Posts filed under “Investing”
Traders returning to their desks after the long holiday weekend will be greeted by the continuing Greek saga, a guessing game about when the Federal Reserve will raise rates and a megamerger in the cable industry. But the debate I am much more interested in is the one taking place about U.S. stock valuations. It is more significant, and not as well understood as those other discussions.
The bears have been saying for some time now that stocks are at best fully valued, meaning there isn’t much room for gains after equities more than tripled from their March 2009 lows. The ursine argument is that low future returns are a given, and an ugly crash is the worst-case scenario.
The bulls argue that ultralow inflation allows for higher valuation metrics based on price-earnings ratios or Shiller’s CAPE (cyclically adjusted P/E). Compared with all historic medians, these measures are rather high. But compared with similar eras of very low rates and very low inflation, they are quite reasonable.
I want to suggest another framework for evaluating the market’s prospects. It involves future earnings growth and a range of possible outcomes. Some may find this approach to be unsatisfactory, for it is dependent upon future events that are both unknown and unpredictable.
Have a look at the table above: It comes from Bank of America Merrill Lynch equity and quant strategist, Savita Subramanian. I have found that many investors focus on the implied 10-year annualized returns, rather than upon the range embodied by the 90 percent confidence interval.
Placing emphasis on specific expected returns embeds an assumed prediction about future earnings. But there are too many variables that affect future corporate profitability to make a specific guess with a high degree of confidence. Hence, many valuation arguments with an embedded forecast are usually binary in their outcome. The guess is either right or wrong; the correlated investment posture is either a winner or a loser.
Focusing on a range allows us to recognize that several factors remain unknown at present. These are crucial in determining future equity valuations.
Consider these variables:
– Will the U.S. economy slip into a recession? Begin to accelerate from its long slow recovery from the financial crisis? Or will it keep muddling along?
– New unemployment claims are at lows not seen in a generation. Will this create wage pressure?
– If wages rise, will consumers save or spend their pay increases?
– Will companies expand their modest capital expenditure budgets? Will research and development spending increase?
– Are corporate sales going to accelerate anytime soon?
– Will corporate profits be hurt by increased capital expenditure and wage increases? Or will a virtuous cycle raise profits?
Each of the above unknowns has the potential to affect U.S. equity valuations. This is why a range of possible outcomes is a better way to think about valuations than declaring stocks cheap, expensive or fairly valued.
Hence, when we consider valuation metrics, we should be aware that many of us build a forecast into those ratios. We don’t know what future earnings will be in 2016 or the year after, and merely extrapolating a number from present levels is at best guesswork.
To clarify, I am not suggesting stocks are especially cheap here or that equities must go up. Rather, I am emphasizing that since we have only limited ability to estimate future earnings, the reliance on valuation metrics such as P/E ratios should recognize the likely range of outcomes.
Stocks, like the Fed, are data-dependent. It is a shame we don’t hear that admission from more market participants.
Originally published at:
I love this debate between the idea of Tobin’s Q-Ratio as th be all for valuation analysis. It is embodied between Smithers & Co. quoted in this scary BBRG article and Pragmatic Capitalism’s Cullen Roche. Here is PragCap: “Better yet, look at the number of times this ratio has been cited during the most recent bull market…Read More
The data on this is fascinating:
Many people plan on supplementing their retirement funds by working past 65, but this plan may not be as sound as it seems. Bloomberg’s Suzanne Woolley breaks down the expectations and often unfortunate truths of working through retirement.
Source: Bloomberg May 18, 2015 7:32 AM EDT
“We are not done on the cost side . . . We think we need to keep raising the bar on that.” So says Bill McNabb, CEO and Chairman of the Vanguard Group. The firm, managing over $3.1 trillion dollars in client monies, has long been known for its obsessive focus on keeping costs low….Read More
Tren Griffin runs 25IQ, a blog about business models, investing, technology, and other aspects of life that he find interesting. He works for Microsoft; Previously he was a partner at Eagle River, a private equity firm established by Craig McCaw. ~~~ A Dozen Things I have Learned from Barry Ritholtz about Investing As part of my “A Dozen Things…Read More
“Men in the game are blind to what men looking on see clearly.” ~ Chinese Proverb In the game of investing, the players are often the ones who are unknowingly being played… The phrase, caught up in the game, can be attributed to “blind ambition” and the emotional trappings that accompany the desire to win….Read More
I love this collection of Paul Tudor Jones insights and rules by way of Ivanhoff Capital: 13 Insights From Paul Tudor Jones 1. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am…Read More
Fed-Driven U.S. Stock Advance Leaves Grantham Waiting for Bubble by David Wilson (Bloomberg) — Adjusting U.S. stock-market indicators for Federal Reserve policy since the 1980s shows a bubble has yet to come, according to Jeremy Grantham, Grantham, Mayo, Van Otterloo & Co.’s chief investment strategist. The attached chart highlights one gauge, Yale University Professor Robert…Read More