"Don't Fight the Fed" Remains in Place

John Mauldin |

A recurring theme in my letters is the various ways in which we can go about determining valuations for stocks and other investments. My good friend Steve Blumenthal has gathered a number of charts from various authorities showing different ways to look at valuations for today’s US stock market. He topped it off with some very good estimates of forward-looking returns on total US equity portfolios. He is not arguing to get out but rather to be aware of where we are and to temper your expectations for the future. Steve writes in an easy, fluid style that I think you will enjoy as this week’s Outside the Box.

I’m in New York and on Monday was part of the closing-bell ceremony at the NYSE, where Monty Bennett, the chairman of a new public company (whose board I am on), Ashford Inc., rang the bell before we headed over to Bobby Van’s to hang with the Friends of Fermentation. I got to spend some quality time with my friend Art Cashin (more below).

Steve Blumethal was in NYC, and we were able to sit down and catch up, and I also got to see George Gilder and Jim Grant do a presentation. Lots of other meetings as well before I headed out to speak at a small, intimate conference in New Hampshire, where I get to hang out with David Rosenberg, Gary Shilling, Marc Faber, and probably a few friends who will show up and surprise me. I will be looking at apartments on Manhattan, where I will be for a whole month starting mid-June. I have always wanted to stay for an extended time in NYC, and a special opportunity opened up for me that requires me to be there for a whole month (and maybe more later!)

I went to the NYSE floor early to spend some time with Art Cashin and walk around.. It had probably been 10 years since I actually walked around the floor. I generally just head over to Bobby Van’s after the exchange closes, or Art comes to dinner somewhere in Midtown with “the guys.” I was really amazed at how different the floor felt this time. I’d been told and had read that the physical exchange is shrinking, but it’s hard to really understand that until you’re actually there. As I sat with Art later, marinating some ice cubes with the Friends of Fermentation, I commented on the changes. Art pointed out that physically there are 80% fewer people, both as “seats” and as support staff, than there was 10 years ago. That is an astounding number. He walked me up to one “post” where stocks were trading. In the past, the traders would be looking at screens and madly punching buttons to make trades and would be handling at most 4-5 stocks. Today, a post will handle 30 stocks and all the trading is automated, with the trader there for special situations, which didn’t seem to develop as I was walking around.

The options floor of the American Stock Exchange has been squeezed into an alcove about the size of a floor of my apartment building. That is the entire options trading exchange. Most of the options are traded by computer, but when traders or investors are looking for something unusual or “in size” they can go to a specialist. During my 10 minutes of walking around, I actually heard one large, complex block trade, an option on the QQQs, being put together in the old-fashioned, open-outcry manner. Ten years ago there would have been a full-on constant buzz.

I seem to remember three massive caverns filled with trading posts, which have been more or less pushed into one of the original rooms with lots of room to spare. You could set up a bowling alley in several of the lanes, as there was nobody walking in them. A lot of people recognized and stopped me, and we talked about the markets. Many of them had changed jobs several times in order to be able to stay on the floor. There is a certain romantic camaraderie that I would find enjoyable, I think.

One of the big (and to me very sad) changes has been the ability of the exchange to deal with problems. In the “old days” Art could just walk around, and if he saw something that didn’t look or feel right he could literally halt trading until things got settled. While he could technically do that today, it wouldn’t do any good. Perhaps as much is 80% of the trading is actually done outside of the exchange floor, so halting trading on the floor would do nothing except disadvantage members. I think the day is going to come when we are going to miss having a sheriff walking the “city streets” looking out for the little guys.

It’s time to hit the send button. Have a great week. We are supposed to get a lot more rain in our part of Texas, which I wish we could send west and south. Our lakes around here are finally full once again; and Texhoma (the largest in Texas), after being as down as far as I have ever seen it, is now full and threatens to overflow the dam. Have a great week!

Your always watching valuations analyst,

John Mauldin, Editor
Outside the Box

On My Radar

By Steve Blumenthal
May 15, 2015

“Anyone in investments should know that when you add together a number of uncorrelating returns, something magical happens.”
- David Harding of Winton Capital Management

This week let’s take a look at current market valuations (high) and what they are telling us about probable 10-year forward returns (low). The stock market has had an outstanding five year run. With that, I believe, many individual investors have misguided expectations. The market is overvalued, over-believed and over-margined yet trend evidence remains positive and Don’t Fight the Fed an important theme. For now.

I share some concluding thoughts below (please note: the piece prints longer than normal due to the number of charts).

Included in this week’s On My Radar:

  • Valuations
  • Forward Returns
  • Don’t Fight the Tape or the Fed
  • Trade Signals – Zweig Bond Sell Signal Timely, Stock Trend Remains Positive


One of my favorite valuation measures is median PE. It is based on actual reported earnings (not Wall Street’s oft over-inflated forward estimates). This first chart shows median PE to be 21.5 (price times earnings) on April 30, 2015. The 51 year average median PE is 16.8.

Note that in the upper left of the chart that the Median Fair Value (taking current earnings times 16.8) is a S&P 500 level of 1627.24. The market is at 2121 today and was at 2085.51 at April month end.

Overvalued is measured at a 1 standard deviation move above Fair Value or S&P 500 level 2128. We are a long way away from undervalued or S&P 500 level 1126.29.

The next chart looks at S&P 500 PE based on (normalized earnings). The current reading is 20.3.

The data in the box in the upper left of the charts shows the S&P 500 Gain/Annum when this PE measure is above 16.5 (shaded grey). It shows that PE has been above 16.5 about 30.7 percent of the time since 1927 and over that time period the return averaged -0.5% when PE of 16.5 or higher.

We are in a high valuation = low return zone. Stocks are richly priced.

This next chart is said to be Warren Buffett’s favorite valuation measure. It shows the stock market capitalization as a percentage of gross domestic income. Simply take the total number of shares outstanding times price and compare that to U.S. gross domestic income.

You can see that we are at a higher level than we were at the market peak in 2007. Only March 2000 was higher. The charts shows the market to be in “bubble territory”.

Recently, Buffett mentioned that given where inflation and interest rates are, the market is not too overvalued. Fed Chairwoman Janet Yellen took a different view this week and said that U.S. stocks are “quite high”.

The following is a clip from Bloomberg’s David Wilson in an email he sent me this week.

Yellen referred to share valuations as “quite high” on May 6 at a financial forum in Washington. “Now they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there,” she said.

Wilson continues, “Last week, the S&P 500 closed at a GAAP P/E of 21.3. The ratio was lower than an average of 22.5 at inflation rates of less than 1.5 percent, calculated on a year-over-year basis. Consumer prices slid 0.1 percent in March from a year ago.”

And Stan Stovall from S&P IQ concludes,

“When an inflation overlay is included, P/Es don’t look as expensive.” The New York-based strategist cited data showing the S&P 500 ratio was 18 percent higher than the average regardless of CPI.

If the above is true, then keep a close eye on interest rates. I think they’ve bottomed and will likely be higher two to three years from now. Don’t Fight the Fed and paying close attention to interest rate trends means everything here.

Here is a different valuation take: one that looks at Price to Sales. Conclusion: “Market Expensive”.

Lastly, I think the next summary is pretty cool. NDR put together a valuation dashboard. I see a lot of red.

Source: S&P Capital IQ Compustat, Bureau of Labor Statistics, Ned Davis Research, Inc.,
Robert Shiller, Irrational Exuberance, S&P Dow Jones Indices

I mentioned that while PE is a poor foreteller of market peaks and troughs, it is good predictor of probable forward returns. Let’s look at that next.

Forward Returns – Highly Predictable

This next chart breaks median PE into five quintiles. I’ve previously shown a chart taking the data back to 1950; however, an astute advisor asked me what the returns looked like since 1984. Over this period of time, PEs tended to remain much higher than periods prior to 1984.

The idea here is to divide all data points of PE since 1984 into quintiles and then see what the 10-year return was if your starting point was at any point in a given quintile. Quintile 1 is best (lowest 20% of PEs) and Quintile 5 is the most expensive (highest 20% of PEs).

If an investor bought in when the market was inexpensively priced in Quintile 1, the annual return over the subsequent 10-year period averaged 15.91%.

Conversely, if you bought in at any time median PE was in Quintile 5, the annual return over the subsequent 10-year period averaged 2.94% (note this is before inflation).

The next chart takes a whole different look at probable forward returns. Interestingly, it looks at stocks as a percentage of total household equity ownership and tracks the subsequent 10-year return based on just how much equity individuals owned as a percentage of their total financial assets.

The idea here is that when investors have fully committed to the stock market, most of the money is in the game – having already bid up prices. When low, most of the money is out of the game creating buying power that ultimately comes back in to drive prices higher.

In short, the current data is telling us to expect returns over the next ten years of just 2.25%. Note the high correlation coefficient since 1952 (the dotted black line is the actual rolling 10-year returns). The top red arrow shows what actually happened to investors who bought at the market peak in 2000. The second red arrow shows the top in 2007 (note it has not yet been ten years so the dotted line stops). The yellow circle shows where we were at year end.

Here too the story says to expect low returns.

Finally, Jeremy Grantham and his team at GMO take a more dire view when forecasting the next seven years.

Don’t Fight the Tape or the Fed

In my view, so much hinges on the Fed and the overall market trend. I post this next chart from time to time in Trade Signals. It has been steadily deteriorating and while not yet at a -2 reading, it is just one step away.

“It’s all ‘bout that Fed ‘bout that Fed”…

Trade Signals – Big Mo Still Says Go, Sentiment Nearing Extreme Optimism

I mentioned the following in Wednesday’s post:

  • Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
  • Volume Demand Continues to Better Volume Supply: Bullish for Stocks
  • The Zweig Bond Model: The Cyclical Trend for Bonds is Bearish Weekly Investor Sentiment Indicator:
    • NDR Crowd Sentiment Poll: Neutral Optimism (short-term Neutral for stocks)

    • Daily Trading Sentiment Composite: Neutral Signal (short-term Neutral for stocks though nearing Excessive Optimism which would turn the indicator Bearish)
  • Recession Watch – My Favorite Recession Forecasting Chart: Currently signaling No Recession
  • The Zweig Bond Model: The Cyclical Trend for Bonds is Bearish

Click here for the full piece including charts.

Concluding thoughts

We are in an environment that favors a focus on absolute returns instead of relative returns. The problem is that the markets are doing their best to throw us a head fake and like 2000 and 2008, investors are biting on the move. Memories tend to be short lived. While sometimes that may be helpful in life, it is not helpful in investing. Don’t bite on the head fake!

The reality is that valuation metrics are very poor at predicting a market peak. Don’t Fight the Fed remains in place and there are better ways to more accurately risk manage the market turning points. I’m a big fan of NDR’s Big Mo (for momentum), yet nothing is perfect. Fortunately, there are ways to inexpensively hedge that doesn’t require perfect.

What we can do is fairly accurately predict forward 5- and 10-year returns. Here too, not perfectly but we can get pretty darn close. With the market richly priced, forward returns just don’t look good enough. Worth the risk? I think it’s better to have a game plan in place that enables you to capitalize on the next major market correction – which in my opinion could be in the -40% to -60% range.

Recessions tend to happen once or twice in a decade. The Fed and the global central banks are in play but the Fed is nearing a change in plan. Play defense until a better opportunity presents. There are a number of things that can drive the market higher than we might imagine – a rush of foreign capital into U.S. assets driven from negative interest rates and a loss of confidence in government and bank safety in Europe. I think it’s a probable maybe. How’s that for confidence? It could happen.

Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.

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