Stock markets have displayed a remarkable lack of volatility so far this year. Trump’s election and the promise of healthcare, tax, and immigration reform played a part in boosting the confidence of investors, but the advent of a more normal, self-sustaining business cycle greatly reinforced the willingness to take more market risks. As a result, stocks have made a series of new highs throughout the summer, driven by three factors.
First, global economies are enjoying a synchronized upturn for the first time in over a decade, with Europe, Asia, and the US putting together consistent growth numbers for several quarters in a row. Second, liquidity is still plentiful, providing the necessary fuel (cash) for the bull market to continue. While the US Federal Reserve stopped their “quantitative easing” (QE) program in late 2014, the QE efforts of Europe and Japan are still running at full tilt, and thus injecting billions of dollars a month into the global financial system.
Finally, there are the twin factors of TINA and FOMO. TINA, or “there is no alternative,” has led investors away from bonds, money market funds, and other safe havens to the stock market, in the belief that those low-yielding sectors provide no alternative to the returns from stocks. FOMO stands for “fear of missing out” and reflects the competitive nature of the investment management industry and their single-minded obsession with performance. Rather than miss out on the rally, investment managers have thrown caution to the wind in order to keep up with the well-known indexes, and in fact explains a large part of the immense popularity of passive, index-based investing today.
But all this good news belies a hard truth, which is that stocks have now reached an overvalued extreme. The chart above, available at www.DShort.com, has appeared many times in the Market Outlook. It is a composite of four different valuation metrics, and seeks to measure how far away we are from the average historical readings of valuation. Unfortunately, there is no single accepted way to measure value in stocks. These four yardsticks, however, are traditional approaches to market valuation, (mostly) unpolluted by modern accounting trickery. Thus, a major advantage to this approach is that the readings can be calculated back 117 years, to 1900.
We want to point out a very important observation: today’s valuations have now reached the second highest levels in the 117 year history of this measure. It is now second only to the all-time, blowout high extreme reached in 1999-2000. It is flashing a warning for all to see, and we recommend investors not ignore this slow-moving, but very real, measure of risk.
Valuation indicators aren’t very useful as short-term signals of market direction. Periods of over- and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present, today’s high market overvaluation continues to suggest a cautious long-term outlook and tempered expectations of future returns. However, with today’s low annualized inflation rate and the extremely poor yields on fixed income investments (Treasuries, CDs, etc.) the appeal of stocks, despite overvaluation risk, is not surprising.
Points of ‘secular’ undervaluation such as 1922, 1932, 1949, 1974 and 1982 typically occurred about 50% below historical mean valuations, and were associated with subsequent 10-year nominal total returns approaching 20% annually. By contrast, valuations similar to 1929, 1965 and 2000 were followed by weak or negative total returns over the following decade. That’s the range where we find ourselves today.
Each of those years of peak valuation have become infamous in Wall Street history, as they became synonyms for the major bear markets that followed. 1929 was legendary, and 2000 will not be forgotten by anyone who lived through it. With valuation now at the second highest level in history, will 2017 or 2018 become another “infamous year?” More importantly, what investor has the courage (or naiveté) to ignore the message that valuation is now sending?
Of course, underlying the stock market rally over the last eight years have been the aggressive efforts of central banks worldwide to stave off deflation and boost asset prices. Ironically, the Fed has publicly voiced puzzlement over the lack of consumer price inflation despite lots of monetary stimulus since 2008. They are looking in the wrong place. Inflation is present in the economy, but it is in asset prices. Most of the money created by the central banks has found its way into the markets, and if the stock valuation chart is any indication, there is a sort of hyperinflation taking hold.
Just like in the dark days of the 1970s, the inflation of asset prices is leading to a misallocation of resources and an underestimation of the level of risks in the market. In the 1970s, there was a wholesale movement into hard assets such as real estate, gold, and oil, and away from paper assets such as stocks and bonds. Today, the misallocation of resources comes about as funds that were historically fixed income buyers (e.g. pension plans), have been forced by low bond yields to move into assets such as stocks and real estate, increasing their risk profiles at the very time they should be reducing it. The lack of a meaningful correction in these riskier assets has led to an underestimation of risk, wherein the longer we go without a correction the less likely it is assumed one will occur.
A key change to the last eight years of monetary policy is that the Fed has clearly begun to implement its program to shrink its balance sheet, and slowly reverse QE. This has come to be called “quantitative tightening,” or QT, and was discussed in the August Market Outlook. We believe this will have a dampening effect on the stock rally, as the plentiful liquidity of past years becomes constrained. This will not happen immediately, but with valuation levels at the second highest levels on record, it raises the risk profile of the markets.
Currently, it is hard to appreciate the risk in the markets, as new highs have become commonplace and money continues to flow into index funds, perpetuating a virtuous cycle of cash fueling demand for stocks, which in turn pushes stocks higher and draws in more cash. This was also the case in the late stages of the bull markets ending in 2000 and 2008, when the lack of any tangible risk led to a dangerous complacency among investors. We think this cycle is no different, and will also surprise many when the correction comes. The catalyst for a correction, and its timing, is unknown. It could be military confrontation with North Korea or simply rising interest rates. But with valuations so high and the Federal Reserve committed to QT, we may be looking at another “infamous year” in the not too distant future.
Stock market bulls have a lot of evidence on their side, which makes our worries about valuation seem misplaced. But valuation concerns always seem out of place, and even old fashioned, in the midst of a bull market. Remember the “old” vs. “new” economy rationalizations during the Internet bubble of the late 1990s? We are witnessing something similar today as the attitudes of TINA and FOMO have become pervasive.
Market breadth, momentum, and basic economic and earnings growth are all supportive of stock prices, even at these high valuation levels. The NYSE advance/decline line, for instance, has been on a steady march upward, indicating that liquidity is plentiful. The number of stocks making new highs has started to climb again after a period of flatness during the summer. All these indications argue for the idea that valuations can stay at these high extremes for a while, maybe even a year or more. Therefore, it is important to look at the behavior of securities themselves for clues about the future.
One of the best indicators of what “is” happening, rather than what “should” be happening, is the NYSE Bullish %. The bullish % measures the percentage of stocks on buy signals, using the point-and-figure charting method. This method gives easily defined buy or sell signals, thus making it easy to calculate the percentage of stocks in a given index (e.g. the NYSE) on buy signals. In a bull market, the percentage on buy signals will rise, and that is what is happening today, lending credence to the bullish case. Once this measure turns down, gives a sell, and fails to maintain its upward trend, then investors can begin take more defensive action in their portfolios. But for the moment, despite our misgivings about valuation, the bull appears to be alive and kicking.
We believe the best interests of clients are served by learning the lessons of history. High valuations historically have been followed by low future returns, so to expect high returns based on today’s valuation levels, we have to believe that the old standards of financial behavior no longer apply. Should we be willing to make that bet with client monies? Is it time to chase returns, or learn from history to do what is in clients’ best interests? Today’s level of valuation means we should prepare for another infamous year in the not too distant future.