I CARE – Valuentum

Image Shown: The S&P 500 from early 2009 through today, June 15, 2017.

By Brian Nelson, CFA

There it is — the upward-sloping chart of the S&P 500 (SPY) since the March 2009 panic bottom. What a sight to see…

The past 8 years have marked an incredible bull market in US equities and one for the record books in many instances. The drivers behind the multi-year rally have been many — ultra-low interest rates and their magnifying impact on equity valuations, strong earnings growth from the doldrums of the Financial Crisis, and the proliferation of passive and dividend-growth strategies de-emphasizing the price-versus-value equation. “Money,” it seems, is chasing stocks at any price, and most of the trading on exchanges has become “speculation.” We predicted in December 2016 the stock market would reach highs again in 2017, so why does this all seem like a dream, or perhaps better said, a nightmare?

Well, in some ways, the financial industry may very well be off the tracks. According to a study by JP Morgan, ‘fundamental discretionary traders’ account for only about 10% of trading volume in stocks today…The majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals…Passive and quantitative investing accounts for about 60%, more than double the share a decade ago.” Are investors that are counting on income for retirement supposed to be excited about these stats? Are those saving for their children’s college fund supposed to be comfortable parking their assets in a stock market where only ~10% of participants are “paying attention” to fundamentals. Surely this is not something to be proud of. I’m not viewing this statistic positively at all. Is the stock market truly on a firm foundation? It doesn’t appear so.

The financial industry doesn’t seem to care either. After all, times are great–perhaps like the roaring 20s all over again. The stock market continues to set new highs after new highs, unemployment continues to set new lows, and all appears well on Main Street. Those bringing forward concerns about equity valuations today are being mocked by the cheerleaders, the propogandists. Oh—they are good, too. Those that are truly worried about the mom-and-pop capital invested in a market where few are “paying attention” are being laughed at. How can this possibly be? How can the cheerleaders, the propogandists not care? They, and those encouraging them on, ought to be ashamed. Has this always been the case? Am I just finally wising up to what Wall Street is about? Frankly, I don’t like it at all.

That said, Warren Buffett has been known to quip a time or two that we only know who is swimming naked when the tide goes out. The stock market is not and never will be a magic generator of wealth, no matter what historical studies going back centuries suggest. The stock market is a market (step I), and it will always be a market (and market participants can become irrational, and they often do). According to FactSet, the forward 12-month P/E ratio for the S&P 500 is 17.7, above the 5-year average of 15.2 times and above the 10-year average of 14. The forward P/E ratio for consumer staples stocks (XLP) is nearly 21 times, above its 10-year average of ~16 times.

Even consumer discretionary stocks (XLY), trading at nearly 20 times forward earnings may be getting such multiples on near-cyclical peak earnings numbers. Yikes. What kind of growth is supporting such multiples? Well, excluding the energy sector (XLE), earnings growth for the second quarter is expected to be less than 4% for S&P 500 companies. And what happens if Trump’s initiatives with respect to corporate tax reform fail? 2018 consensus numbers are probably at risk, in my opinion. Forget about the political uncertainty that might be caused under Trump impeachment proceedings, the probability of which may be immaterial. There’s tremendous tail risk regardless.

The forward P/E isn’t the only measure raising red flags. The Shiller P/E, also known as the CAPE (cyclically-adjusted price-earnings) ratio, is at nearly 30 at last check, about where it stood during the stock market euphoria of 1929 and only lower than the dot-com bubble levels. The historical mean of the CAPE ratio is a whopping 16.8 times. Today’s level implies a near-80% premium. Netflix (NFLX) is trading at ~80 times 2018 earnings. Tesla (TSLA), expected to lose money in 2018, sports a market capitalization of over $60 billion at the time of this writing. According to Advisor Perspectives, what Warren Buffett called “probably the best single measure of where valuations stand at any given moment,” the market-cap-to-GDP ratio, stands at ~133%, the highest it has been, save for the dot-com bubble when it topped at over 150%. “Cryptocurrency” is now a part of the market’s vocabulary, with Bitcoin speculators driving its value up 3-fold during 2017–incredible performance for a digital currency. Castles in the air? I think so.

I’m worried, and I’m not afraid to admit it. I care. But what am I worried about? I’m worried that investors don’t know the risks. I’m worried that some are buying wholly into index funds with the stock market trading at nearly 18 times forward numbers, expecting that stocks may “climb to heaven,” as astrologer Evangeline Adams once put it. I get really uneasy when John Bogle predicts “magical” 4% 10-year equity returns from current peak levels. How can professionals make such prognostications? I’m not pro-passive or pro-active, per se. After all, Valuentum is a publisher, and I’m just a newsletter writer. But I do feel that when Vanguard’s founder John Bogle says that the markets will become “chaos” if indexing becomes 100%, that’s a problem. Would any upstanding market participant recognize it as so?

I heard that “last year, two thirds of Vanguard’s fund flows were from advisors.” Whoa – is this all indexed money generating advisor fees? Do stocks really underperform the index after advisor fees? I’m not sure that studies have been done on this important question, and I’m itching to get started. But at the core with these markets, something is not right. Is this all unintended consequences of the DOL Fiduciary Rule? In my humble opinion, it’s hard to make the case that indexing completely at 18 times forward earnings is prudent, especially with the market more than tripling since the March 2009 panic bottom. I almost feel like I’m speaking a different language than some. The market is not altogether scary. What I am hearing from market participants, however, is making things scary to me. Surely they can’t believe that valuations don’t matter. Surely they must understand that indexing is speculating. Surely they must care enough to take things seriously. Right? I’m serious. I care.

As I wrap up the introduction to the June edition of the Best Ideas Newsletter, the 72nd monthly installment, I wanted to make mention of the numerous changes to the newsletter portfolio that occurred since the last edition. On May 15, we removed General Electric (GE) roughly at cost. On May 17, we added put protection in the form of options on the S&P 500 index, and we also added put options on Netflix, both about the time the CBOE Volatility Index (VIX, VXN) spiked. We did some “Spring Cleaning…” May 25 where we took profits on Kinder Morgan (KMI) and the two financial ETFs, the Financial Select Sector SPDR (XLF) and SPDR S&P Bank ETF (KBE), and shed the portfolio of Teva Pharma (TEVA) and Michael Kors (KORS). You can read all about those changes in this edition of the Best Ideas Newsletter. Did I mention that the yield curve is flattening and the Fed is raising rates? Please don’t be blind to the risks ahead of us! Always my very best.