The Impact of Market Valuation on Returns

A market commentary or analysis generally summarizes the quarter’s news events that are perceived to be the cause of the markets ups or downs during that period. It can be difficult to write a market analysis since the direction the market takes as the result of a news item (positive or negative) is actually not as important as the relative difference from what the market had anticipated. Meaning, the market does not react to news, but rather to surprises in the news that it had not already accurately anticipated. If you think it through, this creates quite the challenge as an effective market analysis should guide us to what will happen in the future. By definition this is unknowable, so why do we write market analyses?

Rather than focus on predicting the future, let’s look at what the market is telling us today about its valuation. From there we can better speculate what unknown news is already priced into the market valuation. Better yet, let’s just look at what is known and see if it looks like we will make money in the future on a real risk adjusted basis. Not as exciting, but really what we need to know.

Valuation Table
The above valuation oriented data points are extremely well behaved. Separately, and in total, they tell a story that the market is slightly overvalued (relative to their 25 year average) unless we adjust for the fact that yields are low. In which case the markets are still relatively inexpensive. A deeper look at each component may help us reach a more refined conclusion.

FORWARD P/E = Current market index value (P) divided by the next 12 months estimated earnings per share (E)

If we are in the middle of an economic earnings cycle and we have a forward P/E that is similar to the average of the last 25 years then we might assume the market is properly valued (if we can accept the returns of the last 25 years).  We could probably assume that we are well beyond the midpoint based on the record breaking duration of this market cycle (11 years and counting). If we look though at the strength of the expansion in terms of real GDP growth, we lag the real growth of prior shorter expansions (See Chart Below). If a recession is to make up for the excess of the prior recovery we may be early stages given the paltry real growth over such an extended period of time.
Strength of economic chart
SHILLER P/E = Inflation adjusted average of the last 10 years earnings divided into the current index price

At a half a standard deviation above its average the Shiller P/E is a bit high. If we look though at the trough that was created in 2008 we can see from the above chart that it was not until almost a year and a half into the recovery that we actually achieved any GDP growth. This means that the denominator is still being pulled down by one of the worst earnings declines in history. As we get into 2020 and beyond we have constantly improving earnings throughout most the subsequent 10 years. This will bring the Shiller PE down (lower PE) without any corresponding increase in earnings.

DIVIDEND YIELD = Collective dividends paid out by stocks held in the index, dividend by the market price of the index

The dividend yield is just slightly below the long term average. What is not in this number is the other source of repayment to shareholders that take the form of net share repurchases. If we analyze net shares outstanding we find that corporations are using more of their free cash flow to buy back shares than they are to increase dividends. Cash returned to shareholders in combination with dividends is going to be higher than the 25 year average.
PRICE-TO-BOOK = Current index market price dividend by the aggregate book value of the underlying holdings

Price to Book is just slightly above the 25 year average. What is not covered is the more aggressive nature of writing down and depreciating book value.  This was particularly apparent during the Great Recession. Accounting standards have changed over time and corporations oblige with more rapid and severe write downs when earnings are impaired, possibly inflating current values when compared to historical averages.

PRICE-TO-CASH FLOW = Current index market price dividend by the aggregate operating cash flow of the underlying holdings

The high price-to-cash-flow would mean valuations are high if we are again at cycle midpoints for profits and capital investments.  This is the best of the indicators that valuations may be running high. If we couple this with our tight labor market we could conclude that improvements in Price-To-Cash-Flow will be hard to achieve. A more accommodative Fed may reduce borrowing costs but typically cannot stop late cycle erosion in corporate cash flows.

EARNINGS YIELD SPREAD = Earnings yield is the inverse of the P/E ratio and is calculated by dividing earnings per share into the current price. This yield then subtracts the yield on a Baa rated bond

Based on this measure the market is inexpensive. If we look below we see that the price level of the market has not doubled in over 19 years. This means less than a 4% price return. At the same time your compensation for government fixed income returns have declined from 6.2% to 2.0%.
Characteristics Table

We have shown that the market may be more fairly valued than would be assumed from a weighting of valuation measures. The one true measure of value is discounting the future cash flows to determine a present value. In this equation the discount rate will move valuation up or down with the veraciousness of a hungry lion. In other words, a 1% change in the discount rate will drive valuations up or down 20%. If we are going to stay with low rates for a long time then it is hard to see how the market can stay low for any length of time absent some outside force driving earnings down. If rates return to the levels of 2000 we would undoubtedly have severe downside pressure. Since rates do not typically move that quickly it is hard to see that occurring. As we might have guessed the market is telling us it is fairly valued for what it knows. As for what it does not know we have to admit that it is impossible to say. For as Denny Green once said – “They are who we thought they were”. Denny was talking about blowing a 20 to nothing half time lead, we are implying that it is rare when the market is not properly valued for what we know about it. Other than March of 2000, which you can see from above was a screaming sale situation and ended badly, markets can correct from almost any level at any time. If that were not the case we would not earn the extra return it has historically delivered.

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