I would classify my approach to investing (and managing other’s investments) as a value investor. I’m always looking to cycle out of overvalued investments and into undervalued ones, in terms of my expectations of the economy and markets moving forward. If I can’t find decent value, contrary to most professionals in the financial industry, I am happy to sit in cash (or cash equivalents) and wait. This is probably one of the most difficult disciplines for investors to grasp because they hate earning nothing on their money. At the same time, this might be the most important discipline to uphold because it is such an essential part of maintaining and growing wealth in the long run. Markets are very irrational so it pays to have a “rainy day fund” available when you spot fantastic, undervalued investment opportunities. There’s a reason Warren Buffet created the mandate to never have less than $20 billion of cash equivalents in Berkshire Hathaway.
I currently think expectations for future earnings are too optimistic and, at these prices, I believe that US stocks are overvalued. A lot of people are saying that stocks are fairly valued at a Price/Earnings (P/E) ratio on the S&P 500 of 15, which is right around the long-term average. I have two issues with this. First, I’m not a big fan of using the trailing twelve months (TTM) of earnings. Besides the fact that it’s backward looking, it’s too short-term. I prefer the Shiller P/E (PE 10) which measures the average of earnings over the last 10 years – a much better gauge of secular economic trends. It has proven far more reliable as an indication of long-term value over time, correctly identifying major tops and bottoms in the stock market. Second, even if one did prefer the TTM of earnings, this is not an economic environment to support a P/E near the long-term average unless we’re about to get hit with some serious inflation.
The PE 10 is currently at 23 for the S&P 500. Any number over 20 is generally a sign that stocks are overvalued and facing tough years ahead. In the last 100 years, here are the previous times the PE 10 was over 20:
- 1929 & 1938 – stock market crash & great depression
- Mid 1960’s – the end of a secular bull market in stocks, start of a 16 year secular bear market
- Mid 1990’s – Ran up and peaked in December of 1999 at 44. We’re still in that secular bear market in stocks.
Historically, a PE 10 around or below 10 indicates that stocks are undervalued and poised to climb for years to come. I’m not usually one to argue with history so I think it would be bold to say that this time is different and stocks deserve a high multiple. Now, I’m not saying that I think the stock market is going to crash (even though it’s always a possibility). I simply think US stocks, in general, are overvalued and it’s probably worth cutting back here and looking for better value elsewhere. Here’s the chart illustrating the PE 10 and S&P 500. I’ve colored the PE 10 to turn red when high (above 20) and green when low (below 10).
S&P 500 (inflation adjusted) and the Shiller PE 10 – 1871 to Present
A best case scenario would be for stocks to hold their nominal price while earnings catch up over time via inflation (a P/E ratio will drop if prices fall OR earnings rise) as they did in the late 1970’s/early 1980’s. It would feel like a win because the market didn’t tumble – but investors would lose in real terms. Below is the S&P 500 in both nominal and real terms (adjusted for inflation) over the last 13 years, which is when this secular bear market began. I also included the S&P 500 priced in Gold because, let’s be real, it’s a far better gauge of inflation than the government’s Consumer Price Index (CPI).
S&P 500 – Jan 2000 – Jan 2013
A huge part of investing is judging other’s future perception, meaning, will someone be willing to buy my stock from me at some point in the future for a higher price? In order for this to occur, there needs to be positive news that will entice people to buy. This is why markets will top out when everything seems great (no more good news to come) and bottom when things seem terrible (no more bad news to come). Unfortunately I’m just not seeing a lot of positives down the road to continue this climb (other than inflation, as illustrated above).
As I mentioned yesterday, the rise in the Euro will almost certainly make things worse for Europe. Japan is an export driven economy, full of retirees and savers. The fall in the Yen will benefit Japanese companies but it’s won’t help US companies. Here in the US, I don’t think we’ve seen, or are pricing in, the effect of the 2% increase in Social Security tax. This, plus the recent rise in gas prices, will put pressure on consumer spending this year which is mainly why I think earnings expectations are too high. Lastly, the emerging economies have been the bright spot for growth. However, after a flood of new money came in over the past 6 months, some nations (Philippines, Thailand, etc.) are beginning to intervene to slow the rise of their currency. This will ultimately slow growth for the US-based companies that generate sales there.
At this point, I think US stocks are overvalued and I see little down the road that will improve the outlook. I have been cutting back this week and I’m now underweight US stocks in portfolios. I understand the income argument that stocks yield more than bonds, but a 4% yield doesn’t do you any good if you lose 4% in price. If interest rates really are beginning to rise, the dividend paying stocks that have traded in line with bonds should also come down with them to maintain the yield premium.
I spoke with two clients earlier this week that wanted to make sure we weren’t “missing” this run. I told them things have been growing but now I feel it’s time to start pulling back (re-balancing to more defensive investments). No point of getting caught up in hype and risk giving it all back. I’m happy to wait for better value – whether it be in US stocks or another asset class.
-Nick