Some months ago, with the stock market averages several percent higher than they are now but the economic data much better, I described the stock market as being in a topping process.
The averages have been kept where they are, in my view, primarily because standard valuation criteria have been encouraged by both projected earnings growth, dividend growth, and low interest rates: a trifecta.
As I have stated on innumerable instances, though, there is an alternative reality in valuing stocks, as follows.
This can be summarized by the charts at Smithers.co.uk (See FAQs) that show a version of q and CAPE since 1900 onwards. After the USSR dissolved and “the end of history” began, U.S. stocks have spent virtually 100% of the time in the historically “overvalued” side of this now-112 year chart. In other words, the prior decades didn’t count anymore. What fools those investors were, actually asking for– demanding– that in order to take a minority, powerless share of someone else’s company, they actually expected that company to have: assets, earnings, and dividends. In order for that company to not have them all, these investors wanted a deep discount from what cash the company might reasonably distribute back to shareholders. This demand has been lost. One simply has to look at FaceBook and LinkedIn, and Amazon.com, to see how speculative investors have gotten– once again. This concept is the polar opposite of the old thinking that led to “undervaluation”– which then led to high stock market returns– which led to overvaluation.
The quantitatively-oriented money manager Jeremy Grantham just came out with his updated monthly projections for stocks. In summary, he sees the U.S. stock market as a whole as highly overvalued. He gives its total return for the next seven years an expected return of zero after inflation. This projection comes with a wide standard deviation. Adjusted for a lower standard deviation, this is essentially the same return he projects from cash and bonds over the same time frame.
Stocks have much greater downside risk from even a mild U.S. recession than “should” be the case. The recessions of 1948, 1953, 1958 and 1961 all ended with the Dow at or about to be at new recovery or all-time highs; plus dividends were higher than now.
As one brief example, Procter & Gamble came out yesterday with a downbeat sales and profits assessment. Its problems are global. The stock traded down but remained at 17X trailing earnings. Yet its net working capital is negative, as is its tangible book value. Back in the conservative 1950s, Dow companies actually had lots of tangible assets underlying their valuation. Thus if operations had a difficult year or two, there was a fundamental value to the company. This protection is, broadly, gone today. Note this comment ignores derivatives and other leverage.
As I noted on my trading blog at econblogreview.blogspot.com a couple of days ago, all precious metals charts were looking bad before yesterday’s FOMC meeting. They are getting hit hard simply from the lack of a new QE program plus some slightly worse-than-expected global economic news, and are now at vulnerable positions on the longer-term charts.
When the closest stock approximation of growth and value comes from the likes of AAPL at 5X book value (and I own it), lots of growth is priced in. Everyone “knows” that housing has bottomed. But when there had been no national housing bubble, by around 2002 these stocks generally sold for single digit P/E’s and at tangible book value. After all, everyone knew they were cyclical. Now their valuations uniformly incorporate strong, non-cyclical growth for years to come to merely get back to their reasonable valuations of a decade ago. I think that eventually, we will see stocks valued much more as they were in those days; thus I agree with Grantham, though I am not a “quant” so I don’t even dare make a 7-year projection. Next week (seven days, not seven years) is far enough away these days!
In closing, it strikes me as noteworthy that the “bears” such as Gary Shilling who predicted a 2.5% yield on the 30-year T-bond and Lacy Hunt, who predicts a 2.0% yield on the same bond when this down-cycle ends, are the same economists who have been predicting a 2012 U.S. recession. (Remember that Doug Kass, a short-seller, averred a few months ago that the U.S. had a zero percent chance of a 2012 recession. When short-sellers are “all in” on the bullish economic consensus, look out below!) The drop in the VIX (“fear index”) well below 20 this week strikes me as a psychological top in the markets. As I’ve said several times, historically high stock valuations and extraordinary economic times help make cash “kingly”. It would be reasonable to expect that the recent VIX high around 27 is not the highest we will see this year. If so, the only major stock asset class I am comfortable holding large amounts of are utilities with “bond-like” dividends, especially utilities that are not in the business of selling power at high prices. Utilities that purchase lots of power from those companies, though, are well-off in a recession, as their cost of doing business declines. Again on that theme, a company such as Con Ed (ED) is somewhat unique amongst utilities, as it supplies a region with minimal manufacturing, and thus I think its sales and dividend are as secure as most things are as we continue to explore the world of Talebian financial Extremistan.