“The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.”
“In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.”
“Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.”
“Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.”
– Howard Marks, Oaktree Capital Management, “There They Go Again…Again”
Howard Marks’ “Memos” are a must-read. Years ago, I was invested in Marks’ hedge fund. We exited our fund of funds business in 2007, though it would have served me well to have stayed in his fund. Like most great investment managers, he keeps risk front of mind.
Today we all have access to great information. Type and click. Ray Dalio, Stanley Druckenmiller, David Tepper, Ken Griffin, David Shaw, Seth Klarman, Paul Singer and Howard Marks to name just a few. I’m not sure about you, but I want to know what’s on their minds.
- These Behavioral Biases Are Driving Investor Decisions
- S&P 500 Total Return Index With & Without Contributions — 1926-2017
- US Equity volatility Is Near 90 Year Lows
The quotes above summarize what Marks feels are “the four most noteworthy components of current conditions.”
Do valuations matter? Can they tell us about future returns? Yes and Yes. As we do at the beginning of each month, let’s take a look at valuations today and see what they tell us about coming 7-year and 10-year annualized returns.
Art Cashin appeared on CNBC this week and his comments on market cycles and the tendency for challenges in years that end in the number 7 caught my attention.
- Art cautioned not to get overly excited and said that August is the second worst performing month of the year with September being the worst.
- He said that years ending in the number 7 (1987, 1997, 2007) have seen the market peak in the first three weeks in August.
- Serendipitously, I had just finished reviewing an interesting chart from Ned Davis Research (NDR). The chart suggests August 2.
Here is how to read the chart:
- The blue line is the combined composite line of the one-year seasonal cycle, the four-year presidential cycle and the 10-year decennial cycle. It is based on daily data from 1-2-1900 to 12-31-2016.
- It looks at what happened to the DJIA in years past and makes a forecast for the current year. Note, this chart was published last year.
- The red dotted line is the actual DJIA composite January 1, 2017 through July 26, 2017.
- The trend direction is more important than the level. But interesting how closely the year has tracked.
Bottom line: Expect a challenging next few months (August through October).
Art concluded his interview saying that over five decades of experience has taught him to always know where the exit door is. You can find Art’s four-minute interview here.
But the trend remains positive and as you’ll see in the Trade Signals link below, the Don’t Fight the Tape (trend) or the Fed indicator sits at its strongest reading at +2. The market has historically performed best when the reading is +2.
With that said, what can you do? For now, the equity market trend indicators remain bullish and there is little sign of recession over the next six months. But valuations are rich and as Howard Marks shared, there are a number of risks that should stay front of mind. My two cents: Have a plan to both participate in gains and protect against significant loss. More defense than offense. Put stops in place.
You will find today’s read to be short or long depending upon whether you click to Howard Marks’ full piece, “There They Go Again… Again.” I do hope you find the information helpful.
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Included in this week’s On My Radar:
- Valuations and What They Tell Us About Coming 7-year and 10-year Returns
- “There They Go Again… Again” by Howard Marks
- “Markets in a Post-Volatility World” by Artie Grizzle, CFA and Charles Culver
- Trade Signals — A Strong +2: Don’t Fight the Trend or the Fed
- Personal Note – Great Stream Lake, Maine
Valuations and What They Tell Us about Coming 7-year and 10-year Returns
U.S. equities – I’m borrowing from Howard Marks’ memo because I think he sums it up well:
The good news is that the U.S. economy is the envy of the world, with the highest growth rate among developed nations and a slowdown unlikely in the near term. The bad news is that this status generates demand for U.S. equities that has raised their prices to lofty levels.
- The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
- The Shiller Cyclically Adjusted P/E Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
- While the “P” in P/E ratios is high today, the “E” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
- The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – is immune to company-level accounting issues (although it isn’t perfect either). It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
- Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.
- The thing that is clearest is that the low Fed-mandated short-term interest rates make high valuations seem reasonable. When yields are low on fixed income instruments, low earnings yields on equities (that is, low e/p ratios, which equate to high P/E ratios) seem justified. As Buffett said in February, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.”
- But he went on to say, “. . . the risk always is that interest rates go up a lot, and that brings stocks down.” Are you happy counting on continued low interest rates for your investment security, especially at a time when the Fed has embarked upon a series of rate increases? And if interest rates do remain low for several more years, isn’t it likely to be as a result of a lack of vigor in the