This market is 100% crazy stupid. Anyone who thinks otherwise doesn’t understand the history of valuations and their effect on returns and doesn’t care about protecting their capital long term. Yes, the current P/E is not as bad as other valuation metrics, but P/E ratio is one of the least reliable valuation metrics because of how short term oriented it is.
The most reliable long term valuation metric is the stock market to GDP ratio, which Warren Buffett often refers to as the “single most reliable measure of stock market valuation at any given time.” If you look at the chart below, created by John Hussman, you will see a remarkable correlation between current stock market to GDP and the subsequent 10 year returns in the stock market, INCLUSIVE of dividends. This means that taking dividends out, you would have to subtract 2% per year, roughly, from the total returns.
So first off, if you don’t look above and think that the next 10 years in the stock market are going to be ugly, you need to take all of your money out of the stock market, bury it in the back yard, and remove yourself from society because you’re dense.
Look at the period around 1999/2000…if anyone remembers those times, expectations were of 15-20% returns for the rest of time. If you don’t believe me, go look up articles from Barrons and other financial organizations and see what was said by “professional” money managers who were considered experts. The scary part is, we aren’t that far off of that time right now! The annualized return expected over the next 10 years is around 1% per year! WITH DIVIDENDS!! Which is close to what it was back in 1999 and 2000, when expected returns were sub 0% even with dividends, and things played out exactly that way. For valuations today, that means that based on 92% correlation, we should expect the nominal market price of the S&P to be LOWER in 10 years than it is today because taking out dividends takes the nominal price of the S&P growth to negative territory!
Historically, the average stock market to GDP ratio has been in the 90% range and as Warren Buffett says, when you are in the 60-70% range, you will do quite well for the foreseeable future. However, at the start of past secular bull markets, the ratio has gone as low as 42% before the big rises start, which means that prices are much lower based on history. Why? Well think about it…
The most important thing to future returns is how much you pay for an investment today. Can an investment still do well even if you pay more for it today than you wanted to? Of course. That happens all the time. I’ve successfully done it in real estate. But when you are investing in a broad base of companies, like any diversified portfolio should be, it will all average out. So you need to pay as little as possible, as a whole. The less you pay, the more return you will get because over the long run, stocks will perform to their long term valuation levels. In the short run, it’s a crap shoot. As Warren Buffett always says “stocks are a voting machine in the short run and a weighing machine in the long run.” Which means that in the short run, the popular ones will do the best but in the long run, the fundamentals of cash and cash flow and revenue will be what determines success.
So in 1982, when the stock market to GDP ratio was around 42%, it would make sense that the following 18 years yielded 18% returns and when the stock market to GDP ratio was north of 1.5, as it is today, the following ten years produced very poor results. Paying a higher price for anything will always take away future returns because returns are calculated on what you PAY for an investment. The results will factor into your return as well, don’t get me wrong, but the income and cash flow are not at all affected by what you pay for the investment. They will be what they will be whether you pay $1 or $1MM for it.
10 Year Cyclically Adjust P/E Ratio
This was created many decades ago (earlier part of the 20th century) by the writers of Security Analysis, which is the Bible of value investing. We all know that P/E is the price to earnings ratio and it can be applied to the market. However, these guys understood that any given year can have massive fluctuations based on short term expenses or revenue gains that aren’t reflective of long term performance. So what they did was even it out a bit by taking the present value of the previous 10 years of earnings and see where the market stood. The historical average is around 16.6, and CURRENTLY we are at 27. 27! The only other time in HISTORY that it has been higher was 1999/2000. In fact, all previous secular bear markets prior to 1999 started when the S&P 10 year P/E was around 23-25! So we are even higher than what starts a 17-20 year flat stock market.
In past secular bull markets, the S&P 10 Year P/E is in the single digits. Usually around 6-9 so in this situation, for us to get to that level again, we would need the S&P to go from 2100 today down to 700. I know it sounds unfathomable but that’s where it would need to be to have the 10 year P/E at 9. Is it a coincidence that when valuations are high, future returns are low and when valuations are low, future returns are high? Of course not. Go back up and read my statements on paying more for an investment will always chip at your returns. 100% of the time.
I love watching CNBC and having all these pundits and experts talk about how we are in the early stages of a long term secular bull market. Liz Ann Sonders is one person I love to pick on because she is the Chief Investment Officer at Charles Schwab and she should know much better. But she doesn’t. She doesn’t look at history just like 99.9% of the average person. So pat yourself on the back for being just as smart as Liz Ann Sonders.
Valuations will ALWAYS mark the end and start of secular bear and bull markets. Always. Remember, the less you pay for something, the better your return will be. When valuations are low, you are paying less and therefore, your long term return will be higher. So long term secular bull markets will ONLY begin when valuations are low. How low? Well below historical averages, that’s for sure. And secular bear markets will begin when valuations are high. How high? Higher than the long term average.
Remember, the average is the average but we are never at the average point. We are always either overvalued or undervalued. Never at fair value. (I say never but really what I mean is for a sustainable period of time…) So we talked about the historical average of 16.6 on the 10 year P/E, but how often are we actually there? See the chart below…
This is from GuruFocus.com. They say the current 10 year P/E is 25.5, which I won’t argue. Close enough to 27. But if you look, the average they have is the 16.6 that I mentioned above. But how often did we actually hit that? Very rarely! And we were never there for long. So as you can see, stock valuations are never really at fair value for long enough to matter. We are either over or under value at all times. So you have to decide: are you going to be a buyer or seller at any given point? Now, do I make my investing decisions based on this? No. You can find good buys at high valuations and bad buys at good valuations. But if I am buying broad based funds, then this would elicit some caution at the extreme levels.
BTW, interesting enough, look at when stocks were at their highest valuation peaks…1900, 1929, 1966, 2000, and today…what did stocks do after those levels? See below…
In 1900, the S&P was at the equivalent of 7.5 or so. At this point, the 10 year P/E was around 22. For the next 24 years, the S&P fluctuated between 7 and 10 continuously until the late 1920s boom took things to the next peak/bubble. Coincidence? If you think so, you’re smarter than me.
In 1929, the S&P 10 year P/E got to 27. The nominal price of the S&P at that time was 25 or so. So what happened after that? The S&P dropped down as low as 7 and didn’t recover to its previous high of 25 until 1952! It took 23 years for the market to hit the same level again. Again…coincidence? Come on…let’s go to the next extreme…
In 1966, the S&P 10 year P/E hit 24 and the S&P’s nominal price was around 100. So what happened from there? For the next 16 years, the S&P went sideways and stayed at or below that level until 1982…which was the start of the biggest bull market run in history.
Now for the biggest market extreme ever…1999/2000. The S&P 10 year P/E got as high as 44 and since then, we have seen new highs…all the way up to 2100 as of late, but the S&P also got as low as 666 and based on valuations, the only reason stocks are so high up right now is that they are at high valuation peaks…so this is not meant to show that paying a high premium is ok. It is not. We are going to have a bad stock market for the coming 10-12 years. History has shown it going back to 1871..why would it be different now? It’s not. It never is. Yes, stocks can go higher and higher for a long period of time and irrationally, but it eventually stops. The music stops. And suddenly the chairs disappears…
Anyone who reads this has seen me short Amazon. Well, I’ve been killed on it. And guess what…I’m not worried. Amazon officially is the most expensive stock, valuation based, in the stock market. Granted, that’s based on P/E and we all know that P/E can fluctuate wildly but either way, it’s overpriced. When other companies such as Wal-Mart and Target sell for 0.5 or 0.8 times revenue, Amazon is selling for 3 times revenue. When other companies are selling for 3-5 times book value, Amazon is selling for 28 times book. There is no valuation metric that shows Amazon is a good deal. It has more than doubled in stock price this year alone.
No one cares about valuations during bull markets. Look at private venture tech companies. We have never had more “unicorns” (private start ups that are valued over $1Billion) ever in our history. Including 1999/2000, the most overpriced tech market we have ever had!
The scary part, for investors, should be that Square just announced they are going public for 33% LESS than their last round of private valuation! Less! That’s not good. They raised money at a $6Billion valuation recently but are now going public based on a $4Billion valuation.
Back in 1999/2000, the only positive of the market was that smaller companies didn’t have bad valuations. The horrible valuations were on the higher end value of companies. Today, we are seeing it on all levels, but also high end value companies are seeing larger than life valuations. Yahoo, Facebook, Amazon, Adobe, etc…these companies have been around for a while and are still sporting very high valuations! As I write this, some douche from Edward Jones named Aaron is saying that he has Amazon as a strong buy because of robust growth and stronger margins. Meanwhile, he also says he values Amazon’s retail business at 2.5 times revenue….WTF?!?!
Here is why I am confused. Amazon has worse margins on their retail portion than Wal-Mart and Wal-Mart sells for 0.5 times earnings but he decides to put 2.5 times margin on there?!?! Why?!?! Why not 3 times? Why not 4? 5? 6? Just saying a number when the average is a lot lower is insane…of the 81 consumer companies on the S&P 500, the average price to sales ratio CURRENTLY in this massively overpriced market is 1.8 times earnings and the average gross margins is 40% and Amazon’s, on their retail side, is 24%. Wait, so they are 40% lower on margins and they are worth a premium to sales? Does that even make sense? yes, it is growing but as it has grown it’s margins have decreased and the majority of their better margins are coming from AWS, it’s cloud computing services which is a commodity. It will be a price war. Margins will shrink because the costs to operate are pennies. Google and Microsoft are already in it and growing their portions like crazy.
Another example: Tesla. Tesla is a great company. Their product rocks. They’re the new hot thing. But what’s it worth to us? So typically, car companies sell for the following:
Ford: 0.38 times sales
GM: 0.39 times sales
Honda: 0.48 times sales
Toyota: 0.83 times sales
Daimler: 0.54 times sales
Are we seeing a pattern yet?
Tesla: 7.1 times sales.
WTF?!?!? Why?!?! Yes, they are cool. Yes, their cars are awesome. But they make no money! Yes, they are trying to grow, but something has to give!! Yes, their gross profit margin is much better than Ford and GM, but it’s not THAT much better than Daimler, Honda, and Toyota, who all sport around 22% margin and Tesla has a bit over 24% margin! So what gives?!?! It doesn’t add up at all. But it’s a sexy and fun company and so everyone will pay whatever they can to get it.
What is the Right Price?
When I go back to my high school, the first thing I do is take my iPhone out and say “Who here has this kind of phone and loves it?” Sure enough, over half the class raises their hand? So I then asks the students “would you pay $1 for this phone?” And of course, they say “of course we would.” No duh. Then I ask “Would you pay $1Million for this phone?” And of course they say “no way.” Again…duh.
But that’s what it seems is what happens with stocks like Amazon, FaceBook, Tesla, etc….people say the product or company is awesome so pay whatever it takes to own it. You may say I am wrong about this, but I’m not. Why is 7.1 times sales ok for Tesla when similar companies are getting 0.8 times sales, at best? Why is 3 times sales ok for Amazon when similar companies are selling for 0.5 times sales?
This is a prime example of a bubbling market. There are massive overvaluations across the board and margins are high because of lower interest costs because of the Fed reducing rates so aggressively over the past 6 years and keeping them low. When corporate debt interest charges are down 80%, of course you earnings on the same revenue will increase but it doesn’t mean you’re a better company because of it.
If you think about investments the same way I thought about the iPhone, you will realize that there is a price for EVERYTHING. It doesn’t matter what it is. You can buy a pile of dog shit for the right price as long as you can figure out a way to make something on it. There is always a price for something. When Long Term Capital Management went under and rocked the financial world in 1997, Warren Buffett made an offer to buy the very assets that took the company down. So the same assets that took a company down had gone down in price enough that it was attractive enough for Buffett to make an offer on it. That is a prime example of how prices are what dictates the returns.
It’s hard to see the market go up and read something above. I get it. I’m not here to argue that the market can’t go up higher because it can. And it probably will. Markets can stay irrational longer than you can stay solvent. Look at Japan. Those markets have been irrational for decades.
But at the end of the day, valuations do matter. And anyone who thinks that buying today will yield good results long term has another thing coming. It may not happen this year, but it will happen eventually. People have to give up on stocks for stock prices to go to the point where they are a great buy again. Literally they need to be saying “if you want to retire well, do not buy stocks.” Just like in 2009 when the world fell apart and in that same year in real estate. People have to give up.
Peter Lynch has an anecdote he has told many times. He talks about how he knows when to buy or sell stocks. When he goes to a cocktail party and people are telling HIM what to buy, he knows it’s time to sell. When he goes to the cocktail party and people are feeling bad for him for being a money manager, he knows it’s a good time to buy. People think you MUST own stocks and that’s when things get crazy. Prices have to drop and prices only drop when people don’t want something anymore.
There will be a tipping point soon. Just like it was mortgage backed securities in 2008. That isn’t what caused markets to crash, it is just what caused markets to care about valuation suddenly. The tipping point is something we don’t know or see yet, probably. But when it happens, everyone will blame this one thing and then later say they saw it happening. So many people now say “it was so obvious that real estate was overpriced back in 2008.” Oh was it? Hmm. It’s ego on my part because I have 3 years of blog posts showing my views on the market and so far I have been “wrong.”
When this market does take a turn, for us to get to the point of starting a real secular bull market, we have to get to an ugly place. Years and years of bad returns. People have to give up. We aren’t anywhere near that now. Even 2008 and 2009 wasn’t that bad. I think in the last 12 years, we have have 11 of them be up years. That’s unreal. It shows you how short and quick the last drop was. You don’t lose faith in markets when it’s a quick pop and then rebound. We need a long term drudging. It will eventually happen…but I just don’t know when.