February 10, 2020
As we move deeper into 2020, it’s a good time to provide an update on U.S. equity valuations.
Stocks are very expensive by most metrics, but there are many different opinions on how to value them and how highly they should be valued. So, this newsletter issue takes a look at current equity valuations from a few different angles, and then provides an update on ongoing coronavirus impacts.
Distance from an Idealized Market
In a healthy and well-ordered market, equity securities should ideally provide higher forward returns over the long run than long-term investment-grade fixed income securities, long-term fixed income securities should ideally provide higher returns than short-term fixed income securities, and short-term fixed income securities should ideally provide higher returns than gold.
This should be intuitive. Equities are volatile and are at the risky end of the capital stack; the last people who would get any money back in the event of a bankruptcy, compared to corporate bondholders and other lenders, and especially compared to investors in the nominally “risk free” asset class of government bonds.
Long-term fixed income securities make you lock up your lending period for a longer period of time, which inherently means more risk, and thus should demand higher yields than short-term securities of the same level of current credit risk. In other words, lending money for 10 years should earn you higher yields than lending to the same borrower for 1 year. However, especially with modern financial vehicles like ETFs, many investors don’t hold such securities to maturity and instead trade them around.
Lastly, gold has no yield and incurs a small storage cost. So, when the financial system is healthy, gold should provide lower returns than fixed-income securities.
In general, riskier or more volatile asset classes should provide better long-term returns than safer or less volatile asset classes. If this doesn’t occur over, say, a decade, then most likely one or more of the asset classes was misjudged or mispriced from the starting point.
During many periods in history, markets are not healthy and well-ordered, and instead become sick and imbalanced. Equity valuations get too high, for example, and therefore end up underperforming bonds and/or gold over the next decade or longer. Yield curves sometimes invert, meaning that long-term securities pay lower yields than short-term securities. Inflation switches from low to high, or debt defaults occur, and therefore bonds end up underperforming gold. Interest rates on cash and bonds sometimes go below the inflation rate, meaning that gold suddenly becomes a lot more attractive as a store of value.
There are all sorts of events that can potentially re-organize the forward expected returns of these asset classes over a decade or more, meaning that a lower-risk asset class ends up outperforming a higher-risk asset class. We should be on the lookout for such things, and occasionally measure the distance between our market and an ideal market, to spot potential imbalances.
For example, I have shown in a few articles the historical 10-year total forward outperformance of the S&P 500 over gold (orange bars), plotted alongside the inverse CAPE ratio of the S&P 500 (a measure of valuation, blue line):
Data Source: Robert Shiller
We can see that stocks outperformed gold over most 10-year periods during this near-century long period, but specifically underperformed during 10-year periods that started when stock valuations were at historic highs, which is where we are at now.
Of course, we can’t know the future, so we can’t say for sure which asset classes will outperform others from, say, 2020 to 2030. We can, however, piece together available evidence to see how many warning signs there are for certain asset classes relative to others, for the purpose of asset allocation and risk management.
It shouldn’t be news to many people by now, but based on many ways of measuring it, absolute U.S. equity valuations are historically high at the current time, which if history is any guide, implies a high probability that they will provide rather low long-term inflation-adjusted forward returns. However, they’ve been elevated for some time, and have continued to march higher, in what has become the longest economic expansion in U.S. history.
As a measure of valuation, we can start by looking at U.S. total stock market capitalization (via the Wilshire 5000 price index as a proxy), compared to U.S. GDP and U.S. broad money supply, each measured in billions of dollars:
Chart Source: St. Louis Fed
And log form for those that prefer it:
Chart Source: St. Louis Fed
Based on the market-capitalization-to-GDP ratio, U.S. stocks are at record price levels.
Some investors push back by pointing out that, for example, Apple is the top stock in the index and it’s basically a global company, rather than a U.S. company. The same can be said for Alphabet, Microsoft, Facebook, Starbucks, Visa, McDonald’s and so forth. They sell their products and services to the world. Therefore, it shouldn’t be a surprise to see U.S. stock market capitalization start to outpace U.S. GDP.
Except, that’s not correct for the index as a whole. Not by a long shot. The S&P 500 makes up about 80% of total U.S. stock market capitalization, and the percent of revenue for the S&P 500 from outside of the United States has been flat-to-down over the past decade. And the small caps making up the remaining 20% of the U.S. market are mostly domestic-focused. Here is the percentage of S&P 500 foreign sales over time:
Chart Source: S&P Global Indices
If the “it’s a global index now” view was correct, we should see S&P 500 companies have a larger and larger share of foreign revenue as they extend their reach beyond the United States, but that’s not the case, especially in this strong dollar environment. (The current cycle of dollar strength started right at the end of 2014, and the percentage of S&P 500 foreign revenues has declined since then.)
At the end of 2013, the U.S. stock market capitalization was 115% of GDP, and the S&P 500 earned 46.29% of its revenue from abroad. By the end of 2018 (the latest full year that is available), the U.S. stock market capitalization was 151% of GDP, and the S&P 500 earned only 42.90% of its revenue from abroad. There was no significant change between those two years in terms of S&P 500 globalization, and in fact a small backward move. S&P 500 earnings were flat in 2019, and revenues were up only slightly, so it’s not as though that changed much this past year either. And yet, the U.S. stock market is at a record 156% of U.S. GDP.
It was mainly higher stock valuations as well as corporate tax cuts that drove this gain in the market-cap-to-GDP ratio, not the idea that U.S. companies are becoming more international companies than they used to be, when looking back 10-20 years. If you go back 30-40 years, only then does it become true.
In addition, the CAPE ratio, the Q ratio, price-to-sales, price-to-book, EV/EBITDA, dividend yields, and other ways of measuring U.S. equity valuations are indicating very high levels, and indeed the highest or second-highest that they’ve ever been in history, depending on which specific metric is used.
In general, pre-tax measures of valuation (such as market-cap-to-GDP, price-to-sales, EV/EBITDA, and so forth) are showing their highest levels ever, while after-tax measures (CAPE ratio, price-to-book, dividend yield, etc) are showing their second highest level ever after the 2000 stock bubble.
Stocks vs Bonds
All of that being said about equity valuations, bonds are historically expensive as well, meaning their yields are historically low. The 10-year treasury currently offers a yield of under 1.6% (which you get taxed on), while official inflation is currently 2.3%. That’s not exactly a great bargain for those that intend to hold to maturity. Cash is in a similar quandary; bank interest rates are mostly below inflation rates.
The cyclically-adjusted equity risk premium, which compares the inverse S&P 500 CAPE ratio to the current rate on U.S. 10-year treasury yields, shows that equities are still fairly-priced relative to treasuries in a no-recession scenario.
Back during the dotcom bubble of 2000, treasury yields were 5-6% compared to a cyclically-adjusted earnings yield of the S&P 500 of only about 2-3%, meaning that the equity risk premium went as low as negative 4% at its bottom. It was a no-brainer to buy treasuries instead of stocks.
It’s far more complicated than that today, with both stocks and bonds at expensive levels, with a comparison showing that equity returns may still outpace treasuries over the next decade. With a cyclically-adjusted earnings yield in the ballpark of 3.1%, and 10-year yields hovering under 1.6%, the equity risk premium is currently positive.
However, stocks will naturally be far more volatile, and are likely to have a significant period of underperformance compared to treasuries if/when a recession occurs.
Three Potential Catalysts for a Reversion to Mean
Many investors have been predicting for years that stock valuations will unwind and revert to their historical mean. It’s important, however, to identify some of the main catalysts that could cause such a thing to occur.
There are three main catalysts to be aware of that if they were to occur, would likely push the market level down to a more normal historical trend with GDP and money supply. Investors might do well to weigh the probability of any of these occurring in their view over the next, say, 1-year, 3-year 5-year, or 10-year periods, to help determine their asset allocation mix.
Catalyst 1) A Recession
The first and most obvious catalyst would be a recession, where corporate earnings fall, valuations fall on those earnings as investors get spooked, and stock prices get ugly in a hurry.
Currently, analysts are expecting 10% S&P 500 earnings growth in 2020, and continued growth in 2021 and thereafter. This assumes no recession occurs in the foreseeable future. Even if that growth rate comes to pass, however, stock prices are currently stretched compared to their average:
Chart Source: F.A.S.T. Graphs
Whenever stock valuations become stretched, however, one should always assume the possibility that they can become stretched even more.
Catalyst 2) Renewed Inflation
The second catalyst would be a resurfacing of high official inflation after four decades of declining official inflation. The main reason that equity valuations were so low in the 1970’s and 1980’s was that inflation and bond yields were very high.
It’s easy for slow-growth stocks to have a P/E ratio of over 20 today when bonds yield next to nothing, but if inflation pushes bond yields higher, the cost of capital would increase, the opportunity cost for investing in equities would increase, and equity valuations generally would have to come down to offer competitive forward returns.
The chart below compares the ratio of market capitalization to GDP (blue line) to 10-year Treasury yields (red line). As you can see, historically there has been an inverse correlation with interest rates and equity valuations. There have been temporary divergences from that trend on the blue line due to stock bubbles and recessions, but overall, the value of the stock market has inflated as interest rates have declined:
Chart Source: St. Louis Fed
Catalyst 3) Higher Corporate Tax Rates
The third catalyst would be higher corporate tax rates, which depends on political outcomes. Consistently decreasing effective corporate tax rates (forget the headline number, which isn’t the real number) have been a multi-decade tailwind to support higher and higher equity valuations over the last few decades, as the government takes a smaller and smaller share of corporate profits.
Below is the chart of corporate tax receipts divided by corporate pre-tax income over time (red line) along with the ratio of market capitalization (blue line). Outside of recessions that temporarily throw off the numbers, effective tax rates used to be 20-25% in the 1980’s and 1990’s, 15-20% in the 2000’s, and 10% or lower now.
If corporate tax rates ever start moving in the opposite direction and it becomes a headwind, stocks are likely in for a rough patch. Even if corporate tax rates start remaining flat at low levels for a while, the tailwind will no longer exist, even if it doesn’t become a headwind.
Chart Source: St. Louis Fed
Apart from the clear humanitarian toll it is taking, we still don’t know the full impact of what the Wuhan coronavirus will be on the global economy or U.S. economy. The market doesn’t seem to be pricing it as significant, and those of us without doctorate degrees in viral epidemiology have little to go on other than to track the numbers and measure the actual economic impacts of the multi-country government response.
On one hand, the Wuhan coronavirus has infected and killed more people than 2003 headline-making SARS did. In addition, it is occurring at a later stage in the economic cycle than SARS (ie, the U.S. economy and several other economies were already on a slowing streak when this virus hit the headlines), and China is a much larger piece of the global economy today than it was during the time of SARS.
On the other hand, its official death toll (to the extent that we accept Chinese government figures as accurate) is currently below a thousand compared to the roughly 500,000 people that die each year globally from the seasonal flu. Some sources rationally speculate that the real death toll of the coronavirus could be an order of magnitude higher than what is currently reported, based on limited availability of testing kits, inconsistencies in the official data vs evidence of what’s happening on the ground, and other factors.
However, it’s not just the disease itself that we must consider, but the government response that has, without exaggeration, put most of China on economic and in many cases physical lockdown. China is the second biggest economy in the world, a major manufacturer, and a major end market, and so the global economy is tied to them.
Commodities have taken it on the chin harder than almost anything else. Oil prices went from over $60 to about $50 within a month. Copper encountered its longest streak of down-days in history, with 14 consecutive down days in a row before finally bouncing a bit.
Travel stocks have been slammed as well, with airlines, cruise operators, hotels, booking websites, and others cancelling flights, cruises, and rooms. China sends out about 150 million international tourists each year (roughly equal to the total populations of Germany and the United Kingdom combined), and that is now effectively on hold.
Apple, Starbucks, McDonald’s, Tesla, and other U.S. consumer brands have closed stores and/or offices in China. In addition, China’s manufacturing facilities, including electronics, are at risk of remaining closed for longer than initially expected, which could impact sales of these major companies to U.S. and worldwide consumers. The longer that this persists, the more questionable the consensus analyst expectation for 10% S&P 500 earnings growth in 2020 becomes.
Overall, risks have become elevated in recent weeks. Value investors would do well to keep many of these troubled areas, such as emerging markets, commodity producers, and travel stocks on their radar for potential bottom-fishing entry points as more information becomes known, but overall, the S&P 500 is entering this slowing-growth period at high valuations with the unknown global and domestic impact of the virus (and just as importantly, the response to the virus) as an additional variable.
I have several investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue every six weeks.
These portfolios include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the model portfolio account specifically for this newsletter at M1 Finance that I started last year.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $22k so far.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
After adding $1,000 in fresh capital in January, here’s the portfolio today:
Here is the full list of holdings within those various sections:
Changes since the previous issue:
There was only minor pruning in the portfolio over the past month and a half.
- I sold Nordstrom (JWN) and Kohl’s (KSS). Nordstrom had a large gain while Kohl’s had a small loss.
- I bought Amgen (AMGN) and Tractor Supply (TSCO).
Primary Retirement Portfolio
This next portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash. This was due to higher stock valuations and being later in the market cycle more generally. If the U.S. economy encounters a significant sell-off, I would likely increase equity allocations to upwards of 90% once again.
Related Guide: Tactical Asset Allocation
For my TSP readers, this is equivalent to the 2030 Lifecycle Fund. One reason this is so conservative for my age is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have some precious metal exposure in this one in place of some of the bonds if I had that option.
My accounts at Fidelity and Schwab are mainly for large core positions in individual stocks, single-country ETFs, and selling options, and helps to fill some of the gaps that my index retirement account has.
Changes since the previous issue:
- I sold Micron (MU) and the iShares Brazil ETF (EWZ) for significant gains. I sold covered calls on them to generate extra income, and they were called away.
- I bought shares of Lukoil (LUKOY).
- I initiated a small short position on Tesla (TSLA).
U.S. real GDP grew by 2.3% last year, which is slowing but positive. As the business cycle stretches into its 11th year, year-over-year payroll growth is grinding lower.
Chart Source: St. Louis Fed
The coronavirus, and mainly the lockdown of China, is an extra variable to deal with on top of the fact that the U.S. business cycle was already slowing down. The market is ostensibly priced for 10% S&P 500 consensus earnings growth estimates in 2020 (and is historically expensive compared to even that scenario), but it remains to be seen how the disruption of global supply chains due to the virus and its response will affect those estimates.
We’ll see in the coming months how this plays out, for better or worse. Hopefully the virus headlines will blow over, global supply chains and commodity demand will resume, and it will have been just a big economic hiccup. We did recently get positive ISM manufacturing and non-manufacturing PMIs. The other potentiality, if it persists longer, is that the seizure of large portions of the global supply chain is the sort of unpredictable “black swan” catalyst for the U.S. economy to turn from slowing to outright recession.
Chart Source: Trading Economics
The best thing that investors can do overall, is to make sure their entire financial situation is robust, rather than just their portfolio. Do you have diversified sources of income, low or no debt, and plenty of liquidity and assets? Is your overall risk tolerance in line with your financial goals and unique situation?
For those that want more frequent business cycle updates and deep-dives into individual stocks, my premium research service releases a report every 2 weeks, compared to every 6 weeks for this free newsletter.