Category Archives: Market Valuation

Market Valuation Update – November 10, 2010

I have updated the market valuation data based on closing prices for November 9, 2010. The S&P 500 has advanced almost 18% since September 1, 2010. Equities still appear attractive on a relative basis given the historically low yield on government and corporate bonds. However, stocks do not look cheap at these levels. Never invest without a margin of safety.

Generally speaking, from month to month relatively little changes in these indicators. The trick is to develop the discipline to follow them on a regular basis. Doing so, along with developing a rational investing framework, should improve your odds of being greedy when others are fearful and fearful when others are greedy.

Market Valuation Update – October 7, 2010

I have updated the market valuation data based on closing prices for October 6, 2010. The S&P 500 has advanced approximately 10% since September 1, 2010, when I last updated the indicators. Equities still appear attractive on a relative basis given the historically low yield on government and corporate bonds.

Buffett recently commented at the Fortune Most Powerful Women Summit that, “It’s quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they, the lack of confidence. But that’s what makes for the attractive prices. If they had their confidence back, they wouldn’t be selling at these prices. And believe me, it will come back over time.”

Generally speaking, from month to month relatively little changes in these indicators. The trick is to develop the discipline to follow them on a regular basis. Doing so, along with developing a rational investing framework, should improve your odds of being greedy when others are fearful and fearful when others are greedy.

Market Valuation Update – September 2, 2010

I have updated all my market valuation data as of the close on September 1, 2010. I make no attempt to time the market using these valuations. These are simply another set of tools to try to, “Be Fearful When Others Are Greedy And Greedy When Others Are Fearful.”

As these indicators rise, you should be increasing cautious about committing capital. Conversely, you should look for periods such as March of 2009 to commit funds. Obviously, nobody can predict WHEN extreme price levels will reoccur. What is certain is they WILL reoccur.

Currently, stocks are attractively valued compared to bonds. What is unusual here is the extremely low yields that investors are accepting from bonds. These seem to indicate that many market participants are fearful and uncertain. The good news for investors is that it is quite easy today to put together a basket of high-quality stocks with an earnings yield materially higher than that of the S&P 500 and double that of high quality corporate bonds. Plus the yield on the basket of stocks can be expected to grow over time.

The Bottom Line and a Word of Caution

The market as a whole is not compellingly undervalued. But, given the low yields on bonds, the odds seem to favor equities. As a final word, never invest without a clearly identifiable margin of safety. Think about the downside first. What could go wrong? What are you missing? Why are people willing to sell me this stock if it’s so attractively valued? Are they selling because they have better information or are they acting irrationally? If you’re not sure, take a pass. Buffett has said on more than one occasion that many have recognized the same values he has seen and acted on them. What is different is that those same investors have taken undue risks and invested outside their circle of competence thereby diluting – or destroying – their overall returns.

Longleaf Partners’ Mason Hawkins: “Equities Offer a Superior Opportunity for Investors Today”

Longleaf’s second quarter letter to shareholders was just released and in it highly regarded value investors Mason Hawkins and Staley Cates make the case that equities are still attractive.  They view the market as overly fixated on negative macroeconomic news, namely debt, demographics, doom and the possibility of a double-dip recession.

Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.

By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. The following table compares corporate earnings yields to bond yields at bear market lows since 1932. When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows.We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.

Here’s a link to the letter. The table they reference with their data is on page 2 and is worth a look.

The potential flaw with Hawkins’ argument is that it is based on the assumption that 1) the S&P’s earnings in 2011 will be approximately $96 (the S&P was at 1022.58 on July 2; the yield of 9.4% assumes 2011 earnings of $96) and 2) interest rates will stay at these historically low levels. Both could happen, but I think it is prudent to consider that these assumptions could prove to be wrong. For the record, per Robert Shiller’s data the all-time high earnings on the S&P 500 were $84.92 in June, 2007.

Understanding Stock Market Returns – Part 2

On July 19, 2010, I posted part 1 of this article in which I argued that long-term stock market performance is largely explained by corporate profits. Students of stock market history will immediately recognize that this explanation of stock market returns fails to explain the large variability in stock market returns over multi-decade periods during the past century.

As Buffett pointed out in a 1999 Fortune article, in the 17-year period from December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average (DOW) was flat, going from 874.12 to 875.00. In stark contrast, during the ensuing 17-year period, the market advanced from 875.00 to 9181.43, which comes out to a whopping annual return of 19%. Surprisingly, GDP rose 373% during the first period compared with 177% during the second period.

Buffett explains that interest rates on long-term government bonds were a major factor that held the stock market back in the first period because they went from 4.20% at the end of 1964 to 13.65% at the end of 1981. Just the opposite happened in the second period: interest rates on long-term government bonds went from 13.65% to 5.09% at the end of 1998. Because all assets must compete with the risk-free return available from long-term government bonds, as rates move higher it causes a reduction in the value of all competing assets. When rates fall, all competing assets are re-priced at a proportionately higher level. This is easy to see in the prices of bonds because they have a fixed coupon and, if held to maturity, return the invested principal. The impact on bond price when interest rates change can be dramatic.

Whereas this relationship between asset value and interest rates is easy to see in bond prices, it can be harder to immediately see in the price of equities, because a number of other factors affect the price of stocks which can obscure this relationship, especially in the short run. Buffett argues that regardless of these other factors the effect of interest rates on the value of equities is real and constant, much like the effect of gravity, and over time will cause equities to be re-priced.

Another factor in the extraordinary returns from 1981 to 1998 was the fact that corporate profits as a percentage of GDP rose significantly during that period. Buffett points out that starting from a depressed level of 3.5% of GDP, after-tax corporate profits rose steadily, ending the period at around 6%. The 6% level represents the upper end of their normal long-term range. This increase in corporate profits relative to GDP provided a powerful boost to stocks.

Finally, Buffett points out that the final significant factor affecting stock prices is sentiment. Investor sentiment over time oscillates between periods of extreme pessimism and extreme optimism. A large part of Buffett’s success is having the emotional discipline and fortitude to purchase stocks during these periods of pessimism, which can make even great businesses available for less than they are worth.

At the beginning of the 1980’s, Buffett points out that investors were very pessimistic about the outlook for corporate profits, especially given the historically high interest rates that prevailed at that time. As the market advanced over this 17-year period, investors became increasingly optimistic owing to the extraordinary returns the market was throwing off. By the mid-90’s, the party was in full swing and many know-nothing investors began to get involved simply because stocks were going up. These investors did not want to miss the easy profits that were sure to follow. The rise of the Internet sent the whole thing into further orbit as it provided a justification that this time things were different and that equity prices could decouple from the constraints of traditional valuation metrics owing to the paradigm-shifting wealth and productivity that the Internet would usher in.

To sum up, we can identify three primary variables that account for stock market performance:
1. Corporate profits
2. Interest rates
3. Investor sentiment

If you understand these key variables, you will be in a better position to value – not predict – the level of the general stock market. Buffett does not primarily take his cue from the general market but from the availability of undervalued securities. He is primarily a bottom-up investor who puts much less weight on macro-economic factors than he does on seeking out undervalued companies within his circle of competence where he can arrive at a usefully certain conclusion about what they are worth.

Buffett believes that macroeconomic forecasts are difficult to make and that the level of certainty which he can reach about the long-term prospects of select companies within his circle of competence is much greater. To him, it would make no sense to give up the advantage afforded by this certainty by making it secondary to his ability to forecast the economy.

Nevertheless, Buffett has a very deep understanding of the general stock market and uses that knowledge to assess the valuation level of the general market. This is grounded in the reality that virtually all stocks, unless there is a clear extraneous factor such as a pending acquisition, decline in a sharp correction or bear market. Therefore, it makes sense to be increasingly cautious if the market reaches price levels that are not supported by its fundamentals.

Understanding Stock Market Returns – Part 1

If you are an investor in the stock market, it makes sense to understand the nature of stock market returns. If you are trying to outperform the market, you need to understand how the market works. The long-term performance of the stock market is not based on chance, but rather is largely explained by the growth of corporate profits.

As Keynes noted, this growth occurs because, in aggregate, corporations, “Do not as a rule, distribute to shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of the profits and put them back in the business. Thus there is an element of compound interest (Keynes’ italics) operating in favor of sound industrial investment.” This is exactly the same thing that happens when you add money to a savings account. Assuming a steady rate of return, if you increase the funds in your account by 10%, your yield will go up by 10%.

Since 1950, firms in the S&P 500 have, on average, earned approximately 12% annually on their invested capital. This figure, which is often referred to as return on equity, is a highly useful figure because it measures how effective a company is in utilizing its capital.

On average, firms in the S&P 500 have paid out 50% of their earnings in the form of dividends and retained the balance for reinvestment in their business. (This example does not consider other uses of capital, such as share repurchases, spin-offs, etc.) In round numbers, this reinvestment of 6% – half of the 12% return on equity of companies in the S&P 500 – largely explains the growth in corporate profits over the past hundred years.

If you had a savings account earning 12% annually, and you spent half the interest and reinvested the balance, your 12% yield would grow at a rate of 6%. The reason is that you would have increased your invested capital by 6%, and this additional capital would also earn a return of 12%.

If you’re wondering why the S&P 500 does has not historically paid a dividend yield of 6%, it is because, on average, investors in U.S. equities have paid over two times book value for stocks. The same thing would happen if you deposited $1 million in a savings account that paid 12%, but you had to pay a $1 million one-time surcharge to gain access to this rate of return; it would cut your effective yield in half. In the past twenty years, dividend yields have declined as average stock valuations have increased and as corporations have returned larger amounts of capital in the form of share repurchases in lieu of higher dividends.

This growth in corporate profits of 6% roughly tracks the growth rate of the United States’ gross domestic product (GDP), which is a broad measure of the country’s overall economic output. The GDP’s average growth rate has historically comprised about 3% real growth plus an additional 3% from inflation. The relationship between the growth in corporate profits and GDP is firmly established and grounded in the fact that corporate profits are a significant component factor of GDP, which is an aggregate figure. Historically, after-tax corporate profits have fluctuated in a range of 4.5% to 6% of GDP. These profits have at times ballooned to 10% of GDP and shrunk to 4%, but consistently regress to a mean of around 6%.

Given the relationship between corporate profits and GDP, your expectations for stock market returns should be grounded in your assumptions about GDP. Looking forward, if you expect GDP to grow at a 5% – 3% real growth plus an additional 2% for inflation – then you can expect stocks to grow at a similar rate. Add in 2% for dividends and that gives you an expected total return of 7%. Of course, if 2% or more of the growth comes from inflation, your real return will only be around 5%, which is certainly much lower than what many investors are expecting.

Corporate Profits / GDP

Hussman: The Market Is Significantly Overvalued – Morningstar.com

Hussman: The Market Is Significantly Overvalued – Morningstar.com

Here is a link to Hussman’s most recent weekly market comment upon which Morningstar’s interview is based.

Gurufocus tracks Hussman’s portfolio and provides information on his bio and investing philosophy.

Related Posts

Lessons from Buffett’s Partnership on General Market Prices

Is the S&P 500 Overvalued?

I have updated the general market indicators which you can find in the right sidebar. My general conclusion is that the S&P is not materially under or overvalued – it certainly does not appear “cheap”.

There is also grounds to be somewhat cautious given the fact that interest rates are so low. Any significant upward movement in interest rates would cause a downward revision in the intrinsic value of equities. Predicting if and when that will happen given the current economy, or at anytime, is probably not possible. On the flip side, earnings are only two thirds of their 2007 peak. There again, I obviously have no way of knowing how long it will take to get back to these levels.

For now, I think it continues to make sense to search for good businesses that can be purchased at a margin of safety. Stick to what you understand and don’t reach. Remember, Buffett’s understanding of what it means to “understand” a business goes beyond the common meaning of the word and includes the idea that you can make a reasonable estimate of what the business will look like in five to ten years, i.e. think Coke vs. a biotech company. Remember, the forces of creative destruction are real and powerful; don’t neglect this step.

General Market Indicators Updated

I have updated all four general market valuation indicators found in the upper right column of this blog. In general, according to these indicators, the market appears to be neither over or undervalued.

If the Total Market Cap/GDP indicator – the “Buffett Metric” – is at a 70-80% reading it is thought to indicate that the market is undervalued; it currently stands just under 100%. For more information on this indicator, see the article in Fortune that gives a nice overview.