We’ve certainly had a decent run in U.S. equities. Aren’t things expensive?


Written by: Jon McGraw

We brought up this same question back in August, and markets have just continued higher from that point. That’s really the issue with trying to time markets and waiting to invest when things ‘feel’ better. Too many investors fall prey to this consistently: waiting until every problem in the world has been solved is usually way too late.

Markets really do climb that ‘wall of worry,’ which implies that investment opportunities are available to those that are willing to accept a bit of uncertainty… If/when that uncertainty dissipates and everyone feels good about the economy, or employment, or oil prices, or politics, or whatever else, in theory no one is left to invest… that last marginal buyer has already put his last dollar in. Then, the pressure naturally turns to the downside when any unfavorable news items could spark an avalanche in the other direction.

Despite strong returns from the 2009 lows, we do not appear to see such complacency. Unlike the 1999-2000 timeframe when technology stock tips were being thrown around cavalierly, many investors continue to largely distrust stocks, distrust the Fed, distrust the government in general and maintain a strong preference for safety—despite the very low prospective returns for low-volatility assets. This isn’t surprising, since the Great Recession—the worst in 50+ years—still weighs in recent memory. Missing are the sustained cash flows into equities, the positive pro-stock bent in the media and general public exuberance. It’s just not there yet. From a behavioral finance standpoint, that’s important. We saw this well-described recently in economic terms as ‘inverse elasticity,’ in that stocks are one of the few items whose demand tends to increase as prices go up (contrary to what classic economics teaches us about supply and demand of elastic goods, like a pair of jeans).

How do we put equity valuations into context?

Including our general fundamental dividend discount and price ratio modeling, you can look at equity valuations through a variety of measures. You can use the ‘Fed Model,’ which takes the price/earnings ratio (currently 16 or so), and inverts it into a ‘yield’ of 6.25%, which then compares favorably to 2.75% on the 10-Year Treasury. There are other measures one could use, such as total stock market capitalization as a percentage of overall U.S. GDP or valuation related to corporate profits relative to economic growth, and, while somewhat correlated to valuation, the meaningfulness of the ratio changes period to period. A combination of ratio and DDM measures tell us that the U.S. large cap market is roughly fairly valued—not overly cheap, but not overly expensive, either.

Nevertheless, this ‘neutral’ signal should not imply complacency. Goldman Sachs’ market strategy group assigns a 2/3 probability of a 10+% correction sometime in 2014; however, this is not really going out on a limb since this has happened roughly once a year historically anyway. From an asset allocation perspective, when valuations become much more stretched, our recommendations will change. But fair value is, well, normal. We’ve just forgotten what ‘normal’ is.

What about bonds?

As usual, it’s all about the math. One good part about analyzing fixed income is that outcomes can be foreseen if you only know what happens with interest rates (and spreads). Unfortunately, rates are among the most difficult data points in finance to predict. They never cease to provide a surprise. Some baselines to go off of are nominal rates compared to GDP, or levels of ‘real’ rates, in addition to spread levels of non-government debt compared to historical averages. Currently, since nominal rates can’t go negative, the ‘zero bound’ compresses the spring and offers a great deal of asymmetrical potential risk on the upside. One can and likely will be off in the timing of these rate changes, but it could be quite detrimental to be caught on the wrong side of a rate spike while holding intermediate- or longer-duration bonds.

We’ve moved the duration of our bond portfolio models progressively lower, perhaps giving up some opportunity cost (in the form of higher coupons, although not as much as one might think), but are much better protected than the general bond market if this spike eventually does occur. We got a dose of that this last summer. As we move ahead, we wouldn’t be surprised to see a continued struggle between accommodative Fed policy while labor markets struggle to recover, but also rising rate pressure from better economic strength. Corporate bonds, notably high yield and floating rate, continue to offer better prospects in our view than do governments, which are barely offering a real return after inflation—and one far less than historical norms.

REITs have moved from fairly valued to slightly inexpensive (at least in the ‘quality’ firms and sectors), since fears of rising rates resulted in some volatility. However, improving economic fundamentals and lack of an oversupply/overbuilding situation could serve to at least sustain if not boost valuations looking ahead, as those factors are much more important in driving longer-term real estate returns than are shorter-term rate issues.

In short, markets aren’t priced on where we are now—they’re priced on the ‘collective wisdom’ on where we’re going. Analyst earnings and stock target price projections are rising, but that is common of a market already in recovery. Analysts are human, too, and are subject to the same behavioral biases as the average investor, but also the added ‘agency’ issues caused by pressure to remain part of the herd. Being a contrarian can be uncomfortable and sometimes career-threatening at some firms. Market activity is data-dependent but also sentiment-dependent. While the data has improved, and that has buoyed risk markets, Main Street sentiment does not seem to have moved to the level of exuberance quite yet.     (Note: the question was in reference to U.S. markets—we’ll likely cover foreign stocks and bonds another day)