“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

– Sir John Templeton

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The New, Patient, Focused Intelligent Investor

I presented at a recent advisor conference alongside a famous economist.  He told a story about an investment manager who told him, “You know… it is easy to pick out the investment amateur in any room.”  He said, “He’s the person who says, ‘it’s different this time’.”  He then looked at the economist and said, “Unfortunately, it really is different this time.”

We had the Nifty Fifty stocks craze in the 1970s, Portfolio Insurance in the mid-1980s, Tech in the 1990s and Real Estate in mid-2000s (easy mortgage capital creatively engineered on Wall Street – those slices and dices of subprime junk somehow sleeved into AAA-rated tranches that enabled massive amounts of mortgage liquidity that turned out to not be AAA). Who would have imagined the near collapse of the global financial system?

What remained relatively consistent in all of the prior periods was the relationship between equity market valuations and the subsequent 10-year return outcome.  What is also true is that on the other side of those bubbles was a great investment opportunity.  So what is the relationship between valuations and returns telling us today?  Let’s take a close look.

But first a quick comment: I believe we’ll one day look back at today and point to two bubbles – one in passive index investing and the other in massive size, relative to GDP, of developed market government debt.  It is fair to say that with 71% of developed market sovereign bonds yielding less than 1% and 33% yielding less than zero, which counts as “it is different.” But let’s not get nervous and instead simply look at the data, set a plan in place and be prepared to act when the next great opportunity presents.

The good news is that the data can tell us a great deal about probable coming returns and levels of risk.  But how do we best explain this to our clients? Since we advisors get lost in our world of financial terminology (confusing to our clients), I’m going to try my best to explain where we are today in a way that my wife Susan or your retail client might better understand.

This morning, with coffee in hand and sitting in my favorite chair, Susan asked me what I’m writing about today.  I told her the piece is about current valuations and coming returns and tried to explain in layman’s terms how to know when to buy low and sell high. What does P/E mean?  Many people don’t know.

The Era of Financial Engineering

I then told her to think in terms of her soccer coaching business.  If she earned $50,000 (a made-up number) and her company had 50,000 shares outstanding, her company earned $1 per share.  I told her to just think of it as a data point.

Next, if I could invest in her business by purchasing her stock and at a price of $24 per share, how do I know if I’m getting a good deal or a bad deal?  I want to make as high a return as I can.  The price means nothing if I don’t consider how much money her company can earn.

So we can look at the price of Susan’s stock ($24) relative to her company’s earnings ($1) and determine if you are getting a lot for our money (high future return on our investment) or little for our money (low return).

If her company earns a $1 and is trading at $24, then her price relative to her earnings is a P/E ratio of 24.  Think of it a second data point.  What is important about that number is that we can compare it to other points in time and see if you are getting a bargain or paying too much.

Of course, her business might hit a home run in regards to earnings next year but if we think of the overall stock market in general, companies collectively grow their earnings by about as much as the U.S. grows its economy each year (for the last 17 years that’s been about 2% per year).  And we can also factor in things like debt levels, tax cuts and global growth to see if that earnings number can pick up, but let’s keep it simple for now.  We don’t need all those other factors because current actual reported P/E levels tell us a great deal about future returns.

Now, if Susan’s stock price was $17 per share, her company would be trading at 17 times that $1 of earnings.  If her stock was at $10, her company would be trading at 10 times earnings.  That’d be a steal so long as she could maintain that $1 of earnings.  Can you see how what you pay relative to what a company can earn can help you determine the good or bad future return you might receive?

So, let’s do just that but look at the broad stock market.  You’ll see that the evidence shows that prices are high relative to earnings and thus future returns will be low (statistically).  Next, you’ll find several of my favorite valuation charts.  If you are a long-time reader, you will be familiar with many of the charts but I like to review them at the beginning of each month because it helps me stay grounded in terms of return probabilities and levels of risk.

I also share with you a cool (well, cool if you are a quant geek like me) chart I found that looks at the data over the coming one-, two-, three-, four- and five-year returns based on where the current price is relative to current earnings.  The data tells us to expect low returns.  The chart would be even cooler if the returns were higher.

Let’s start with median P/E, then look at forward 10-year returns, then a few selected dates and subsequent 10-year returns and then the cool chart and then see what that may tell us about where we are today and what forward returns might look like.

Here is how you read Chart 1:

Bill Gross and GMO warns asset prices too high

  • Many people consider the stock market to be the S&P 500 Index. So let’s use the S&P 500 as the proxy for the market.
  • Think of Susan’s company and consider what she earned relative to what her current price is. The S&P 500 Index is a collection of 500 large U.S. companies, but think of it as one large company you can buy (and you can in a low-fee ETF such as SPY).
  • Here we look at the April month-end median P/E based on actual earnings. Median P/E is my favorite way to measure P/E (there are many others as you’ll see when you click through below).  The current number is 23.8.
  • For now, just think of the number as a data point. If Susan earned $1 per share and the price of her stock was $23.80 per share, her current P/E ratio would be 23.80.  So the overall market is trading at 23.80 times more than its earnings.  A data
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