“To be clear, ‘valuation’ is an opinion.”
Admittedly while quoting Keith in this forum can come off as a tad ostentatious, that phrase from yesterday’s Early Look really resonated with me. I think about valuation all the time – most specifically ways in which I can succinctly and effectively explain why it has such a diminutive role in our tactical asset allocation process.
I’ve gotten better at it over the years, but not without learning from a number of very thoughtful investors in the process:
- “Valuation is not a catalyst.” – Keith McCullough
- “Valuation is not a catalyst, but when a catalyst occurs valuation really matters.” – long-time Hedgeye client
- “Never express yourself more clearly than you think.” – Niels Bohr
The last quote comes from one of the greatest physicists the world has ever seen and was Bloomberg’s Quote of the Day yesterday. While it doesn’t explicitly pertain to valuation, I do find that it adds value to this discussion.
Specifically, when investors cite their valuation opinions on a particular market, they use words and phrases like “cheap”, “expensive”, “fair value”, “rich”, “bombed out”, etc. It’s a really clear and succinct way to express one’s views on the underlying fundamentals.
But that’s just it – valuation is a powerful reasoning tool only if you’ve done the associated fundamental analysis and have a differentiated view from other investors based on your research.
Take Hedgeye energy analyst Kevin Kaiser for example; his seminal work on Kinder Morgan or Linn Energy started and ended with his belief that the companies didn’t generate enough cash to cover their respective distributions. The likelihood of meaningful distribution cuts rendered these stocks grossly overvalued on relevant industry metrics.
These stocks didn’t get hammered (LinnCo. actually went bankrupt) because they were suddenly “expensive”; they got hammered because there were catalysts to perpetuate material downside – catalysts that were only foreseeable by someone who did the work.
Back to the Global Macro Grind…
Is the U.S. equity market “cheap” or “expensive”? What is your process for obtaining an accurate answer to that question? Have you done “the work” on the 30 stocks in the DOW? What about all 500 stocks in the S&P? Doing the work on all 2000 constituents in the Russell is a beast; may I suggest copious amounts of Red Bull.
I’m obviously being a bit facetious here to prove a point – which is that the way in which investors “value” the $26 trillion U.S. [public] equity market contains substantially less analytical rigor than what would be expected of them for any of the securities underpinning said market. At best, such characterizations are intellectually lazy; at worst, they are intellectually dishonest.
Take, for example, the Old Wall dog and pony show of generating a cockamamie EPS forecast for the S&P 500 and suggesting the market is “cheap” or “expensive” (usually “cheap” of course) on said number.
How is it even plausible for an analyst or team of analysts to come up with accurate EPS forecasts for that many stocks? Perhaps these firms have fantastic people and the best models; who knows? All I know is that we can’t for the life of us replicate such magic here at Hedgeye.
Another example that’s increasingly found its way into our inboxes is Yale professor Robert Shiller’s Cyclically Adjusted Price-to-Earnings Ratio – commonly referred to as the CAPE Ratio. From my vantage point as a macro strategist, Professor Shiller’s methodology for determining the valuation of the U.S. equity market is ripe with analytical rigor. That being said, however, its application by investors and financial journalists is typically far less thoughtful.
When an investor says to us something like, “the market is expensive on CAPE” or “no bull market has ever commenced from a CAPE this high”, we always concede their point with little-to-no pushback. Instead, we typically reply with questions. What are the associated investment implications? Is the market going to crash tomorrow?
That’s typically where the conversation morphs into what said investor is doing with their own capital, rather than what their previous statement implies for the U.S. equity market as a whole. That’s totally fine and we get it, but anyone striving for greatness (and the alpha associated with it) needs to be able to quantify statements like that.
We have. Currently the S&P 500 Index has a CAPE Ratio of 28.26. That’s in the 96th percentile of all readings (dating back to January 1881). If you concentrate on the trailing 30-year time period – which is arguably far more relevant than readings 100+ years ago – its 83rd percentile reading is still elevated, though not by as much.
Indeed, the CAPE Ratio itself has been on a “permanently high plateau” since the mid-80s – probably as a result of a combination of factors (e.g. falling interest rates and business cycle volatility, increased information, globalization, foreign “savings glut”, increased retirement savings due to demographic tailwinds, etc. etc.).
Empirically speaking, percentile readings between the ninth and tenth decile have not necessarily been catastrophic for market performance. Specifically, the average returns on a 1-year, 3-year and 5-year forward basis are +2.3%, +1.9% and -2.7%, respectively, and said returns are positive 55%, 40% and 25% of the time.
As l like to say in meetings, “mean reverting data sets rarely spend a ton of time at their average; rather, the mean is typically a function of the data oscillating from one extreme to the other”. At this current extreme CAPE Ratio, the expected value, or probability-weighted average, of buying the S&P 500 today is +1.2%, -3.8% and -5.3% on a 1-year, 3-year and 5-year forward basis, respectively.
As the Chart of the Day below shows, these outcomes aren’t good given that they pale in comparison to lower decile CAPE Ratios. That said, however, they don’t necessarily imply one needs to sell everything today.
Specifically, the top ten 1-year forward returns of CAPE Ratio readings between the ninth and tenth decile carry a whopping average of +34.8%! That figure drops to +30.2% for the top 20 and +21.3% for the top 50. Over the last 30 years, the average of the top ten 1-year forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%. Can you afford to miss a +31% move to the upside in your benchmark?
All told, these statistics would seem to suggest that pinpointing where we are in the economic cycle and identifying catalysts to perpetuate a continuation or a reversal of the existing trend(s) are far more important tasks than trying to identify what valuation the stock market is. Being too early is the same thing as being flat-out wrong in PnL terms.
Click on the following hyperlinks to download our full analysis of Professor Shiller’s CAPE Ratio data:
- Arithmetic Average Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile
- Expected Value of Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile
- Positive Hit Rate of Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile
- Arithmetic Average Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile (trailing 30 years)
- Expected Value of Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile (trailing 30 years)
- Positive Hit Rate of Nominal S&P 500 Return Based on Starting Value of CAPE Ratio by Decile (trailing 30 years)
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.37-2.64% (bullish)
SPX 2 (bullish)
VIX 10.99-13.85 (neutral)
EUR/USD 1.03-1.05 (bearish)
YEN 113.31-119.41 (bearish)
Oil (WTI) 50.30-54.11 (bullish)
Gold 1118-1157 (bearish)
Keep your head on a swivel,