased.
3. Assets' mark-to-market increase their pro-cyclicality.
In brief, as often repeated in the past, I think markets should be valued at lower levels, not higher levels than historically.
Thus it isn't surprising that AAA and AA bonds represented almost 60% of the Barclays Capital Investment Grade Index at the end of the '70s while they only represent 25% today.
Investors attach a lot of importance to what happens to earnings on the very short-term while they have a very negligible influence on the intrinsic value of the markets. Indeed, even if earnings were to be 0 in the next two years, this wouldn't affect the intrinsic market value derived by a dividends or cash flows discount model by more than a few percentage points. Remember that markets are a claim on a very long-term stream of cash flows.
What moves market valuation around fair value in the short-term is investors’ risk appetite. This is what I analyze extensively in the Sentiment, Breadth, Liquidity, Seasonality, and Cycle section of our presentations.
In the long-term, I believe that the main driver of long-term generational fluctuation in valuation ratios from very undervalued to very overvalued is the reallocation of the stock of wealth (as demonstrated by J. Tobin more than 40 years ago). One can see this phenomenon in action looking at the Saver/Spender ratio or Middle to Young cohort (Chart 2).
This is the ratio of the population aged 40-49 years to 20-29 years (I'll show graphs for other markets later). For the US I think the time for the next structural bull market to start will be the low made between 2014 and 2016 (with a preference for 2014).
As I've said in the past 10 years, this doesn't mean there won’t be cyclical bull markets in between.
In the past I've showed that during structural bull markets the market rises about 85% of the time, while in structural bear markets it rises approximately 65% of the time.
So where do we stand now?
Valuations
For longer-term return projections (seven years), I use a methodology similar to Grantham, Mayo, Van Otterlo & Co, so let’s use their graphs (Chart 3 and 4) showing their estimated seven-years forward performance for the various categories if they trade at the average valuation normalized to average margin in seven years.
Another indicator I look at is the Value Line Median Appreciation Potential, which P.Bernstein used in his valuation estimation of the market. It's the median price appreciation potential estimated by Value Line of all the 1,700 stocks they cover for the following three to five years. It fell below 60%, which is at the bottom-end of its history -- one should start accumulating stocks when it rises above 100%.
High-quality stocks' expected return has declined by more than 2% to 9.6%. This is where we still would be greatly overweight.
As I'll show in the next few pages, I think there's a non-negligible risk (it's a risk identified and not a prediction) that the markets will make the bottom at levels up to 50% below where the markets are now.
In 2000 I said that the S&P 500 would fall below 500 before the next structural bull market could start, I still believe that this is a potential outcome but I would add 5% to 6% a year to this objective going forward (would be a combination of extension and time for the correction i.e. the longer it takes the lower the required decline).
But I also know that timing the exact bottom is impossible so we'll automatically increase our recommended allocation on declines once we fall below 700-750 on the S&P 500 and we see breadth extremes without regard to the trend. The allocation will be increased along price declines, exactly as we did in March of this year.
One needs a plan to stick to in an environment like this. We'll also limit the extent to which we take net short positions the closer we are to what we consider rock-bottom valuations.
We have shown that the concept of book value has changed in the last 15 years (Table 1 earlier).
This is especially true for the US and Europe.
In 2007, in our effort to convince clients of the overvaluation of the market, we presented data demonstrating that balance sheets had experienced a radical mutation in the past 25 years. Not only did we see a decline of the importance of the tangible assets, those were now dominated by financial assets whose pro-cyclicality was masking the potential problems and over-leveraging.
We understand that in a service economy tangible assets aren't as important as when manufacturing dominated (see the proportion of tangible assets in emerging economies on table 3), but once more, ask yourself what intangibles are worth in a bankruptcy.
On the various charts the semi-transparent area represents time when the market was cheaper than today on a book value per share basis.
A cursory look at the graphs confirm that valuations aren't as attractive as they were just six months ago.
Valuations -- A Repeat
Valuations aren't useful for short-term market projections but are essential in forecasting long-term returns. They become informative in the shorter term when they reach extremes. When they're very high one shouldn't allow the other indicators in one’s arsenal to deteriorate too much before pushing the exit button, the reverse is true when they reach very low levels.
The perpetual question is what constitutes high and low and which valuation ratios to look at. I look at normalized price-to-earning ratios (normalized using a trailing reported-earnings moving average, average margins, or peak earnings) and price-to-book value. I like to look at a historical data set as long as possible. It's also important to consider the quality of the data. One often hears that valuations should be higher because the markets are less risky.
I disagree.
Main Street has clearly been less volatile in the past 30 years (well up to now), as has inflation. The consequence is that companies have increased their leverage dramatically. In the process, earnings volatility has increased rapidly in the past 10 years (Chart 1). From the mid-50s to the mid-80s, real annual earnings were rising or falling by 3.8% for every percent change in annual real GDP growth. In the past 10 years it was 22%.
This has been aggravated by a substantial deterioration of the assets where:
1. Intangibles have become legion in some countries (Table 1) (ask a bondholder of a bankrupt high-intangibles company what intangibles are worth). Goldman Sachs has calculated that the S&P 500 constituents asset/equity ex-goodwill has risen from 2.5 in the '80s to 4.4 today.
2. Financial assets have proportionally increased.
3. Assets' mark-to-market increase their pro-cyclicality.
In brief, as often repeated in the past, I think markets should be valued at lower levels, not higher levels than historically.
Thus it isn't surprising that AAA and AA bonds represented almost 60% of the Barclays Capital Investment Grade Index at the end of the '70s while they only represent 25% today.
Investors attach a lot of importance to what happens to earnings on the very short-term while they have a very negligible influence on the intrinsic value of the markets. Indeed, even if earnings were to be 0 in the next two years, this wouldn't affect the intrinsic market value derived by a dividends or cash flows discount model by more than a few percentage points. Remember that markets are a claim on a very long-term stream of cash flows. What moves market valuation around fair value in the short-term is investors’ risk appetite. This is what I analyze extensively in the Sentiment, Breadth, Liquidity, Seasonality, and Cycle section of our presentations.
In the long-term, I believe that the main driver of long-term generational fluctuation in valuation ratios from very undervalued to very overvalued is the reallocation of the stock of wealth (as demonstrated by J. Tobin more than 40 years ago). One can see this phenomenon in action looking at the Saver/Spender ratio or Middle to Young cohort (Chart 2).
This is the ratio of the population aged 40-49 years to 20-29 years (I'll show graphs for other markets later). For the US I think the time for the next structural bull market to start will be the low made between 2014 and 2016 (with a preference for 2014).
As I've said in the past 10 years, this doesn't mean there won’t be cyclical bull markets in between.
In the past I've showed that during structural bull markets the market rises about 85% of the time, while in structural bear markets it rises approximately 65% of the time.
So where do we stand now?
Valuations
For longer-term return projections (seven years), I use a methodology similar to Grantham, Mayo, Van Otterlo & Co, so let’s use their graphs (Chart 3 and 4) showing their estimated seven-years forward performance for the various categories if they trade at the average valuation normalized to average margin in seven years.
Another indicator I look at is the Value Line Median Appreciation Potential, which P.Bernstein used in his valuation estimation of the market. It's the median price appreciation potential estimated by Value Line of all the 1,700 stocks they cover for the following three to five years. It fell below 60%, which is at the bottom-end of its history -- one should start accumulating stocks when it rises above 100%.
High-quality stocks' expected return has declined by more than 2% to 9.6%. This is where we still would be greatly overweight.
As I'll show in the next few pages, I think there's a non-negligible risk (it's a risk identified and not a prediction) that the markets will make the bottom at levels up to 50% below where the markets are now.
In 2000 I said that the S&P 500 would fall below 500 before the next structural bull market could start, I still believe that this is a potential outcome but I would add 5% to 6% a year to this objective going forward (would be a combination of extension and time for the correction i.e. the longer it takes the lower the required decline).
But I also know that timing the exact bottom is impossible so we'll automatically increase our recommended allocation on declines once we fall below 700-750 on the S&P 500 and we see breadth extremes without regard to the trend. The allocation will be increased along price declines, exactly as we did in March of this year.
One needs a plan to stick to in an environment like this. We'll also limit the extent to which we take net short positions the closer we are to what we consider rock-bottom valuations. We have shown that the concept of book value has changed in the last 15 years (Table 1 earlier).
This is especially true for the US and Europe.
In 2007, in our effort to convince clients of the overvaluation of the market, we presented data demonstrating that balance sheets had experienced a radical mutation in the past 25 years. Not only did we see a decline of the importance of the tangible assets, those were now dominated by financial assets whose pro-cyclicality was masking the potential problems and over-leveraging.
We understand that in a service economy tangible assets aren't as important as when manufacturing dominated (see the proportion of tangible assets in emerging economies on table 3), but once more, ask yourself what intangibles are worth in a bankruptcy.
On the various charts the semi-transparent area represents time when the market was cheaper than today on a book value per share basis.
A cursory look at the graphs confirm that valuations aren't as attractive as they were just six months ago.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
