At which point do rising interest rates spark the fire? Rates are key to the equation of risk. In Friday’s On My Radar, Steve surveys what the current equity market valuations tell us about risk… and likely forward returns. Should you be playing more offense than defense or more defense than offense? Valuations can help.
READ MOREMonthly Valuation Update
Every month, Steve reviews several market valuation metrics in an effort to provide visibility into forward 7-, 10-, and 12-year returns. In this week’s On My Radar, Steve looks at Median P/E and also shares GMO’s 7-Year Asset Class Real Return Forecasts. It’s a must-read!
READ MOREMarket Valuation & Forward Returns Update
In the May 5th issue of On My Radar, Steve Blumenthal provides his popular survey of current market valuation and 10-year forward returns forecast.
First, Steve offers a quick primer on valuation and price-to-earnings (P/E) in layman’s terms. Most investors (and even some financial advisors) don’t understand valuation methodologies and how median P/E works and what it tells us.
Steve presents a number of informative charts that advisors can use in their own valuation work and to discuss valuation and forward returns with their clients.
In sum, the broad market (i.e., S&P 500) remains very expensive and overvalued according to several metrics and 10-year forward returns are likely to be muted (0%-3% before inflation). Steve says, “We clearly find ourselves today in a high valuation and low potential forward return environment.” Click below to access the charts and Steve’s analysis!
ON MY RADARCharts of the Week
This week we offer several charts concerning inflation, interest rates, U.S. economic recoveries, equity market performance and equity mutual fund flows.
This chart plots U.S. economic recoveries. Note the blue line. Debt’s a major drag:
Source: Crestmont Research
Keep an eye on inflation (rising):
Year-over-year change in CPI – look at the January numbers in the far right of the chart. The most recent BLS – Bureau of Labor Statistics Annualized Inflation Rate year-over-year equals 2.5%. The Fed’s target has been reached:
Source: Advisor Perspectives
And if you were wondering what inflation looks like by category:
Source: dshort.com
Source: dshort.com
Here is the current probability of a Fed March interest rate hike:
Switching to equities, Ned Davis Research has something they call “Top Watch Indicators”… meaning indicators that help them spot a probable market top.
Here’s how you view the next chart:
- When the green bars in the lower section rise above the horizontal dotted line (50), a market top is indicated.
- The vertical dotted lines and shaded area indicates the times that more than 50% of their top watch indicators signaled a market top.
- Percentage declines are indicated.
- Green bar on the far right shows where we are as of 2-14-17.
Source: Ned Davis Research
Chalk one little dot up for the active fund managers. All the money has been flowing into passive index funds and ETFs:
And all that money that chased into “high dividend papers?” In a few short months, they’ve given up six years of excess returns. I continue to be cautious on high dividend stocks due to over popularity, low interest rates and the risk of rising rates.
Diversification has been under pressure the last few years. The average university endowment lost 1.90% in 2016. However, it is best viewed over the long term and designed to achieve a certain return relative to an acceptable amount of risk. 100% allocation to stocks is for a different investor risk profile. Not wise to compare one asset class to a diversified investment plan. With that said, in case you were wondering… this is how the 10 richest universities invested their money in 2016:
Real Implications of Reduced Pension Fund Returns
Last week, the investment staff of CalPERS — the $300 billion California pension fund — announced that they want to reduce its target of 7.5 percent annual returns. According to Chief Investment Officer Ted Eliopoulos, achieving a 7.5 percent annual return is no longer realistic. Holy cow!
The implications of this proposal, if adopted, are significant and “would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.”
Can you imagine how many people are going to be affected? Here’s the bottom line. The pension system, across our great nation, is underfunded and in trouble.
READ MOREPaul Tudor Jones’ 200-Day Moving Average Rule
Paul Tudor Jones is one of the greatest traders of all time. Jones’ firm, Tudor Investment Corporation, manages about $13 billion across multiple strategies.
Jones says, “The whole trick in investing is: ‘How do I keep from losing everything?’” To which, he said he would advise investors to “to get out of anything that falls below the 200-day moving average.” Visually, it looks something like this:
Source: dshort.com.
Here’s a trend following idea for you to consider. In the next chart, the black line is the simple 200-day moving average line. The red dotted line is the 50-day shorter-term moving average line. Both are a way of showing us the current price trend. When the 50-day trend line moves above the longer 200-day trend line, the overall trend is bullish. When below, it is bearish.
Since 1929, 65.98% of the time, the market trend was bullish and returns highest. Likewise, the data since 2006 shows similar results. The return figures are the percentage annualized gain per year. The yellow highlight shows the regime we are in today. The trend by this measure is currently bullish.
Monthly Market Valuation Review
Early each month, we look at market valuations to see where we are. It’s also important to consider what valuations may indicate with respect to probable (7- and 10-year) forward returns. We believe risk is most when we feel it least and the risk is least when we feel it most. Today, we feel it least.
In Friday’s On My Radar, we presented several valuation charts, including median price-to-earnings (P/E) and Warren Buffett’s favorite.
Bottom line: the market remains overvalued. Trend following strategies can help you participate and protect.
The Quest for Yield
Yields are at 5,000-year lows.
71% of the world’s government bonds are yielding less than 1%. 33% yield less than 0%. In a picture it looks like this:
Source: Bloomberg; JPMorgan Asset Management, BofA Merrill Lynch
Risk is being overlooked in HY bonds. Yields on high yield debt are close to the same yields on less risky loans. The chase for yield has driven investors to riskier asset classes.
I am anticipating a once-in-a-generation buying opportunity in HY bonds. While the trend this week is up, continue to invest with the trend. Move to the safety of cash or Treasury Bills when the trend crosses down.
Click below for a great chart showing what a 1% increase in interest rates does to bond prices. Show it to your clients!
READ MOREMarket Valuations Remain Excessively High, Probable Forward Returns to be Muted
Regular readers know that I favor the median price/earnings (P/E) ratio to assess broad market valuation. Median P/E tends to remove common one-off accounting gimmicks. However, by almost any valuation methodology, the market is overvalued and probable forward returns will be lower.
As of September 30, the median P/E of the S&P 500 Index was 23.3 (with the S&P 500 at 2,168.27).
- 1,576.33 = Current Fair Value (this number is based on a 52.6-year median P/E of 16.9)
- 2,057.69 = Overvalued (the S&P 500 was at 2,168.27 on 9-30-2016, so it is at a level of more than 5% above what is considered overvalued)
- 1,092.81 = Undervalued is at 1,092.81 (a crisis event might get us there)
What does this tell us about returns over the coming 10 years?
READ MORE
The current opinions and forecasts expressed herein are solely those of Steve Blumenthal and are subject to change. They do not necessarily represent the opinions of CMG. CMG’s trading strategies are quantitative and may hold a position that at any given time does not reflect Steve’s forecasts. Steve’s opinions and forecasts may not actually come to pass. Information on this site should not be used as a recommendation to buy or sell any investment product or strategy.
Current High Valuations Suggest Low 10-Year Returns for Stocks
Both professional and individual investors must recognize the relationship between risk and reward (i.e., returns). Indeed, as fiduciaries, investment advisers are duty-bound to protect their clients’ interests and elevate them above their own. We’ve been writing for some time that current market valuations are very high and, when the market is at these excessive levels, returns are typically reduced.
On August 31, the S&P 500 median price-to-earnings (P/E) ratio was 23.7. (Think of “median P/E” (which is based on actual, reported earnings and current share price) as the middle P/E (250 stocks have a lower P/E and 250 have a higher P/E).)
I’ve shared the chart above previously. It shows that returns are highest when the market is most favorably priced (low median P/Es) and lowest when the market is least favorable priced (high median P/Es). We are in Quintile 5 today. The next chart shows that not only were returns lowest when P/Es are high, like they are today, the risk is actually the highest.
In fact, some investment managers, are further lowering forward return expectations for equities. GMO recently revised its real return forecast for large-cap equities to -3.2% from -1.9.
For charts, analysis, and commentary, see the rest of the story in On My Radar: Why? Because We Need the Eggs
The current opinions and forecasts expressed herein are solely those of Steve Blumenthal and are subject to change. They do not represent the opinions of CMG. CMGs trading strategies are quantitative and may hold a position that at any given time does not reflect Steve’s forecasts. Steve’s opinions and forecasts may not actually come to pass. Information on this site should not be used as a recommendation to buy or sell any investment product or strategy.