As regular readers know, I have a cautious outlook for the stock market these days.
I’m not predicting a crash, per se, but I would not be surprised if we saw one. Mostly, I think that from today’s levels, stocks are likely to deliver lousy returns for the next 7 or so years. I am holding onto my own stocks only because 1) I have a balanced portfolio and a long-enough investment horizon that I am comfortable with the possibility of stocks plunging, say, 50%, over the next year or two, and 2) the likely returns on bonds and cash are also lousy.
Over the last few months, when I have aired this view, it has been met with snickering and ridicule, because stocks were still going up. Now, stocks have begun to go down, so more observers are voicing concern. (Market views follow the market.) But, by and large, the recent ~4% drop off the peak is viewed as a buying opportunity, not the start of a bear market. Most people think stocks are soon going to blast off to the moon.
For what it’s worth, I have no idea whether the recent dip is the start of a bear market or whether stocks are going to blast off to the moon. I do know, though, that no one else knows, either. And I find the arguments that stocks are alarmingly expensive and vulnerable more persuasive and rigorous than the arguments suggesting that stocks are cheap and safe. I’m also not short stocks. I’m very long. I hope stocks continue to charge higher, but I just can’t find much valid data to suggest that they will.
- Every valid valuation measure I look at suggests that stocks are at least 40% overvalued (see charts below). Importantly, I am not just referring to the much derided “CAPE Ratio” popularised by Nobel Prize-winner Robert Shiller. The CAPE Ratio is almost certainly still valid, but it actually suggests that stocks are less overvalued than other measures. Even Warren Buffett’s favourite indicator suggests that stocks are very overvalued!
- Corporate profit margins are at record levels and look like they might finally be rolling over. America’s companies have never been this profitable before, and profit margins rarely stay at such extremes for long. Yes, some of this has to do with “mix” — we have a higher percentage of high-margin tech and finance companies than we used to — and some of it has to do with globalization. But even if you “normalize” for those things, profit margins are high.
- Lots of sentiment indicators are flashing warning signs (folks are just way too bullish). For example, last week, fund manager John Hussman noted that the average of advisory “bulls” vs. “bears” was a record 58% to 15%. And margin debt, the amount of money traders have borrowed to finance stock purchases on the NYSE, recently hit 2.5% of GDP.
None of this means that stocks will crash. But, the valuation data, at least, does suggest that, at best, stocks are likely to produce lousy returns over the next 10 years (0%-2% per year, including dividends).
And what are the arguments that these concerns are silly and that stocks will keep rising?
- Well, one of the big bullish arguments seems to be that “there’s no catalyst” for a crash or bear market. I don’t mean to be the bearer of bad news, but anyone who thinks we need a “catalyst” for a market break should brush up on their history. If it were possible to consistently identify “catalysts” for market changes ahead of time, everyone would identify them, and markets would adjust. To the extent that there ever are “catalysts” for market moves, they’re usually only obvious after the fact.
- Another bullish argument is that the economy’s getting better. Happily, this is true. The pace of that improvement still leaves much to be desired, however. And stocks don’t usually follow the economy. Rather, they lead the economy — and, particularly, profits. If our sluggish recovery ever stumbles, the stock market will see it long before everyone else does.
- Lastly, there’s a general sense that the financial crisis is finally over and that everything finally feels fine. Happily, this is also true. Alas, what things feel like today doesn’t tell you much about what they’ll feel like six months from now. When I was in Davos a couple of weeks ago, a brilliant CEO billionaire on a panel made exactly this observation — that the financial crisis is finally over and everything finally feels fine. Then, with a wink, another brilliant CEO billionaire on the panel chimed in with the money line: “Yes…. It feels just like 2007!”
Perhaps you have more persuasive arguments than these as to why I should reconsider my cautious view of the stock market and become extremely bullish. If so, please share them.
In the meantime, I’ll tell you more about my concerns.
For example, which valuation measures suggest the stock market is very overvalued?
These, among others:
- Cyclically adjusted price-earnings ratio (current P/E is 25X vs. 15X average — higher than any time in the past century with the exception of 1999-2000 and, very briefly, in 1929).
- Market cap to revenue (current ratio of 1.6 vs. 1.0 average).
- Market cap to GDP (double the pre-1990s norm).
(See charts below.)
And what about profit margins? Why are they important?
One of the reasons stocks have done so well over the past 5 years is that US companies have been able to hike their profit margins and profits every year, in part by firing people and replacing them with technology. The trouble with this is two-fold. First, it’s not a sustainable way to grow profits: Margins can’t go up for ever or eventually they’ll be more than revenue. Second, by firing employees, companies are putting the actual spenders in the economy out of work. As a result, too many American consumers are still broke. And consumer spending accounts for about 70% of the economy. So the collective short-term effort of companies to grow earnings by cutting costs is actually making it harder for companies to grow revenue.
Below, some charts with more details on why I am concerned …
The following three charts show three long-term, time-tested valuation measures, all of which suggest the market is drastically overvalued.
First, from Bill Hester of the Hussman Funds, a recent chart of Professor Robert Shiller’s “CAPE” (cyclically-adjusted PE ratio). The blue line shows the prediction for 10-year returns. The red line shows the actual returns. If you have heard people say, “CAPE doesn’t work anymore,” you might want to read Bill Hester’s analysis. He looks at all the arguments why CAPE doesn’t work and concludes that it does. (We’ll know for sure in 10 years.)
Second, in case you have been convinced that the “CAPE” ratio no longer works, here’s a look at price-to-revenue. This measure is calling for a slightly better long-term return for the S&P 500 — just under 5% — but still a far cry from the long-term average.
Third, in case your favourite bulls wave away both earnings and revenue, here’s a chart of market-value-to-GDP. It’s the most pessimistic of the lot. This chart suggests that the S&P 500’s average annual returns for the next 10 years will be negative.
2. A bogus (but popular!) valuation measure.
One thing that people do when stocks get expensive is to find ways to explain why they aren’t expensive. They don’t do this to hoodwink you. They do this because stocks have been expensive for so long that the obvious conclusion must be that they’re not expensive — that it’s different this time.
One measure that people are using right now to argue that stocks are not expensive is the difference between the “earnings yield” and “Treasury yield.” Interest rates are low and earnings are high, so it appears that stocks are delivering far higher “yields” than bonds and are therefore cheap.
The problem with this analysis is that it doesn’t work. Check out this chart below from John Hussman, which “backtests” the analysis. It doesn’t have any predictive power at all.
Over the long haul, stocks track profits. And profits and profit margins are at record highs. Every time previously that profit margins have gotten way above or below average, they have violently reverted to the mean. Many people, including me, think this will happen again this time. The only question is when.
Here’s a long-term look at profit margins. Note how high they are. Note what has happened every time this has been the case in the past.
Byron Wien, a strategist at Blackstone, is worried about profit margins. He also just circulated this chart, which he says suggests that profit margins are “rolling over.” This, he says, is bad news for earnings in 2014.
John Hussman is also worried about profits. He thinks profit margins are so out of whack that corporate earnings will decline at 10% per year for the next four years.
Hussman thinks that two things might cause profits to tank: 1) the decline of government deficits (which have been going directly into corporate coffers), and 2) increasing labour costs, as the labour market gets tighter. Hussman believes that these factors are already causing profits to miss estimates. This, Hussman suggests, may be why there are suddenly way more companies missing profit estimates than beating them:
Market timing is always tough, and I don’t know when profits and the market might break down. That really is anyone’s guess.
John Hussman has posted a fun technical chart that addresses this question, though. Technical analysis is generally bunk, and I would never bet a dime on it. But it’s also often fun. And this chart is especially fun.
This chart, a “log-periodic bubble” analysis, suggests that the S&P rise off the 2009 bottom has followed a clear “fractal” pattern that is often seen near the end of speculative advances. This chart suggests that the S&P 500 (blue) might hit 1900 before collapsing. (It peaked around 1,850). According to Hussman, the chart also suggests that the market will peak between December 31, 2013 and January 13, 2014 — e.g., a few weeks ago.
Again, none of these indicators mean that the market will crash, let alone when. And market timing is a dangerous and destructive investment strategy. But the valuation measures, at least, do suggest that long-term stock returns from these levels are likely to be lousy.
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