Bad Things Happen at High Valuations

There is no lack of geopolitical drama right now with war in Syria, tensions with Russia, potential war in North Korea, French elections that may usher in the end of the EU, and of course continued political turmoil here in the United States. Because I am an optimist, none of those situations worry me too greatly since I have staunch faith in human ingenuity and the basic will to survive. What does concern me, from an asset management perspective, is that there appears to be a rising chance that some calamitous geopolitical event may occur, in addition to the fact that corporate earnings topped out in 2014, the Federal Reserve has started raising rates, and US based stock markets are trading near all-time highs. The last point is the most important in my mind. None of the other items mentioned above would be nearly so scary, from an investment standpoint, if markets were trading at cheaper valuations that reflect a pricing in of the potential risks. The old saying is, “the cure for high prices is high prices,” which promotes the idea that high valuation levels are unsustainable over the longer term. I believe the current high market valuations suggest a significant risk to future investor outcomes.

A Twitter-Worthy Executive Summary

Geopolitical risks continue to be a concern but the main threat continues to be high market valuations.

On the Wrong Side of History

One useful measure of market valuation, which we refer to frequently in our past articles, is the price-to-earnings ratio (P/E). This measure reflects the market value per share divided by the earnings per share of the S&P 500 and is useful in establishing relative valuation compared to the past. As it stands, the current P/E reading is in the highest quintile (top 20%) of all previous P/E readings. Similar levels in the past have typically produced a forward return outcome of a miserly median +4.3% per year annualized. The first quintile on the other hand has historically produced median returns of +15.7% annualized, demonstrating once again why it is better to buy low and sell high. History may not repeat exactly, but it often rhymes. This suggests that at current levels, investors should lower their return expectations (for portfolios invested entirely in U.S. based stock markets) for the foreseeable future.

_{Source: Blumenthal, S. (April 7th, 2017). On My Radar: Valuations, Earnings and Forward Returns. CMGWealth}

Being in the highest P/E quintile not only means forward returns are likely low, it has also shown a high correlation with the probability of sharper three year drawdowns (the absolute top to absolute bottom of a market selloff). In the past, the average drawdown from similar points is -18%, with the worst drawdowns having been around -50%. Put in dollar terms, for a $500,000 portfolio that is an average loss of $90,000, to a worst case loss of approximately $250,000. Ouch!

_{Source: Blumenthal, S. (April 7th, 2017). On My Radar: Valuations, Earnings and Forward Returns. CMGWealth}

Not only is the current bull market expensive, it is also very old. In the history of bull markets since the 1920s, the current bull is the second oldest behind only that of the 1990s when the internet was created and personal computing greatly boosted national productivity.

_{Source: Kelly, D. et. al. (March 31, 2017). Guide to the Markets. J.P.Morgan Asset Management.}

Neither market age nor expense is a guarantee that a sharp sell-off is imminent, but it does show the probability of a significant negative market event is increasing. A prudent person stocks up on essentials before a storm arrives, rather than after the fact. We would suggest now is the perfect time to begin positioning portfolios to protect from the coming storm, which will preserve the most capital to take advantage of buying opportunities that usually exist after market sell-offs.

A Flattening of the Yield Curve

Because the Federal Reserve keeps threatening to raise rates (and has raised them twice in the past two years), many investors are starting to fret about their exposure to bonds or other interest rate sensitive investments. Historically, rising rates can be bad for bond valuations but this does not seem to be the case in the current market environment. Since the last rate hike on March 15th, 2017, long-term treasury yields have actually fallen from 3.1% to 2.86% (as of 4/19/17). That result is the exact opposite of what most would expect after a rate hike, which is leading to a phenomenon known as a flattening of the yield curve.

The treasury yield curve has flattened considerably since 2013. This raises the risk of the curve inverting, where it costs more to borrow short-term than long-term. Yield curve inversion has preceded every economic recession in the last 100 years. This frequently happens when the Federal Reserve raises rates, which mainly affects the short-end (left side) of the curve. Longer dated debt is more dependent on investor behavior in the market and other influencing variables.

_{Source: Kelly, D. et. al. (March 31, 2017). Guide to the Markets. J.P.Morgan Asset Management.}

The reason the long-end of the curve (bonds that mature in 10+ years, right side of above chart) are seeing rising prices and lower yields is due in large part to demand from foreign sources. This demand exists because interest rates on foreign debts of similar risk type (i.e. thought to be just as safe as US debt) are yielding much lower and in some places, like Switzerland, the yield is actually negative. Take Germany for example, where the 10-year bund is yielding approximately 2% less per year than the arguably comparable 10-yr US treasury. The yields as of this writing on April, 19th 2017 were 0.20% and 2.21% respectively (the 10-year Swiss yield is a negative -0.25%!!!). It would seem that getting an additional 2% per year for low additional risk (currency exchange risk is a factor) would be well worth it for most foreign investors. The chart below shows the historic spread comparison between the rates of 10-year bunds and U.S treasuries is near all-time highs.

_{Source: Folkerts-Landau, D. et. al. (1/9/17). Deutsche Bank Research Outlook 2017.
Deutsche Bank.}

At our recent CWM Thirdly events, we argued that we expect foreign investment will continue to flow into US debt instruments (corporate bonds and treasuries) and that this demand would put a cap on how yields on longer-term debt would respond to Federal Reserve rate hikes. The chart below demonstrates that foreign investment is indeed high and rising.

_{Source: Kelly, D. et. al. (March 31, 2017). Guide to the Markets. J.P.Morgan Asset Management.}

We continue to argue in favor of bonds and other non-correlated market assets despite the threat of Federal Reserve rate hikes. Our research suggests that those types of assets will outperform stock markets in the near future because of the comparably high valuations of stocks.

The Current CWM PTS® Indication

We perceive relatively little risk from rising rates in the current environment and due to very high market valuations, we believe the stock market is a much greater concern than the bond space. Our own CWM Performance Targeting System (PTS®) metric stands at 1.13 as of 4/18/17. While not an extreme score (extreme scores exist closer to +/-3), this does reflect an environment where we can be more confident that stocks are more likely to underperform bonds/non-correlated investable assets. Negative PTS® scores reflect environments where we expect stocks to outperform, while bonds/non-correlated investable assets are expected to outperform at positive readings. Between an indication of -1 and +1, normal portfolio weightings are the most appropriate response because we cannot be entirely confident of outperformance between either stocks or bonds/non-correlated assets. As it stands, the current 1.13 indication suggests we should remain overweighted in bonds/non-correlated assets.

Though there is potential for stocks to move higher still, current valuations reflect a high and rising probability of a negative outcome, which we are striving to mitigate for our clients when it occurs. CWM PTS™ models continue to be invested conservatively, as they have been for some time. Your CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation with you! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer, Principal
MorganA@CWMnw.com

P.S. While there are many worrisome events occurring around the world at present, the longer term trends show that humanity really is headed in the right direction in many ways. The below charts are courtesy of the excellent website OurWorldinData.org where data geeks like me can find all sorts of interesting data collections and comparisons.

The percentage of people living in extreme poverty has fallen from over 90% in 1820 to around 10% today.

Like extreme poverty rates, the percentage that is illiterate has fallen drastically as well.

Child mortality has fallen globally since 1960 regardless of socioeconomic class.