Wherever You Go, There You Are

At the risk of sounding like a broken record, we find the current market valuation to be very high. But rather than just say that, we thought it might be helpful to give some perspective around that comment. (Please note that this comment was penned prior to the market upheaval on Friday, not because of it.)

We often discuss price/earnings ratios as measures of value, but that is not a measure that resonates with someone that is not financially trained. So let’s look at it a bit differently. When we own a stock, we are a part owner of that company and theoretically own that percentage of the company’s cash flow, or simplistically, the company’s earnings. If we reverse the P/E ratio to the E/P ratio, we calculate the earnings yield. Now we are looking at it much like a bond. Bonds that have a 3% yield pays us 3% each year. The earnings yield is a calculation as if the stock paid earnings like a bond. We can now more directly compare stocks and bonds. If I can own a safe bond with 5% yield, a riskier stock with a 3% yield doesn’t look very attractive.
The chart below shows the earnings yield of the S&P 500 back to 1900. Over the last 120 years, the earnings yield has averaged about 7%, well ahead of bond yields. This makes intuitive sense as riskier stocks should offer a yield in excess of bonds. However, at the moment, the earnings yield has almost returned to the all-time low set at the peak of the tech bubble, which of course was followed by a vicious bear market.
Why has the earnings yield become so low (or valuation become so high)? One reason is bond yields (as measured by the 10 year Treasury) are still slightly lower than the stock earnings yield. So it is fair to say the valuations can become even more extreme, but it is equally fair to say that stocks are historically highly valued.
One criticism of this type of analysis is that earnings are a poor measure of cash flow. Earnings can be manipulated by management and earnings will typically understate cash flow. So let’s take a look at another measure, the price to sales ratio. It is much more difficult for management to manipulate revenue, and therefore price/sales can be helpful in assessing valuations. In the charts at right and below, we take a look at the price sales ratio of both the S&P 500 and NASDAQ indexes, going back to the early 2000’s. For the S&P 500, the current price/sales ratio of 3.6 is about 2X the average over the last 20 years (which is 1.64), and materially higher than at any time during those 20 years. To put this in perspective, if the market suddenly went back to the average P/S multiple, the S&P 500 index would have to decline by about 50%.

The story is similar, yet more extreme, for the tech heavy NASDAQ Index. The current price/sales ratio is about 6, as compared to the average of 2.4. Again to put this in perspective, if the valuation were to suddenly return to the average, it would entail a decline in the NASDAQ index of 60%.
There are many reasons for the extreme valuations in the stock market, the primary one being the continuing support from the Federal Reserve since 2008, which has served to keep a tight lid on interest rates and that translates to higher valuations, but that is not a trend that can last forever.

One might think that the last several years of great stock market returns would make life easy for advisors, in fact it is just the opposite. Valuations this high can always go higher, but the higher they go, the less potential return there is and the more potential risk there is. This is as difficult an investment environment than we have ever experienced. Our answer is avoid market timing and balance risks in our portfolios. Diversification lightens the blows from corrections and allows portfolios to grow over the long term.

Don’t Look Now (Revisited)

Last week we discussed the growing number of COVID cases in the U.S. and the risks that presented to supply chains and the core functionality of the economy. It turns out the news might be much worse. There is a new variant in town, and it looks like it could be a serious challenge. The WHO has named the variant Omicron and this variant apparently has as many as 32 spike mutations. In an interview on Bloomberg, a spokesman for WHO opined that this is unlikely to make the current vaccines irrelevant, but probably less effective, and that a new vaccine will probably need to be developed.

The big question is whether new lockdowns will be imposed. After two years, the appetite for lockdowns is dramatically reduced and the economic cost of those lockdowns has been enormous. At any rate, this appears likely to put a serious crimp in economic growth and creates a serious problem for a Biden administration that is already very low in popularity. As for the Federal Reserve, a sharp drop in demand will likely put the brakes on the inflationary cycle, but this makes the job of the Federal Reserve complex beyond imagination as additional monetary and fiscal support could be required.

It is far too early to know what lies in front of us with any clarity. It will likely take weeks for the scientific community to assess the risk from Omicron, but in the meantime, we will be sitting on pins and needles. The market reaction on Friday appears to be extreme, but in the context of the very high current valuations, was actually more tame than it might appear on the surface. High valuations simply mean that risks from Omicron are more pronounced.