Tsunami etc.

Yes, it's a tsunami. Tsunami of liquidity. A fiscal tsunami. Both at the same time. People seem baffled at the strength of the stock market; they keep saying the market is 'divorced from economic reality' and things like that. Others say this is a big bubble waiting to implode. 

I don't mean to argue that the market is always right or anything like that, but the market is reacting to some massive, massive stimulus and liquidity injection. Some of that is bound to leak into the stock market. As I said earlier about  Covid-19, this is forcing governments around the world to try to offset the negative effects of the virus. And as usual, they are going to overdo it. And this, in turn, will lead potentially to a really massive bubble. 

As of now, with S&P 500 forward P/E of 23, or whatever they say, it doesn't really seem all that bubblish. Too, the median P/E ratio of S&P 500 companies on a forward basis is around 18.5x vs. a 15.2x average since 1982, I think. So that is not that crazy looking either, given much lower interest rates now than most of this time period. 

 

People say the S&P 500 forward P/E is as high as it was back in 1999/2000, but don't forget, interest rates were a lot higher back then. Also, the median P/E is much lower than that, which is again, just like 1999/2000. And if you remember 1999/2000, if you didn't own the bubble stocks, you actually did really well throughout the 2000-2002 bear market. It is very possible that this will happen again. Many of the frothy names can have large declines, maybe the S&P 500 index even goes down 50% or more, and people who didn't own the most expensive stocks might actually still do well. So, don't let people scare you out of the market with this talk of market P/E's. If you are happy with what you own and how they are valued, hold on and things should be fine (like it was in 1999/2000). 

This rickety house can symbolize a highly levered equity fund vulnerable to a bear market, but when I saw this picture, the first thing I thought of was all the shorts being steam-rolled by this tsunami (or simultaneous tsunamis). 

Greenblatt and Marks

Anyway, I wouldn't necessarily put this in a category of good news; some would say this is really bad news. But a recent Howard Marks note talked about all the reasons why current market valuations might be reasonable; that the current tech companies leading the market actually has really good, strong business models. Also, Joel Greenblatt was on Bloomberg TV the other day saying we are not in a bubble like 1999/2000 for the same reason; that the recent market leaders have real business models and are really good businesses that might actually deserve high valuations.

 

While not pointing to any individual names, I have been thinking the same thing over the years.

Buffett, Gold and JPM

So, as usual, the financial media is going crazy over the fact that Buffett bought ABX. Most of them didn't even mention that this could be a Ted or Todd pick and not a Buffett pick. Also, he dumped a bunch of JPM, which is actually kind of surprising. Not sure what is going on there. Maybe it's a valuation play as BAC is cheaper. I think Dimon is a much better CEO than Moynihan (who hasn't really been tested yet, whereas Dimon has been through many crises). Maybe BAC has a longer runway as Dimon has health issues. I don't know. Maybe he is a lot more worried about this pandemic than most of us. 

 

Market

Anyway, back to the market. So yes, it's kind of acting contrary to the expectations of many, but not really. If you look at the market leaders, they are really doing well earnings-wise. Sure, this may be a one-time bump for some of these names, but for the most part, Covid-19 is only accelerating what was going to happen anyway (move to cloud, retailers dying off etc...). So there is nothing wrong with being in companies who have been enjoying a tailwind for years and then suddenly gets a big gust from behind. 

As for consumption, as Dimon said, some unemployed, I think he said 60%+, were making even more money from the $600/week assistance than they were making when employed. So that explains the consumption figures. Of course, this is not sustainable forever (new plan hasn't been passed yet as of now). 

I have been spending more time recently looking at things to do due to the extraordinary nature of the what is happening, but I have to say nothing is really jumping out at me. 

I am tempted, of course, to jump into airlines, hotels, real estate, energy, anything travel-related and some other areas hit hard, but nothing is really jumping out at me. If you like any of these businesses and believe in them for the long term and are fairly sure they will survive this crisis without too much dilution, then it's a great idea to buy. 

But the problem is that most of the above businesses are not in areas I would have been interested in pre-crisis. So if I got into any of them now, they would just be 'trades'. I would get in, hold until normalization, and then get out. They would not be situations where I would want to buy and hold forever. So that makes me a little hesitant. 

 

 

Election Stuff

There is a lot of uncertainty about the elections. But as usual, I would say, look back at all the other times we were worried about something. We should never forget 2016 election day. What about the fiscal cliff? All sorts of problems, uncertainties over the years. 

 

So, as usual, I would just say ignore it all. I don't want to talk about politics here as there is plenty of other places to talk about it, and I don't think I have anything to add to what everybody is saying anyway. 

 

But I would say that whatever people worry about, I wouldn't worry too much about it. Whether it's pharmaceutical stocks when Clinton got elected, insurance companies with Obama, financial stocks when Elizabeth Warren was looking good etc. Whenever you have big moves on those worries, as traders, it's actually probably a good idea to trade against it. 

 

Books

I am reading this new book about GE, Lights Out, and it is terrifying. I'm only 1/3 way through it but it sort of confirms what we suspected all along, but at least for me, it's a lot worse than I thought.  

If you always wondered why Buffett always spoke so highly of Immelt and GE but never bought stock (other than emergency financial crisis financing), this would help explain it. I've always wanted to love GE, and it was always on my to-do list to do a detailed analysis of GE and even buy some shares at some point, but it never got to that point because of Immelt. He came across to me as this rah-rah cheerleading type; the kind of manager I would not want to put money with. And his denials and lies throughout the crisis was worrisome too (I didn't realize how much he was lying, though...)

And Immelt apparently still blames Welch, but jeez, the guy ran the place (into the ground) over 16 years; that's enough time to fix things, and many of the big moves / mistakes were his own. It's like a 40 year old man blaming his parents for his behavior.

I am still looking at it and wanting to jump in, but it is quite scary.

Long Book Excerpt

So, during this pandemic, I have been reading a lot as usual, and I started reading an old book that I am embarrassed to say I've never read before. 

Paths to Wealth Through Common Stocks

This is a Philip Fisher book. I think Philip Fisher is sort of underrated compared to Benjamin Graham. Everyone (including me) always talks about Security Analysis and Intelligent Investor, but not everyone talks about Common Stocks and Uncommon Profits or this book. 

That's probably for a good reason. First of all, Graham was the first in setting the ground rules of value investing so comprehensively. But on the other hand, I feel that Fisher has had more of an impact on Buffett (and he admits it) than even many Buffett followers realize. Buffett is still referred to as a 'value' investor, and 'value' is still viewed as things with low P/E ratios and P/B ratios. But Buffett has for decades been saying that he would much rather pay a fair price for a decent business than a good price for a mediocre business (OK, I totally butchered that one, but I'm a little rusty, you see...). 

Anyway, I was reading it and this whole section made me jump out of my seat as I immediately thought of quite a few people I would need to send this book to:

The Economists Go out -- The Psychologists Come In

    I have already commented on the strange tendency of the supposedly forward-looking financial community so often to fail to recognize a changed set of circumstances until the new influence has been in existence for years. I believe this is why the man who attempted to forecast the course of general business was regarded as so important a factor in the making of investment decisions during all of the 1940's and much of the 1950's. Even today, a surprising number of both investors and professional investment men still believe that the heart of a wise investment policy is to obtain the best business forecast you can. If the outlook is one of expanding business, then buy. If the outlook is for a decline, sell.

    Many years ago there was probably considerably more merit to such a policy than there could possibly be today. The banking structure was weaker. There was no assurance it would be shored up by the government in times of real trouble -- a process bound to produce a massive dose of inflation. There was no tax system of a type that can hardly fail to produce strong inflationary spending whenever business (and therefore federal tax revenues) are at abnormally low levels. No public opinion had crystallized to assure that whenever business levels dipped sharply, the government would take strong countermeasures to stem the tide. Finally, the industrial base was much more narrow. The large number of industries in today's complex economy that bear little relationship to each other in their basic characteristics probably assures that even without the actions of government, modern business recession would be somewhat less severe than its former counterpart. Some industries would be enjoying unusual background conditions enabling them to expand, while the majority might be in a declining phase. This tends somewhat to stabilize the economy as a whole.

    All this means that a depression is of less significance to the investor than it was many years ago. It does not mean knowing what business is going to do would not be quite useful information to have. But having such information is not vital for obtaining magnificent results from common stock investments. Simple arithmetic should show this. When a stock market decline coincides with a fairly sizable economic slump as happened in 1937 to 1938 or 1957 to 1958, most stocks sell off from 35 to 50 percent. The better ones then recover when the slump ends and usually go on to new high levels. Even in the greatest slump of all time, only a small percentage of all companies failed, that is, went down 100 per cent. Most of these companies were companies which had had fantastic amounts of debt and senior securities placed ahead of their common. After one of the wildest speculative booms ever known, much of it financed by borrowed money, the average stock slumped 80 or 90 per cent. In contrast, when stocks rise over a period of years, even the most casual study of stock market history shows many figures of a very much greater order of magnitude. Compared to the temporary declines, usually of 35 to 50 per cent, that frequently accompany depressions, the outstanding stocks (those of the unusually well-run companies that have maneuvered themselves into growth fields) go up several hundred per cent, stay at these levels, and then go still higher. Many can be found for which a decade's progress can be measured in multiples of 1000 per cent rather than 100 per cent. 

...

    From the standpoint of obtaining results, I have noticed that investors who place heavy emphasis on economic forecasts in the making of investment decisions usually fall into one of two main groups. Those who are inclined to be cautious by nature can nearly always find an impressive sounding forecast that for quite plausible and persuasive reasons makes it appear that important economic difficulties lie ahead for the business community. Therefore, they seldom take advantage of opportunities when they present themselves and, on balance, these missed opportunities mean the economic forecasts have done them considerable harm. The other group are the perpetual optimists who can always find a favorable forecast to satisfy them. Since they always decide to go ahead with whatever action they are considering, it is hard to see how all the time they spend on business forecasting does much good. 

    More and more investors are coming to recognize the wisdom of making their decisions about common stocks largely on the basis of such outright business factors as appraisal of the quality of the management and the growth potential of the individual company's product line. These things both can be measured with a fair degree of preciseness and have a far greater influence on how good a long-range investment will be... 

This book was published in 1960, and it is amazing as it still applies to this day; there are still people who think that predicting the economy accurately will lead to superior investment results. 

So...
Anyway, this is a fascinating time to be living in. This pandemic is really terrible and I hope we at least find some sort of treatment to take death off the table. I feel this is the key to normalization rather than vaccines. Of course, a vaccine would be great, but it is probably unrealistic to expect one to come within a year. If we can figure out how to treat the worst cases, and this treatment becomes widely available, this would sort of turn Covid-19 into something like the flu.

But who knows, really. 

As for stocks, there is certainly a lot of trading opportunities, but for us long term investors, I would stick to things that have secular growth potential. I don't really feel that excited about buying the dip on something in a long term downtrend. Not to say those can't be great trades. I would rather buy the dip on things in long term uptrends. If things are in secular downtrends but got a bump up due to this, then that's probably a great time to sell.

As for the market, it may seem like it's crazy, but keep in mind the amount of stimulus and liquidity injected into the system. It's not just lower interest rates. Also, people keep talking about overoptimism about the virus, but if you look at hotels, airlines etc., the market is clearly not all that optimistic about anything returning to normal any time soon.

Also, keep in mind that a lot of the big winners this year are making a lot of money; revenues are growing at incredible rates, profits etc. Other than the cloud players, look at COST, WMT, TGT etc. What is happening is that the smaller operators are suffering. Fast food is taking share away from the independent restaurants. As those are closed, if you want to eat out, you have fewer choices so you end up at CMG or QSR (Popeye's). A lot of the eating out money is moving to eating at home (groceries, again, COST, WMT, TGT etc...). 

 

If airline and hotel stocks were making new highs, then I would think the market is nuts. But that's not what's happening. You have to sort of look under the hood to see what's going on, but of course, that's too much work for most! I get it. 

Also, a lot of the revenues / profits that were not listed (small, mom-and-pop restaurants / stores) are moving to listed companies; as independents go under, the only ones left standing are the big ones, and often those are listed companies.

So there is a lot about this market that does make sense. This is not to say the market is always right, or that the valuations of each of these businesses at this point is correct. I am just pointing out that it may not be as crazy as some suggest. Airlines and hotels, REITS are down, and they are down big. Cloud players, stay-at-home beneficiaries are up big. What is so crazy about that? I don't know. 

Also, I think there has been a lot of tech adoption from the never-adopters. I see all these posts about kids teaching their grandparents how to use a tablet, how to get on a Zoom call with family, how to chat on FB, Line, or how to use email. People (many of them seniors) who only used land-line phones and didn't know how to turn on their TV (well, I have trouble with that too with so many remotes and buttons...) are chatting with their kids / grandkids on Skype on their tablets. They are learning how to order things online. 

A lot of this will be permanent. When things clear, many of these newbies will keep using their new devices and will continue to shop in their new ways. Not all of them, of course, and maybe not as often as right now. But this has caused an increase in this market for sure.

 

As for all the talk about how things will never go back to the way it was, that people will never go to conventions ever again, and that client visits will never happen again as Zoom calls work just as well, and offices will decline as people get used to working from home, I think, is rubbish. People always extrapolate what they see. Sure, it may take some time to get back to normal, but things will get back to normal, eventually. 

 

Surely there will be some permanent changes for the better, utilizing things we have learned during this time, and that's great. But I wouldn't expect a lot of this stuff to be permanent by any means. 

 

Bubble Yet?

Bubblicious?
People still speak of bubbles a lot, bubble in the bond market, stock market, unicorns etc. But I still don't really see a bubble except in certain areas of technology. Otherwise, things seem to be in a normal range to me, except interest rates. They do seem a bit low, but having said that, I still see 4% as a decent 'normalized' long term rate for the U.S. (as I have said here before many times).

The Valuation Sanity Check shows the Dow trading at 20.6x current and 16.4x forward P/E,  and the Berkshire portfolio (largest holdings) trading at 17.4x and 14.3x their current and forward earnings. Browsing down that page, there is nothing really alarming about anything, really. Some things look expensive, but nothing insane.

Also, here are some charts I plucked off the internet. The first bunch is from the JP Morgan Asset Management's Guide to the Markets. This is a nice report that they put out every quarter, and is fun to flip through. 

These charts too show nothing really crazy.

I keep hearing people talk about how crazy it is that the market is up 20% this year, but given that a lot of that is recovering from losses last year, it doesn't sound crazy to me.

Also, people keep saying that the returns of the last 10 years suggests the market is overvalued. But again, given that the much of the returns is recovering from the financial crisis bear market, I think it's irrelevant. If the market had double digit returns over 10 years from a market high, then I would be more inclined to agree; something bad might be about to happen.

But this is clearly not the case here. In fact, from the October 2007 high, the market has gone up less than 6%/year (excluding dividends), and 3.4%/year since the 2000 peak. This is hardly the long term performance figures you see in a real bubble.

I won't look for them, but look at the similar figures for the 2000 peak, Nikkei 1989 peak etc. It is very different from today.

S&P 500 Index Forward P/E Ratio

The above forward P/E chart shows a normal range, nothing alarming. Of course, people will argue that the market has been consistently overvalued for the past 25 years so this is not indicative of anything. But interest rates are a lot lower now than in the past too, and this chart doesn't show any abnormally high P/E level due to lower rates. I suppose one can argue about the validity of EPS estimates a year out. That is certainly a valid point.

Forward P/E and Future Returns

This X-Y plot of forward P/E ratio versus future returns show potential returns solidly in the positive. I did something similar using Shiller's CAPE ratio and found similar results.

One year forward returns based on P/E

My analysis goes back to 1985, so is longer term than the JPM study (which goes back to 1994), but hasn't been updated (a couple of years shouldn't make a difference!).

MSCI World vs. S&P 500 Index

These charts show nothing extraordinary either. Yes, the U.S. market is doing really well versus the rest of the world. But who cares, right? Unless you are some sort of mean-reversion trader, it's not really relevant. I too tend to like investing in U.S. businesses, mostly because I live here and have access to all the filings, conference calls and things like that, and I do feel U.S. companies are more responsive to shareholders and the system works better (compared to Japan, for example, where I have very little faith that managements care about shareholders).

Median P/E Ratio
And here's something I found. The S&P 500 is market-cap weighted, so the index P/E ratio tends to be influenced by the large cap stocks. When you have a bunch of large caps that are overvalued, it tends to push up the P/E ratio of the whole index.

To get a more 'typical' P/E ratio of the random stock, a median P/E can be more useful, as half the companies would be more expensive, and half would be cheaper than this level.

I found this chart in Yardeni's September report: Yardeni P/E report

Here's the median forward P/E ratio:

Again, nothing spectacular here. Looking at this (and the other charts), if someone is net short the market, you would have to examine their brains. Why would anyone be net short in a market like this? It doesn't really make sense to me.

Just flip through these charts again, and imagine you are the head of the trading desk at a hedge fund or bank somewhere. And say some guy is massively net short the market. You ask him why he is so short, and he tells you that it's because the market is way overvalued. What would you say? Would you feel comfortable going home and sleeping well? Of course, this trader may contribute to reducing the overall exposure of your desk, but don't think of it that way as you can always adjust your market exposure with futures.

If you think of it this way, it's sort of insane.

The other non-bubble thing is that you don't hear people talking about the market at all. Usually, in a real bubble, people really like to talk about the stock market in situations where that is not normal. A couple of years ago, everyone was talking about bitcoin. I don't hear much about that anymore these days.

Also, the news flow is so negative these days, whether it be Brexit, Trump tweet, U.S./China trade, Iran... Wherever you look, it's just bad, scary news. And yes, the market responds by going down, but it comes right back up. This is not to say that the market will always come back up. We will have a bear market at some point.

But if you are net short and all these 'favorable' developments to your position is not making you money, that's kind of a serious problem.  What happens when any of these things resolves itself? What if we do get a blowoff that has happened in most other bubble tops (2007 top was not really a bubble in terms of valuations, so bear markets can happen from normal valuations too).

Value-Growth Gap
The other thing is the huge gap between growth and value stocks. I am not that big a fan of this as the division seems arbitrary and kind of meaningless. But what is encouraging is that despite this slightly higher valuation of the overall market, the gap between value and growth seems to suggest that one can avoid a lot of pain by being more in the value area than growth.

Back in 2000 when the market was actually really overvalued, value investors did fine despite a 50% drop in the S&P 500 index as the drop was driven mostly by expensive companies going down in valuation. I think value stocks actually went up back then.

This may be true this time around too.

Market Timing
Most of us value investors don't believe in market timing at all. It is so amusing to watch the market go down 200 pts (or more) on a tweet only to reverse itself within a day or two by another tweet. Why anyone would trade based on this stuff is beyond me. I am a believer that headlines almost never mark turning points in the market. If the market is making a new high and then plunges on some negative headline, you can bet that that high will not be a high of any significance. I have seen various attempts over the years to analyze peaks and troughs in the market and matching it with news headlines; there usually is no headline that marked the top or bottom of a market.

It's just silly to try to figure out when the next bear market will happen.

There is one thing, though, that I would watch out for. If the U.S. market goes into a situation like the Japanese stock market in 1989, then I would obviously react. I would definitely lighten up equity holdings (still on a case-by-case basis based on valuations, of course) and maybe even consider buying puts, going short or whatever (OK, maybe not as I watched many bears lose a lot of money in 1998-2000 period only for them to be proven right but already having lost too much money made no money on the decline).

In any case, it would be a valuation call; I would lighten up when I can't accept the valuation levels. And it would be by each individual holding, not some vague notion about the directions of the overall market or economy.

Japanification of Markets?
The other worry is the Japanification of global markets. We were all baffled by the low interest rates in Japan for decades, and here we are with multiple countries and trillions of dollars in debt trading with negative interest rates.

Many commentators thought it won't happen here, and yet here we are with long term rates under 2%.

What about the stock market? Can the U.S. go into a bear market like Japan's that lasts 30 years? This sort of thing worries me too a little. We can't say it won't ever happen here as we were wrong about interest rates. Well, I've actually been in the camp of "lower for longer" so am not really all that surprised by how low our interest rates are.

But it would not be fun if the market went into a 30-year bear market.

Here's why I don't think it would happen, at least any time soon:

• The Japanese market went up to 60-80x P/E at the time. That sort of valuation takes decades to grow out of, and it's that much harder when there is no growth! We are nowhere near that kind of valuation. 
• The Japanese government and companies spent most of the time since then hiding things rather than fixing them. When the U.S. had a credit crisis, banks were encouraged to raise capital and fix their problems, not hide them. 
• Regulations are meant to maintain the status quo, protect large companies (who are contributors to the LDP) etc.
• In Japan, companies are discouraged from right-sizing. They run under a system the Canon CEO, Fujio Mitarai, calls corporate socialism. He says that since the Japanese government doesn't offer much of a social safety net, that burden falls to large corporations; they are strongly discouraged from firing employees. This is why there is a word for this category of employee: madogiwazoku (google it!). Here's an article about it: Boredom Room. It's no surprise that the stock market has been dead for so long with so many zombie employees at zombie companies. This is very different than in the U.S.

There are many other problems, but those are just some big ones off the top of my head... You may think of better reasons why Japan has been stuck for so long.

None of these are true in the U.S. That doesn't mean we can't go into a 30-year bear market, of course. But it just seems to me that it is not likely at the moment.

Hard Left Turn in Politics?
Others worry about the progressive left; Leon Cooperman joked the other day that if Elizabeth Warren gets elected, the market won't open. I understand that fear, and as a big fan of JP Morgan, I totally get it.

I am actually pretty progressive myself (I used to be conservative but have been moving left over time), but I wouldn't worry about this at all.

First of all, we really have no idea what's going to happen. We don't even know who is going to be the democratic candidate; it's possible that someone else not even running now will come up out of nowhere (well, not sure if that's possible, actually, but we still have a long time to go).

We do know that Warren is as progressive as she presents herself, so this may not apply, but it's possible that she runs hard left to take Sanders' and other voters only to run back towards the middle if she wins the nomination.

We don't know what she can accomplish even if elected, right? This is a president, not a dictator. Did FDR or Kennedy destroy the country? I haven't looked at the market action around their elections, but I don't really think there is a big, visible dent or bend in the long term charts based on who was president.

So this is certainly a risk factor, but my guess is that things, as usual, will not turn out the way we expect even if Warren wins the election. It's a complex model and things aren't going to be so easy to predict.

Buffett on Valuation

Buffett was on CNBC the other day and it was very interesting as usual. Well, most of what he says is not new.

Not in Bubble Territory
Anyway, he was asked about the stock market and since so many people keep saying that the stock market is overvalued or that it's in a bubble, I found it interesting that he says that, "we are not in a bubble territory or anything of the sort now."

He said that:

• it's a "terrible mistake if you stay out of a game because you think you can pick a better time to enter it...", or something like that. He's been saying the same thing for years. 
• if interest rates were 7 or 8%, prices will look "exceptionally high", but that measured against interest rates, stocks actually are on the cheap side.
• if interest rates stayed at 2.30% over the next ten years, "you would regret not owning stocks".
• we have to measure against interest rates.  Interest rates acts as gravity for valuations.
• compared the long bond to an entity trading at 40x earnings with no growth and said stocks are attractive compared to that. 

This agrees with the charts/analysis I've been posting here relating P/E ratios with interest rates.

I know  there are quants who say this is wrong, that P/E ratios can't be compared to interest rates (we discussed this in the comments section of one of my posts about P/E's). I understand that argument, but history shows that the market does in fact use interest rates to value the stock market however theoretically wrong it may be, and the greatest investor of all time does so too.

What if?
OK, many commentators and pundits are baffled at this huge rally in the stock market thinking it's insane and taking the market to extreme valuations.  I have been posting here for a while that the valuations aren't all that extreme given the interest rate environment, even if you assume interest rates go up a lot from here.

Well, Buffett says if rates get up to 7-8%, then stocks are really expensive. But will rates get up that high? Even though I'm not an economist and have no idea what interest rates will do (actually there is no relationship between the two), I tend to believe that interests rates will get to 4-5% at most, on average.

So, let's play a simple what if game. This is not a prediction or anything, just a scenario that sounds plausible and is not at all a stretch.

What if GDP growth is stuck, more or less, at the 2% level?  Maybe Trump gets it up to 3%, but a lot of people don't think that is possible (except Jamie Dimon who thinks we can go much higher in terms of growth). And let's say that inflation does tend towards the 2% level.  That gets us to a nominal GDP growth of 4% or so over time.

Let's also assume that long term rates do revert to the level of nominal GDP growth.  Then long term rates would get to 4%. Of course, there will be overshoots in both inflation, GDP growth and interest rates. But over time, it's not hard to imagine interest rates averaging 4%. Total debt levels, demographics etc. make it hard to imagine higher nominal GDP growth.

So using the earnings yield-bond yield model, let's assume that the earnings yield tracks closely to the long term interest rate of 4%.  That means, over time, that the P/E ratio can average 25x in this environment.

Right now, 25x P/E ratio just seems super-expensive to many people because they look at the past 100 years and the stock market hasn't stayed at the 25x level for very long and has more often signaled a major market top than anything else.

But given the above scenario, it's not really inconceivable that the market P/E gets up to this level for an extended period of time. Some will argue that Japan has had lower interest rates and has been unable to sustain a high P/E ratio, but Japan has a lot of problems at the micro level too (companies not allowed to cut costs in their system of "corporate socialism" where large corporations are expected by the government to carry the burden of unproductive, unnecessary workers).


S&P 500 at 3250, DJIA at 29,000
The consensus EPS estimate for the S&P 500 index is $130. OK, I know that this will come down throughout the year, but that's what we have now so let's just use it. I'm not making a prediction or anything, just conducting a simple thought experiment.

Using the above, future average P/E of 25x, that would put the S&P 500 index at 3250!.  Using the same percentage increase, that would take the DJIA to 29,000!

Believe me, that sounds just as stupid to me as it does to you. I'm just making simple assumptions and plugging in numbers. My own personal experience (anchoring?), however, makes these figures hard to swallow.

But you see, it doesn't take much for the market to get up so high, and I am using a 4% interest rate, not 2.3%! So a large increase in interest rates is already built in.

Sure, inflation can get out of control and rates can go higher. I am just trying to figure out a long term, stable-state, through-the-cycle sort of scenario, and 4% rates and 25x P/E ratio just seems normal in that sense.  OK, so we can expand that to 5% rates and 20x PE; so let's just say rates can get to 4-5% and P/E ratios to 20-25x without it being stretched in any way.

Again, this sounds crazy and sort of feels like 'new era' thinking and Irving Fisher's "permanently high plateau". I know. Every time I make a post like this, I feel like I am putting in the top. But this doesn't feel like justifying anything new. In fact, I am insisting that things will go back to the way they always were; P/E ratios will be driven by interest rates, interest rates will be determined by nominal GDP growth rate etc.

I'm not making any outrageous assumptions like real GDP growing 4%/year or earnings growing 15%/year into perpetuity or anything like that.

And keep in mind that in this scenario, this is just the future 'average'. The markets can get much higher than 25x P/E in a manic phase and much lower in times of panic.

In fact, this has already been happening. The stock market has been overvalued in the eyes of many since the 1990's and hasn't reverted back to 'normal' levels in a long time. I think the error is that many look at raw P/E's and don't account for interest rates.

Not to be Bullish
And by the way, I have been saying this sort of thing over the past few years not because I am bullish; I am actually an agnostic (but bullish over the long term). I say this stuff to counter a lot of the "market is overvalued so it must go down!" argument and to caution people (and myself) to stay the course and act rationally.

Some funds claim to use a lot of sophisticated models and they write great reports, but at the end of the day, they are just net short the market (and have been for years!). That's just gambling; betting all their client's money on a single trade. Crazy.

Trust me, I get the same queasy feeling you do when I type 25x P/E. I honestly don't know what I would do with the S&P 500 index at 3000.  I know I would be very uncomfortable (if it happened within the next year or two).

So I'm not really being a Pollyanna.

When considering this stuff, it becomes less of a mystery why Buffett would spend $20 billion buying stocks since the election (or including some buys just before). And it becomes a big mystery why anyone would want to be net short this market (unless you are a short term trader who will be in and out as markets rally, like some hedge funds do etc...).

Sanity Check
And by the way, when all this talk of high P/E's make you nervous, just go check out my valuation sanity check page at the Brooklyn Investor website. This is updated after the close every day.

    Sanity Check

I often look here to make sure I am not seeing the trees looking like the Nifty Fifty.  When I see 20x or 30x P/E ratios on the S&P 500 index, I look at individual stocks to see if I see the same thing. If I do, maybe I worry. If I don't, I don't worry at all and assume the high market P/E is due to large cap, speculative names trading at high P/E's and/or hard-hit industries dragging down the 'E', or some of both.

Speaking of the Nifty Fifty, in the Bogle book I mentioned here the other day (Bogle book), he mentions a Jeremy Siegel study that showed that 50 nifty stocks bought at the start of 1971, near the peak, marginally outperformed the market over the subsequent 25 years.  Nifty Fifty returned 12.4%/year versus 11.7%/year for the stock market.

That's kind of crazy.  Even if you bought the Nifty Fifty at near the top, you would've beaten the market over the next 25 years, returning an above average 12.4%/year. By average, I mean the market returned 10%/year in the past 100 years or so.

Pzena Q4 Commentary
Pzena Investments posted their Q4 commentary and it follows up on their theme of the value cycle, and it is very interesting.

Check it out here.

Anyway, it shows that value has started to outperform again but that we are still early in the value cycle. Check out the tables and charts below.

I thought that was really interesting and I tend to agree with it. As much as I agree with Bogle and Buffett about indexing, there does seem to be a big, extended move in that direction which would have impact on valuations of individual securities, so it seems to make sense that maybe individual stock pickers can start beating indexes again (but don't bet on many being able to do so).

I still have a lot to say (or at least think about) in terms of fund managers, but that will have to be in a future post.

Bonds Down, Stocks Up!

So bonds are 'crashing' and stocks are going up. Some say that this can't continue; you can't have stocks and bonds go in opposite directions for long before something snaps. Well, this is true to some extent.

But it sort of depends on which way the 'snap' is happening.  What if bonds were way overvalued versus stocks? In that case, bonds can tank a lot before stocks have to correct. Bears have been saying forever that once the bond market turns and interest rates start to go up, the stock market will crash.

Maybe so.

Let's take a step back and look at what's going on. How can bonds go down and stocks go up?

Here is a look at the earnings yield versus 10-year bond yields since 1871.  The data is from Shiller's website:

S&P 500 Earnings Yield versus 10-year Bond Yield
(1871-November 2016)

Earnings yield and bond yields have sort of tracked each other closely since the 1960's or so. Recently, bond yields went down a lot while earnings yield refused to follow it down. This spread is sort of a cushion for the stock market. Since the spread is so wide, it's not unnatural for both of them to go in opposite directions.

Here is a close-up of this chart from 1950. You can see that that bond yield and earnings yield do sort of track each other, and there is a cushion between them so rising bond yields at the moment do not pose an imminent threat to stock valuations.

S&P 500 Earnings Yield versus 10-year Bond Yield

(1950-November 2016)

Back in 1987 and 2000, for example, bond yields were higher than earnings yield. Back in 1987 before the crash, this spread blew out from 1.3% in December 1986 to 4.4% in September 1987.  That was the rubber-band stretch that caused the market to 'snap' (Black Monday) back into normalcy.

In January 2000, the gap also blew out to 3.3% from less than 1% after the Asian Contagion of 1997.

Here is the spread between bond yields and earnings yields since 1950:

Bond Yield - Earnings Yield

(1950-November 2016)

...and here's a close-up since 1980:

Bond Yield - Earnings Yield

(1980-November 2016)

You can see that pre-Black-Monday-spike in the spread in 1987. Just because the spread is wide doesn't mean a correction is coming, of course. The spread widened many times since 1980.

Nor does it mean that the market can't correct or crash when this is negative. In fact, the spread was negative before the financial crisis in 2007.  That spike you see in the spread chart above actually happened in 2009 when earnings plummeted.

But it is sort of a big-picture-rubber-band indicator. A correction in bonds doesn't automatically mean we must correct in stocks.  One way to look at it may be that if the spread widens too much above zero, it's a warning sign.  We are far from that at this point. 

P/E's Too High

And since I keep hearing, and have kept hearing for years and years that the stock market P/E is too high so therefore must crash or correct, I created this chart to show how meaningless the comment about P/E ratios are when looked at alone.

From the above, we can sort of see that earnings yields and bond yields track each other.  I know many people argue that this Fed model is no good. OK, so maybe it's no good, whatever that means. But you can't really separate the risk free interest rate from asset valuations. Whether you want to use 2.3% to discount long term assets or not is another issue. But over time, of course the treasury rate is going to be a huge factor in determining asset prices.

So, instead of looking at yields, I just drew the same charts as above but using a P/E ratio.  Instead of a bond yield, I created the bond P/E ratio (inverse of yield).

Check it out:

S&P 500 P/E versus 10-year Bond P/E

(1871-November 2016)

...and here's a close up:

S&P 500 P/E versus 10-year Bond P/E

(1950-November 2016)

So you see how bonds are way more overvalued than stocks.  Well, actually, I really don't know if bonds are overvalued or not. In order to know that, I would have to know what future inflation and economic growth is going to be, and I don't know that.

I am always baffled at comments like, "The market has averaged a P/E ratio of 14x for the last 100 years so the stock market is 40% overvalued at 20x...".

How can you compare 14x P/E to the current level without discussing interest rates?  And if you think stocks should trade at 14x P/E today, then you should also think that interest rates should be much higher than they are now. For example, the 10-year bond rate averaged 4.6% since 1871 and 5.8% since 1950. But these periods include a time when interest rates were not set by the market.

OK. So far, we have determined that the bond market rout up to now is no cause for concern for the stock market. Yields of 2.3% is still way below earnings yield.

So What Should 10-year Treasuries Yield?
Obviously, this is the next question. I am no economist so I actually have no idea, but one idea I have always liked is that someone said that long term interest rates should be equal to real GDP growth rate plus the inflation rate, or more simply, nominal GDP growth. This sort of makes sense.

So below is a chart of nominal GDP growth versus the 10-year bond yield. The data is from the FRED (St. Louis Fed) website.

Nominal GDP Growth versus 10-year Treasury Rate

(1930-2015)

Not so bad tracking. Here's a close-up from 1950:

Nominal GDP Growth versus 10-year Treasury Rate

(1950-2015)

So not bad.

From this chart, you can see that the bond market is in fact overvalued, even with a yield of more than 2%. Either that, or the market is expecting nominal GDP growth of only 2.3% or so as of now. As usual, we don't know who is right.

I read a quote of Jeffrey Gundlach of Doubleline saying that he thinks long term rates can get up to 6% in a few years. I don't know if he was referring to the 10-year or 30-year. But who looks at the 30-year anyway, right?

But for yields to get to 6%, Gundlach must be expecting much higher inflation. Real GDP is probably not going to grow that much more than 2%.  Maybe 3%.  But if it does grow 3%, we only need 3% inflation to get to a 6% bond yield.  OK. Maybe that's possible.

So should we be worried about 6% long term rates?

Here is a snip from my Scary Chart post from this summer. 

1955-2014:

            Interest rate range           average P/E

                   4 - 6%                             23.3x
                   6 - 8%                             19.6x 

I looked at the data from 1955-2014 (adding one more year to update this isn't going to change much) to see what the average P/E ratios were when interest rates were in certain ranges.

From the above, we see that the market traded at an average P/E of 23.3x when interest rates were between 4% and 6%.  The 10-year now is at 2.3%.  So we have a long, long way to go for interest rates to threaten the stock market, at least in terms of the bond-yield/earnings-yield model.

Even if rates got up to the 6-8% range, the average P/E has been 20x P/E, or where the stock market is now on a current year basis.

So even if interest rates popped up to 6-8%, the stock market has no need for a valuation adjustment.

Of course, the market can still react negatively to big moves in the bond market, and of course, higher interest rates will impact earnings of companies with debt. This may be offset by a stronger economy if that's what leads to higher rates, not to mention higher earnings at banks and other financials that have been suffering under this low rate environment. It's always tough to model this stuff out.

As we have seen recently with the election, nobody really knows what's going to happen. And even when things are predicted correctly, the market reaction tends to surprise.

From the above blog post, here is a regression analysis of bond yields versus earnings yields. The 1980-2007 period seems overfit for sure; it's a period when stock yields and bond yields tracked each other very closely. I think I used the excuse that post-2007, we have been living in a post-crisis environment of unnaturally low interest rates.

So you can reject that regression as not valid.

Here is the original post when I looked at the relationship between bond yields and earnings yields:
scatterplot.

Again, keep in mind that long term rates after the post-election 'plunge' is 2.3%. The above regression shows that even at 4%  bond yields, almost double the current level, the market tends to trade at anywhere from 19x to 31x P/E.

Conclusion
So bond prices have tanked and the stock market doesn't care at this point. Bears say this can't go on and that overvalued stocks will follow bonds down soon.

The above shows that

• The recent plunge in bonds is a rubber band snapping back (bonds way overvalued versus stocks) and not a rubber band stretching that will eventually snap (like the bond crash before Black Monday).
• Bond yields are still below earnings yields so current bond market correction shouldn't be a threat to stock prices at current or much higher levels. 
• Bond yields will probably have to get much higher than earnings yield before it becomes a serious threat to stock prices. 
• Even with bond yields at 6-8%, stocks prices can be reasonably valued at current levels. 
• Saying the stock market is overvalued with respect to historical averages is nonsense without reference to historic relationship to bond yields.
• etc...

Having said all that, of course the market can still tank for any number of reasons; geopolitical issues, economy tanking, some sort of crisis etc. 

This only isolates and looks at two factors. And according to those two factors, there is no tension that needs to be resolved. 

Since I tend to post these and other charts on occasion, and it's a hassle for me to update every time, I am going to set up a companion website to this blog that will have this data and charts that I can update and reference so I don't need to update and cut/paste into a blog post. Also, anyone can go there and look at it at any time to see what these indicators are saying. 

There will be other information/data posted there too as sort of my public, personal investment notebook.  

I will provide a link to it when it's ready.