March 13, 2017: Long Term Stock Valuation Review

Mar 14, 2017 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, April 17, 2017. You can also find the re-balance calendar for 2017 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Long Term Stock Valuation Review

Stocks have risen dramatically since the US president election, lifting their long term valuation to a very overvalued level. In this newsletter, we look at the current valuation and discuss its implication. 

Long term stock valuation is close to historically high

MyPlanIQ tracks several long term stock valuation metrics on Advanced Strategies -> Market Indicators page. Among them, the most often used are Warren Buffett’s ratio of Total Stock Market Capitalization over Gross National Product (GNP) as a yardstick to measure the stock market valuation.

In a 2001 Fortune magazine interview article, He stated that  

“The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment”. 

He further went on to say 

“If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire”. 

At this moment, the ratio stood at over 130%. It’s just a few percents lower than the historically high made in year 2000. This compares with the long term average 80%. The chart below shows the historical ratios since 2001.

Similarly, at this moment, Shiller Cyclically Adjusted PE 10 (i.e. real price over S&P 500 trailing 10 year real earnings) stood at 29.95, compared with its longer term average 16.74. Its ratio over the long term average is 1.77. 

Furthermore, based on Hussman, the valuation of the median component of the S&P 500 is already  far beyond the median valuations observed at the peaks of 2000, 2007 and prior market cycles: recall that in 2000 peak, the small cap stock valuation was still much lower than the large cap’s, which is not the case right now. 

All of the above are pointing to an extreme valuation. 

Future returns and interim loss

Based on Hussman, who uses his own MarketCap/GVA, a modified version of  the ratio of total stock market cap over GNP, the future 10 year S&P 500 total return (dividend reinvested) is estimated to be negative. Various other metrics are also predicting a low to negative return for stocks in the coming decade. Assume this is the case, let’s do some simple arithmetic calculation on how much lower S&P 500 has to be to become attractive. 

Using Buffett’s Market Cap over GNP ratio, that would mean the ratio has to drop to 80% or so to make stocks attractive. What that means is that, assuming GNP remains intact, Market Cap has to drop about (130-80)/130, which is 38%.  That translates into S&P 500 index price 1460, a bit lower than the 2000 peak 1527 or 2007 peak 1561.  Often, such a bear market happens in an economy downturn, which means GNP could be even lower. This implies that stock market cap has to go even lower for the ratio to get to a level like 80%. Moreover, if one takes the often undershoot behavior in a bear market into account, one can easily see S&P 500 loses about 50% or so. That would mean S&P 500 is at 1100-1200 level. 

Similarly, using Shiller CAPE10 ratio, if the ratio were to drop back to its historical level, it would need a drop of 77/177 or 43% drop to make stocks at a historical valuation level. Again, one can see that the interim loss is at a range of 30-50%. 

The current overvaluation’s implication on portfolios

There are many ways to utilize the above information. One way is to allocate some part of a portfolio in a long term stock valuation portfolio listed on Advanced Strategies: 

Portfolio Performance Comparison (as of 3/10/2017):
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR Since 7/1/2001 10Yr Sharpe
P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy Total Return Bond Funds As Cash 2.1% 8.7% 3.6% 7.9% 11.5% 10.6% 0.86
P Shiller Cyclically Adjusted PE 10 SO SU Stock Market Timing Strategy Weekly Total Return Bond Funds As Cash 2.1% 8.7% 3.6% 9.2% 12.2% 11.6% 0.89
VFINX (Vanguard 500 Index Investor) 6.4% 21.7% 10.3% 13.8% 7.6% 6.2% 0.34

These portfolios buy S&P 500 index fund SPY when the long term valuation metric is reasonably valued or under valued and sells SPY and invests in a total return bond fund portfolio when the valuation becomes too high. For example, the Buffett portfolio went into the bond fund portfolio in 2013, with S&P 500 being at the level of 1600. Though one can say it’s too early to avoid stocks, however, if one looks at a long term picture and the above discussion, the 1600 S&P 500 price level will probably be reached again in the future. 

In fact, even though the portfolios didn’t do as well as S&P 500 (VFINX) in the past 3 and 5 years, it handily outperformed the index in the 10 year and 15 year periods, both in terms of returns and risk. 

Using the above all or nothing portfolios as the sole investment portfolio for an individual is probably too radical. But allocating 20% or even 50% to such a portfolio in one’s overall investments does have value. 

For regular Strategic Asset Allocation (SAA) portfolios, the implication of the current high stock valuation, coupled with the extremely low interest rate (i.e. high valuation in fixed income bonds also), means that one needs to be prepared for a large loss at some point or for a period as long as 10 years, such a portfolio might not derive any extra return.  These investors should either pare  down the risk to a level such that the big loss alluded above is bearable or consider diversifying part of investments to other types of portfolios such as the above Buffett ratio based portfolio, or Tactical Asset Allocation(TAA) or even some other long term timing based portfolios. 

For Tactical Asset Allocation(TAA) portfolios, the implication is that one still needs to anticipate a pain when the market trend turns decisively downward. In fact, it’s also quite likely these portfolios will experience some whipsaw or loss before the real downturn comes in full swing. Furthermore, the investors just need to be more disciplined to execute rebalances in the future. 

Finally, however how gloomy the above discussion might seem, we want to remind our readers that when stock valuation finally comes down to a level that is reasonably fair and under valued, investing in stocks will become much safer, because as in the long term, at that level, quoting Buffett’s in the above, “buying stocks is likely to work very well for you. ” We certainly will have another say when that day comes. 

Market Overview

Last week, as we are approaching the Federal Reserve interest rate decision day, stocks and bonds fell. Small cap stocks are no longer leading. Interest rate sensitive sectors such as REITs and utilities continued to retreat. In particular, high yield bonds have been in a visible persistent short term down trend. We don’t know whether this is a short term event or something more significant. As stated above, investors should be more risk averse right now and manage portfolios more diligently. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

Now that the Trump administration is officially sworn in, the new president is facing the reality to deliver his many promises to make substantial changes. As the nation is posed to invest, the most important factor to watch is how productive the investments will be. Simply put, productive investments will result in better return on investment (ROI), tangibly or intangibly. They should also increase productivity that in turns will improve our standard of living. Capital misallocation can result in a higher growth but might not improve the real standard of living, which is the ultimate goal of economic activities. Whether the new president can truly achieve this goal is still yet to be seen. One thing is certain: we will see more market volatilities. 

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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