Archive for July, 2017

Is the Stock Market Overvalued?

Wednesday, July 19th, 2017


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It has been eight years since the 2008 stock market crash bottomed and the current bull market began.  There have been a couple of corrections along the way, even a couple of double digit ones, but all in all it has been a fairly straight move up.

We can discuss some of the reasons for this, but it has been engineered to a large extent by the Federal Reserve and their money printing activities (called Quantitative Easing – a process of buying bonds with newly created money).  That liquidity has been used by corporate America to buy back shares of stock (as opposed to investing in research and development or expanding operations) which has pushed the market forward in a fairly consistent manner.  In its simplest from, its Supply and Demand – as long as corporate America has the demand to buy back their own stock and the supply of shares is limited to what people are willing to sell, there is always an upward pressure on stock prices.

The Federal Reserve has been raising interest rates for the past several months, which has begun to curtail liquidity.  However they are about to embark on a reversal of their money printing activities – possibly as soon as September.  In essence, they will be flooding the bond market with government bonds hoping to suck up excess cash that has been flowing into the stock market over the past eight years.  This process (called Quantitative Tightening) simply sells bonds into the market and the money they receive for them is retired from the system.

This is a really big deal and you are likely not hearing much about it.  But from a logic standpoint, if flooding the system with money led to the stock market going up due to a consistent buyer willing to pay market price for their own stock, then logically starving the system of money will remove the principal buyer of stock and send the market down.

How far?  Clearly since this is new territory for all of us, there is no way to know for sure.  But realistically, any over-valuation in the market will likely be erased and potentially, depending upon investors’ emotions, a correction could go further than that.

So I thought it was time to break out my trusty S&P 500 Fair Value Calculators to see what sort of exposure we might have.  Lets check out the Ratio Based version:

Fair Value Ratio

This version is based upon the theory that everything eventually reverts to the mean.  It compares current readings of the S&P 500 – like earnings, sales, and book value – to historic median valuation levels for the S&P 500.  This shows what the index would be valued at using current numbers but historically typical valuation levels.

This calculation uses a weighted average of the various ratios – in the graphic above, you can see that there are two calculations.  One of calculations is an outlier so the first column underweights that one with a 10% weight and the other one gives it 0% weight.   For simplicity sake, we will say that the ratio based analysis tells us that the S&P 500 is 13% to 15%  over-valued.

But lets take it one step further.  Below is a discounted earnings based valuation of the S&P 500.  The earnings estimate comes from Standard & Poors and is a bottom up GAAP estimate of all 500 companies in the index projected through 12/31/2018.  The growth rate is the actual 2017 growth rate and the discount rate is a calculated number based upon the historic S&P 500 return since 1950 + the rate of inflation + the increase in GDP (the calculation is shown as Discount Rate Two).   I have disregarded the alternate version of the discount rate calculation that is an interest rate based calculation ( shown as Discount Rate One) given the artificially low level of interest rates.

Fair Value Disctd Earnings

This discounted earnings calculation uses a ten year period of earnings growth at current rates and a an earnings growth rate of 2% into perpetuity.

Based upon the calculation, we show an over-valuation of over 7%, which is half the ratio based valuation result.

Which is correct?  Realistically you cannot look at it that way.  Each of the calculations could be changed with a different selection of data that would give higher or lower results.  The real benefit of this sort of calculation is to give us a feel for whether the market is over or under valued based upon some reasonable set of assumptions about the future using current data about the market.  We can reasonable say that the market is over-valued by 7% to 15% and that any correction we might have (in September or otherwise) would be within that range – and absent some other factor we are not considering, we should not have a crash like we had in 2008.

So, given the uncertainly in the market’s potential reaction to the Fed’s September Quantitative Tightening, I am comfortable with the conservative position we have in client portfolios with cash and short term bonds on hand.  That will give us liquidity to buy shares of our favorite companies a lower prices than currently available.  Until then we just need to have some patience…

and show some smarts.


2017 First Half Update

Thursday, July 13th, 2017

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We are halfway through 2017, and it’s been a good six months for stock markets at home and abroad.

Year to date, international stocks have enjoyed the highest performance, with emerging markets showing double digit returns based primarily on the falling dollar, which was down over 5% year-to-date.  Since most emerging market countries peg their currency to the dollar, when the dollar falls, their currency falls and the companies in those countries being primarily exporters enjoy higher net earnings due to the falling exchange rate.

In terms of the US stock market, large cap companies significantly outperformed small cap companies and growth stocks outperformed value stocks during the first half of the year.  You can see a summary of first half returns in the image above.


When we examine the month of June, the tables turned on the first half winners.
U.S. small caps made up for their relative weakness earlier in the year by having the strongest returns, significantly besting large cap stocks.  Growth stocks were thumped by value stocks while international stocks were mixed in June, with developed-market stocks down and emerging markets up.  You can see these returns in the image above.

Bonds are positive for the year but they experienced a negative return in June as yields rose late in the month.

The most striking thing noted during the first half of the year is the low level of volatility in the markets. June had zero days on which the S&P 500 moved by more than +/-1%. Such movement has happened on only four days this year, which is a material contrast to the volatile first half of 2016.


The image above is a graph of the VIX Volatility Index since the year 2000.  The VIX is the red line and the S&P 500 is the blue line.  You can see the inverse relationship between the two indices – the VIX typically leads the S&P 500.  A low level on the VIX indicates complacency in investors – a high level on the VIX indicates fear in investors.

There was only one other time since 2000 that the VIX has been at 10 or below and that was leading up to the 2008 crash.  This image does not say we will have a crash, but rather it just flashes a warning sign that investors have gotten too complacent and they are not prepared for a correction.

The eight-year bull market we have seen in the stock market since the March 2009 post-crash bottom is getting long in the tooth.  Many of the things that you saw in the first half of the year are typical of aging markets that are readying for a correction:

·    The low economic growth we have seen in the face of rising interest rates pushes investors toward growth stocks that have earnings growth in spite of weak economic times, and growth companies do it with little debt to be impacted by rising rates;

·    Investors favor less volatile large cap companies as they see markets moving toward a top over more volatile small cap companies; and

·    Complacency settles in with investors who have gotten used to markets drifting higher and they do not sell when valuations are high.


The image above compares the Fed Funds Rate (the overnight lending rate controlled by the Federal Reserve) to the S&P 500 Index.  The Fed Funds Rate is in black and the S&P 500 is in blue.  This graph is again from 1998 forward and I wanted you to see the relationship between interest rates and stock prices.  The oldest date for Fed Funds Target Rate in my data service is 1998, but I think you can see the relationship between rising and falling Fed Funds Target Rates and the S&P 500 Index.

Again, there is nothing in this chart that says a correction is imminent.   However, the relationship between rising rates and an eventual correction in stock prices is pretty clear.

We have written to you many times that as valuations on companies move further from their averages, risk increases within stock portfolios.  As risk increases, the prudent thing to do is to employ classic risk management techniques, like increase liquidity in the portfolios and, cull the weakest companies from the portfolio, and book profits on winning positions.

We have been using each of these strategies and feel we have adequate liquidity on hand in preparation for the next correction so that we can be a buyer when others who did not prepare for the correction are forced to sell at lower prices.  Remember, investing is not a linear activity like earning interest on a certificate of deposit.  You want to buy companies when they are low priced and sell them when they are high priced – that does not happen within the constraints of a 12-month calendar nor are the starting points nor ending points clearly delineated.

Greed often leads people to hold onto companies too long and miss a selling opportunity in the hope or assumption that prices will go ever higher.

Unfortunately, with rising interest rates, tepid corporate earnings, slow economic growth, and valuations that are above the 95th percentile, now is the time to be prudent before prices come under pressure so that we can be aggressive buyers when the opportunity presents itself.