After producing a nominal return of around 15% per annum for the past seven years, GMO’s James Montier and Matt Kadnar believe that over the next seven years the index will produce a total return of -3.9%, based on the assumption that valuations revert to the historical average.
However, while their outlook for the market as a whole is downbeat, the duo still sees value in certain sections of the market.
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Market overvalued according to Benjamin Graham
According to Benjamin Graham’s deep value screen based on 1) the stock’s earnings yield should be at least twice the AAA bond yield; 2) the stock’s dividend yield should be at least two-thirds of the AAA bond yield; 3) the issue should have total debt of less than two-thirds the tangible book value; and 4) the stock should have a Graham and Dodd P/E (price divided by 10-year earnings) of less than 16x, 5% of stocks in Japan and Asia are showing up as being extremely cheap. In Europe and the UK, the number is around 1% to 2%. Unfortunately, for US investors, the number of stocks passing this screen is zero, reflecting the market’s overall level of valuation.
And while there are still some opportunities for value investors out there, value is relatively non-existent compared to 2008. GMO’s researchers point out that in 2008 20% of Japanese and Asian equities passed this screen while 10% of equities in Europe and the UK met the criteria. In the US, 5% of stocks qualified as being deep value.
Montier and Kadnar use the number of deep value stocks as a proxy for market valuation in their latest research paper. They point to a statement from the Graham who noted, “True bargains have repeatedly become scarce in bull markets…Perhaps one could even have determined whether the market level was getting too high or too low by counting the number of issues selling below working capital value. When such opportunities have virtually disappeared, experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks in US Treasury bills.”
Price to sales shows a worrying trend
Computing the number of deeply discounted stocks is just one of the methods the duo uses to display their concern about the level of the market. They also point to the Shiller P/E, which normalizes earnings from their current value to an approximate trend using a 10-year moving average. On this metric, “The only times we have seen more expensive US equity markets were 1929 and 1999. Strangely enough, we do not hear many exhortations to buy US equities because it is just like 1929 or 1999,” the report opines.
Other metrics point to a similar conclusion. The Hussman P/E, named after its creator John Hussman, seeks to provide more accurate reading than the Shiller P/E by normalizing 10-year average earnings to peak earnings. This eliminates any significant impact from outlying years such as 2008. On this metric, the market is currently in its second most expensive period in history. Only in 1999 was the market more expensive.
On a company-by-company basis, the same trend persists. GMO’s data shows that both the median price to sales ratio for stocks in the S&P 500 and the Shiller P/E for the median stock in the S&P indicate “We are facing an extremely expensive stock market.” The median price to sales ratio is at its highest level ever recorded, and the median Shiller P/E is about as expensive as it was before the dot-com bubble and financial crisis.