Valuations Only Matter on the Way Down
The long-term investing lessons still apply. Like a game of musical chairs, you never know when the music will stop. Attempting to time markets is a hope, not a strategy. In our view, the better option is to keep your risks balanced and allow markets to give the returns they can.
No one cares about valuation when stocks are rising, but when the market turns, valuation is all that matters. Given the hawkish turn the Fed appears to be taking, it makes sense to talk a bit about valuations. One of the time-tested valuation measures is the CAPE (Cyclically Adjusted PE ratio) developed by Prof. Robert Shiller at Yale. We put together the following chart using Prof. Shiller’s data. On the x-axis is the CAPE ratio at any given point in time, and on the y-axis is plotted the stock market annualized return over the following 10 years. What this mass of dots tells you is that when valuations (the CAPE ratio) are lower, returns over the next ten years tend to be higher. The red vertical line is the approximate CAPE ratio today (38). All the dots at this valuation or higher have produced negative stock market returns over the following ten years. In addition, all of the dots to the right of the red line occurred during the tech bubble of the late 1990’s. This would imply that the market is as overvalued today as during that period, a depressing thought to say the least.
But the CAPE ratio has been far less accurate in recent years as the impacts Federal Reserve interventions into markets has become more extreme over the last 20-30 years. Economists at Vanguard built on Shiller’s work to develop the Fair Value CAPE measure. The mathematical intricacies of this development are unimportant here, suffice it to say that the new measure ‘corrects’ for interest rates and inflation and been a better barometer of value in recent years than the original CAPE measure.
The gray area in the chart below shows the fair value CAPE range as defined by Vanguard. The green CAPE line is well above the fair value range, though not nearly as much as during the tech bubble of the late 1990’s. This new methodology indicates that while valuations are still elevated, they are not as extreme as during the tech bubble. We also note that this data from Vanguard is as of Sept 30, just before a 7% market rally in October, which implies that the overvaluation relative to the fair value range is more pronounced than pictured here.
As we’ve said many times, high valuations do not necessarily imply an imminent correction. Valuations can stay high or go even higher before a correction. So, what are the things that might allow continued, or higher, valuations? On this score we are in complete agreement with the economists at Vanguard. What we need to maintain high valuations includes:
- Further declines in interest rates
- Leadership in the stock market to broaden from the technology sector
- Supply constraints to correct without generating inflationary pressures, particularly wages
- Fed policy becomes more accommodative
The problem, as we see it, is that Fed policy is leaning less accommodative as the taper of bond purchases is expected to accelerate and that raises the prospect of increasing interest rates sooner. In addition, the broadening of market leadership has been fairly weak.
Vanguard’s conclusion, as shown at above, is that this Fair Value CAPE has been fairly accurate at anticipating forward returns, although very recent returns have been much higher. Carrying Vanguard’s methodology forward, it anticipates that equity returns over the coming decade will trend down and be substantially more modest than recent results.
The good news is that the model does not anticipate negative returns as the CAPE ratio does. But from here, expected equity returns are well below the long-term average at low to mid-single digits and we should not expect the heady days of the last several years to be repeated.
It’s time to hunker down a bit. In this supply constrained, demand hyped, inflationary world of today, the Fed can only impact demand, not supply. They appear more ready to do just that.
Wikipedia describes Fedspeak as “a turgid dialect of English used by Federal Reserve Board chairmen in making wordy, vague, and ambiguous statements”. There are many very well-paid economists on Wall Street whose exclusive job is to be a Fed watcher and interpret the Fed’s words and actions. This has been one of those weeks when they have had to earn their money.
When Fed Chair Powell said that they needed to lose the word transitory when describing inflation, the stock market immediately reacted under the assumption that this meant inflation was indeed more persistent. We believe a more careful reading of Mr. Powell’s statement indicates that the Fed still believes that the inflation we are currently experiencing will not result in a structural inflation (i.e., it will be temporary), while acknowledging the obvious fact that the longer inflation is around, the greater the risk that it becomes structural. This conclusion is backed up by the bond market, where long-term bond yields have barely budged in response to those comments, implying that the bond market does not believe inflation will be a long-term problem.
For us, the loss of the word transitory is of little importance. What is of greater importance is the fact that the Fed sees rising risk of inflation, which appears to have turned the Fed Chair a bit more hawkish (that is more likely to raise interest rates sooner). If the Fed perceives the inflationary trend to be more dangerous, at some point they face a very difficult decision. Option A is to act prophylactically by speeding up the taper, which would allow them to raise rates sooner than the market expects. In effect, they would be attempting to ‘tap the brakes’ on the economy, which would reduce aggregate demand and allow the supply chain problems to work themselves out more quickly. The risk is that they tap too hard and a cause recession, rather than the preferred ‘soft landing’.
Option B is to wait until they see the white in inflation’s eyes before acting, which assumes that their temporary inflation theme is correct. If they are wrong, then they have to tap the brakes much harder and a worse recession is virtually assured. We suspect any rational Fed member would choose Option A and that is how we interpret the hawkish shift in Fedspeak. If we are correct, that implies that a slowing of the economy and some choppy markets lie ahead. The jobs report on Friday, while a disappointment on the headline, also showed that the unemployment rate for blacks and Latinos was reduced materially, and that has been a primary concern of the Fed. This should provide more leeway for the Fed to be more aggressive in removing accommodation.
A wild card here is Omicron and how it might affect the global economy from both a supply and demand perspective. It’s very early in the game with Omicron, but we believe the key factor will be how serious the health effects from Omicron are, in other words, how much can/will Omicron pressure our health care system. At this very early point, there is no evidence that we have seen that Omicron is more severe than Delta. If anything, the evidence to date suggests that illness is not as severe and is affecting unvaccinated people to a greater degree. If that holds true, there will not be additional lock downs in the U.S. Nonetheless, it can affect our lives in more subtle ways, impacting when and how much we spend, how we work, etc. But this is not in any way, shape, or form a repeat of Spring 2020. At that time, this was an unknown virus, with no known ways to fight it. Today, we have so much more knowledge, we have vaccines and therapies that reduce the risk of serious disease and/or death.
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