Warren Buffett’s Favorite Valuation Measure: Watch Out For Minus Two by Steve Blumenthal, Capital Management Group

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“The three great essentials to achieve anything worthwhile are: hard work, stick-to-itiveness, and common sense.”
– Thomas Edison

A comment I frequently get is that stocks are cheap relative to bonds.  My answer is that view is short-sighted and runs head-on into the other side of the low interest rate debate – rising interest rates are not good for stock market returns.  What looks cheap today becomes not so cheap when rates rise.  The Fed’s zero interest policy (6 ½ years and counting) and QE bond buying activities have driven bond yields lower and bond prices higher (bond prices go down when interest rates (yields) rise and go up when interest rates decline).

Yes – expensively priced stocks look good relative to ultra-low yielding bonds. But it is forward we must look and this is where the “stocks are cheap relative to bonds” argument breaks down.  I imagine you are getting more client calls expressing interest in high dividend paying stocks and ETFs (a popular spot the last few years). Today’s piece helps address why this may not be such a good idea.

We’ll also take a look, as we do each month, at the most recent valuation data to see what it is telling us about probable 10-year forward returns and I update the Don’t Fight the Tape of The Fed data.  Hint: (the data shows stock performance when interest rates rise – we are nearing a minus two reading: “Watch Out For Minus Two”).

Before we jump into the charts, I wanted to let you know that I’m posting brief pieces intra-week on our Advisor Central blog page.  Usually a quick technical chart or short comment – something that was material to me that I hope can help in your work with your clients.  If you are an advisor, click here to go to the page (there is also a sign-up to receive a weekly email summary – your email information is kept private and the research is free).

Personally, I like to go through the valuation drill each month as it helps to keep me centered on probable future returns and the current level of relative risk.  So, let’s dive right in to see what the latest valuations are telling us.

Included in this week’s On My Radar:

  • Warren Buffett's Favorite Valuation Measure – Stock Market Capitalization as a Percentage of Gross Domestic Income
  • Median PE and Stocks as a Percentage of Household Financial Assets
  • Don’t Fight The Tape or The Fed – Watch Out For Minus Two
  • Trade Signals – Volume Demand Remains Greater Than Supply – Bullish for Stocks 

Warren Buffett's Favorite Valuation Measure - Stock Market Capitalization as a Percentage of Gross Domestic Income

This chart is just one measure of looking at whether the market is expensively or inexpensively priced. Highlighted in yellow is the current level of the stock market’s value as a percentage of gross domestic income. Note that the current level is higher than it was in 2007 and any period prior to that other than the March 2000 peak.

The green arrow points to the level reached at the end of February 2009.  The great financial crisis low was made on March 6, 2009.

Warren Buffett Valuation Measure

Median PE

One of my favorite valuation measures is Median PE as I believe it can tell us upside and downside market potential and a great deal about probable forward 10-year returns.

The upper left hand section of the chart reflects a market overvalued at S&P 500 level 2120.46.  In geek terms, this is a 1 standard deviation move above Median Fair Value at 1621.31.  The Median Fair Value is determined by looking at the historical 51.2 year Median PE of 16.8.  Undervalued is at S&P 500 level 1122.16.

With the S&P 500 Index trading around 2100 today, this measure says we are near overvalued.

Warren Buffett Valuation Measure

Further, with a Median PE reading as of May 31, 2015 of 21.8, this puts the market in the highest 20% of PEs from 1984 to 2014.  So what does this mean?

If we look at all monthly Median PEs from 1984 to present, we can divide those into five groupings – lowest PEs to highest PEs.  Low means you are buying at a good price relative to corporate earnings (P to E) and high means you are buying in at a high price.  What is great about sorting the data this way is that we can then compare the subsequent 10-year annualized returns based on whether you bought in at a low PE or a high PE.

The next chart shows the results. Much as you would expect, Quintile 1 (the lowest 20% of monthly PE readings since 1984) gained 15.91% and Quintile 5 (the most expensive grouping) gained just 2.94% per year.

Today we find ourselves in Quintile 5.

Warren Buffett Valuation Measure

In conclusion, expect less than 3% annualized returns for the S&P 500 index over the coming ten years.

A completely different way to look at potential forward return, which has shown great historical accuracy, is looking at how much money individual investors have committed their portfolios to stocks.  Let’s go there next.

Stocks as a Percentage of Household Financial Assets

Interestingly, the amount of stocks owned by investors as a percentage of their total household net worth can tell us a great deal about probable forward 10-year return.

Here is how to read this next chart: The orange circle highlights where we are today (approximately).  It is telling us to expect an annualized return of approximately 2.25% per year over the next ten years.

The top red arrow points to the equity as a percentage of household financial assets in March 2000.  The dotted black line is what actually happened over the subsequent ten years.  The small red arrow points to 2007.  We’ll only know the average 10-year return in 2017.

Also take a look at the level at the market low in 2002.  We can see that the returns over those subsequent ten years was around 8% per year.

How about the low in 2009?  We know the last five years have been outstanding for the stock market.  A buy when everyone else was selling moment.  So today (orange circle) the market is expensive from the perspective of equity as a percentage of household financial assets.

Warren Buffett Valuation Measure

Source: NDR and CMG Investment Research

Look how closely the black dotted line (actual achieved 10-year returns) correlates to the blue line.  Given its historical accuracy (data from 1952 to present), it is hard to get excited about stocks today. Expect low returns over the next ten years and a significant correction along the path.  Risk is high.

Shoot me a quick email if you want to see the data on stocks as a percentage of household financial assets.

However, as with all valuation measures, while highly probable over five to ten years, they tell us very little about what will happen over the next year or so.  Markets can go on to become even more overvalued driven by central bank activity, global capital flows (fleeing other markets), etc.

U.S. individual investors appear to be nearly “all in” equities; thus, it is far better to be a buyer when the opposite is true. It is about supply and demand – more buyers than sellers or vice versa.

Overall, I like to think of using valuation metrics to identify period of low risk/high opportunity and high risk/low opportunity.  Today risk is high, so some form of stop loss risk management is important.

What you can do:

My view is that it is best to be in a position to take advantage of the opportunity the next major sell off will present. Participate, protect and be prepared to act when the next opportunity presents.

My favorite “how to” indicator is NDR’s Big Mo.  There are other technical trend indicators to follow as well.  Find a process that you have conviction in and stick to it.  Consider buying equity put options to hedge or raise cash on sell signals.  Then look to remove hedges and buy more stocks on buy signals.  I post Big Mo each week (below) in Trade Signals – it is currently in a buy signal and has been since 2011.

Here is a quick look at the last several cyclical bull and bear market periods:

Warren Buffett Valuation Measure

Another important rule is Don’t Fight the Fed.  I like how the following chart combines price trend with Fed policy.  It has been slipping towards the negative zone the last number of months so let’s watch out for minus two.

Don't Fight the Tape or The Fed - Watch Out for Minus Two

Here is how you read this next chart: The indicators are a combination of NDR’s Big Mo Multi-Cap Tape Composite and the 10-Year Treasury Yield percentage.  Simply, the data supports the idea that we should not Fight the Tape or the Fed as higher interest rates tend to be negative for the market.

As I mentioned in the beginning of today’s piece, it is when rates rise that we should become more concerned about the direction of the equity market. When 10-week Treasury Yields are historically lower than their 70-week linear regression, the S&P 500 has produced larger gains. When higher, the S&P 500 has produced negative returns.  See the shaded area in the next chart.

Warren Buffett Valuation Measure

NDR’s Big Mo Multi-Cap Tape Composite Model aggregates the signals of over 100 component indicators and generates a reading between 0% and 100%, reflecting the percentage of the component indicators that are currently giving bullish signals for the S&P 500 Index.

The next chart combines Big Mo with interest rate trends to produce a score that ranges from -2 (both indicators bearish) to 2 (both indicators bullish). You can see for yourself the historical returns.  We are currently at -1 (see shaded area in the chart).  Note the returns when the model reads -2.

Warren Buffett Valuation Measure

Thus the title of today’s piece: Watch Out For Minus Two.

Trade Signals - Volume Demand Remains Greater Than Supply - Bullish for Stocks

Trend evidence remains favorable as measured by Big Mo and the 13/34-Week Moving Average. Volume Demand continues to be stronger than Volume Supply (which is bullish for stocks).

Here is the most recent Big Mo chart:

Warren Buffett Valuation Measure

I also highlight Volume Demand/Supply – I personally like to follow it each week.

This indicator shows that on “buy” signals the S&P 500 Index gain per annum is 16.59% (data from 1981 to present). On “sell” signals where selling supply is greater than buying demand, the gain per annum was a -5.63%.

89.5% of the long trades were profitable. Note the middle orange arrow in the next chart. Worth watching.

Warren Buffett Valuation Measure

Given the talk today about valuations and interest rates, I find the Zweig Bond Model is a great process to identify the trend in the fixed income markets.  It has been in a sell since March (with the exception of just a few days).  It is in a “sell” signal today.

It has been a very wild time in the bond markets and the long-term bonds are down approximately 15% since April.  Here is the most recent chart:

Warren Buffett Valuation Measure

Click here to view all of the most recent Trade Signals. 

Personal note 

I shared a ‘forward looking’ article written by Blackstone’s Schwarzman titled, “How the Next Financial Crisis Will Happen” on Twitter this week.  Put it, too, on your radar. Click here to follow me on Twitter.

I’ll be in NYC next Wednesday for the Envestnet Manager Forum and then again on Friday to move daughter Brianna into her new apartment. One bedroom, two roommates and not cheap.  Living the dream!  Her work career begins in July.  She is frequently reminding me that this is the “last summer of her childhood.”  I keep reminding her she has already passed that marker.  How did my dad put it when he advised me on all things post college?  “It’s all downhill from here.”  It was always followed with a cynical wink.

I tell her that we are creative beings and we are here to create.  Often adding, “think really big and go make it happen.”  Anyway, not a bad way to live life if you think about it. It sure helps me wake up and go forward with excitement. Perhaps this weekend I’ll share with her Thomas Edison’s simple advice, “…hard work, stick-to-itiveness, and common sense.”  Amen to that.

Yesterday was one of those tough days for me.  Hard work – it was, stick-to-itiveness – I think, common sense – let’s just say I fumbled on a management issue. Ugh. But alas, it’s pizza and beer (for the adults) tonight – USA vs. Sweden is on at 8:00 pm and boy do I love the World Cup.

So here is a toast today to stepping forward with excitement and creating really great things. And here is one more with glass held high – a toast to your personal success and happiness!

Have a wonderful weekend!

With kind regards,

Steve

Stephen B. Blumenthal

Chairman & CEO

CMG Capital Management Group, Inc.