Richard Suvak, MSF, CFA
The recent market fall has touched, and then retraced, the 10% bear-market threshold since it’s high of January 26. After such a fall, the bigs of Wall Street and pundits alike will tell you now is the time to buy. After all, you’re getting a 10% discount. Is that true? After such a precipitous fall, it’s time to ask what has changed and where are we now?
Contained in Eunoia’s December month-end update was the following 10-year forecast. It highlighted the impact of the near-extreme valuation as the dominant driving force behind the negative forecast for the US. We have been, as has been highlighted many times by Eunoia Financial, in the 90th-plus percentile of valuation for quite some time. The long-in-the-tooth bull market has seen spectacular returns for sure. However, it has largely been driven by value expansion rather than earnings growth. While the recent Trump tax cuts have brought hope of additional earnings growth going forward, the market raced ahead faster than any such growth could be reported. The anticipation of higher growth ahead saw investors pile into the market en masse.
The natural tendency, and one espoused by Wall Street, after a 10% drop is to invest more. It has precedent as well. Dollar-cost-averaging and buy-low-sell-high each would suggest now is the time to invest more. But how much have things really changed? Updating Eunoia’s 10-year forecast based on Friday’s (February 9, 2018) close shows, unfortunately, not much. Expectations for outsized returns over the next 10-years have not been bolstered by the recent fall.
Examining a few different flavors of valuations, it starts to become clear why this is the case. At the peak (January 26, 2018), markets sold at a P/E of 26.8, Shiller P/E of 34.6 and Market Capitalization-to-GDP ratio of 150.8%. As of Friday’s (February 9, 2018) close, markets sold at 24.5, 30.3 and 137.6% respectively. Thought of in percentiles, markets traded at the 95.6th percentile of historic P/E (ie, it had been higher only 4.4% of the time in it’s past), 97.9th percentile of Shiller P/E and 99.9th percentile of MCap/GDP at the peak. On Friday, those percentiles dropped to 93.7%, 96.3% and 99.3% respectively. Both in absolute and relative terms, the market is cheaper, some 8-12% depending on the measure. However, it remains expensive.
As an indication of the bull market’s powerful rally absent earnings growth, consider the charts below. On the left, the full history of MCap / GDP, while the right chart shows the ratio since January 2017. You can see that the market was trounced during the Global Financial Crisis of 2008, falling well below the 50th percentile. However, once the recovery began, it hasn’t stopped (save a couple brief pauses along the way).
So, what will it take for us to get back to “reasonable” valuation? And, what about earnings growth? As I’ve discussed the earnings growth required to justify current market valuations in the past, let’s keep our focus on the MCap / GDP ratio (currently 137.6%) as it’s a bit broader and we can more easily relate it to the potential impact of Trump’s tax cuts on the overall growth of the economy.
The chart below details market returns were the market to return to the 50th, 75th and 95th percentile along different assumptions of GDP growth. For example, had it fallen from its peak AND we were to experience 0% GDP growth over the next year, the market would have to fall 16.9% for it to return to the 95th percentile of all historic MCap / GDP (125.2%). Similarly, under the same 0% GDP growth scenario, it would have to fall 37.5% and 51.8% to get back to the 75th and 50th percentile. If we give Trump’s tax cuts the benefit of the doubt and the economy grows by 5%, the falls (from the peak) would have been 12.8%, 34.3% and 49.4% respectively. In other words, growth does not always equate to fair market value.
But, we’ve already given back so much, things must be different now… or are they? The equivalent return requirement chart below shows an improved, albeit similarly dim view of future returns. Our pro-tax cut scenario (+5% GDP growth) has the market falling a more modest 4.4% to reach the 95th percentile, 28.0% to reach the 75th percentile and 44.5% to reach the 50th percentile. In fact, GDP (not earnings) would have to grow by 10% for the market to remain flat were it to return to just the 95th percentile.
Perhaps an analogy might help clarify where we are. Eight years ago, a new car was introduced into the market. It is bright, shiny and comes with all the newest bells and whistles. Early and repeat buyers are selling it for a profit years later. It is so desirable that dealers see their chance and increase prices regularly. Today, it sells at more than three times the original cost, and 24% more than it did a year ago. Suddenly, and without warning (if you haven’t been listening to Eunoia Financial), the dealer offers a 10% discount. Car enthusiasts encourage you to make another purchase – after all, you’re getting a one-time discount. Would you buy the car or ask yourself what the car is really worth? After all, unless this car can fly or get us to our destination in record time and without risk of injury, there are other, less expensive cars to purchase.
Returning to the market; even after a 10% discount, future returns are abandon-all-hope-start-cooking-squirrels-sobering kind of numbers. As many have invested as if this bull-market would never end, to avoid living under a bridge searching for your next meal we either have to close our eyes and ignore the reality of the situation or adjust our investment strategy accordingly. While I suppose I could get accustomed to smoked squirrel, the more palatable solution, to me at least, is the latter.
However, not unlike any other industry, in the investment business money talks and bullshit walks. Over the last year, Eunoia has been pounding the table with caution and the results during the recent market turbulence speak for themselves. Risk is back in the market. If your advisor didn’t prepare you for this eventuality, what expertise are you paying for? Put another way, does your adviser work for you, or do you work for your adviser?