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Newsletter-June 2017: Valuation - the Hardest Thing

| June 06, 2017
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Readers of this letter know that we make an effort to be objective about the markets.  We strive to make decisions without allowing our personal biases, or politics, interfere.  We like to say, “It is what it is.  It is not what it ought to be.”  So, over the years we have looked to things that are measureable to give us an indication of a market’s direction in the short term, the intermediate term, and the long term.  We find this useful for all markets - fixed income, real estate, stocks, etc.  It helps keep us honest with ourselves.  None of this is easy, or obvious.  But, in each market there are some measureable things that can be tracked.

In the short term, say two to three months, the most important factor is Sentiment.  If everyone thinks the market is going up (or down), chances are it has already done it.  There is little new money to push the market up (or down).  This, is a very short term indicator, but important.  There are a number of quantifiable measures of Sentiment for the stock market.  But, the one we have used for many years is the Investor Intelligence Survey that reads a large sample of letters like this one.  They grade each one as Bullish or Bearish, or uncommitted.  Our experience is that when the difference between Bulls and Bears is close to 40% one way or the other, it is time to do the opposite of what the letter writers as a group are saying.  When there are more Bulls, as it is now, it might be months before the “overbought” condition is corrected.  But when there are 40% more Bears than Bulls, the correction occurs much more quickly.

For the intermediate term, say twelve to eighteen months, clearly the most important consideration is Money.  Are central banks providing a lot of liquidity?  Is the yield curve positively sloped, ie. short rates much lower than longer rates?

We have been in that condition since 2008 to an extent perhaps never before seen.  No wonder stocks and bonds have been straight up since 2009.  But, that is changing.  The Federal Reserve is “normalizing” interest rates.  That means there will be a couple of more fed funds rate increases and some unwinding of quantitative easing (selling bonds on the part of the Fed) this year.  This is the primary trend factor, and warrants serious consideration for those trying to invest in a “timely” manner.

For the long term, many would say sentiment and money don’t matter, as long as you are patient and disciplined in putting money to work at “reasonable” Valuations.  Over the long term, you will get paid for the risk.  OK.  But, what is “reasonable?”  Valuation is the hardest thing!!!

Currently, many are concerned that the US stock market is “expensive.”  Over many years, the average price/earnings multiple on the S&P 500 has been 16 times.  Based on 2017 estimated earnings for the index, the P/E is 20 times leading many to say that the market is “overvalued.”  But, that is like saying the average temperature in Houston is 72 degrees!  There is not much useful information there since the annual temperature ranges from 100+ to 20 degrees.

It is always a relative thing.  With interest rates as low as they currently are and likely to stay relatively low, why would current stock valuations be expected to revert to the average?

In my professional life, there have been a few times when valuation was so extreme that it really mattered.  In 1980, stocks were facing severe competition.  Overnight interest rates were 20%.  Long term US Treasury Bonds had yields of 13-14% to maturity.  The Dow Jones Industrial Average was selling below book value and at 6 times forward earnings.  It was hard to see at the time, but it was a license to make a lot of money in stocks over the next five years.  In 2000, the Dow Jones was selling at 6 times book value, and the S&P 500 was selling at 35 times forward earnings... clearly, it was a bubble.  In the midst of the “great recession” in 2009, the S&P was selling below 10 times estimated forward earnings, a great buying opportunity. 

So, where are we today?  It is very hard to say, because the stock market has changed.  Twenty years ago, there were 8,000 publicly traded companies, today there are less than 4,000.  Companies like Apple that have great cash flow are borrowing money in the debt market to buy back in their own common shares.  Apple pays an interest rate below 2% to borrow money to buy a share of stock with a return on equity of 13%.  Easy!  And easy money has aided merger and acquisition activity which is taking more shares off the market.  How about big companies like ATT/Time Warner,  Dow Chemical/Dupont,  Bayer/Monsanto, etc.  Who would have thought these were possible 5 years ago?

And there are few initial public offerings to replace all these retired shares,  Last year there were about 150 IPO’s compared to 500-600 per year usually.

Private equity is providing lots of money to start ups, unlike ever before.  Private equity is estimated to be $2.5 trillion, not to mention the institutions that are now investing alongside like sovereign wealth funds and big public pension funds.  Companies do not have to go public to receive a reward for their efforts.  Uber is supposed to be worth $70 billion as a private company.  Air BNB is supposedly worth $30 billion.

All of these forces - fewer public companies, stock buy-backs, big private investors, etc. have reduced the potential supply of shares available for US companies.  Demand for stocks essentially remains the same, or greater due to the low interest rate environment.  In this environment, is 16 times forward earnings relevant?  Many have missed good market opportunities citing “expensive” valuations.  Demand and supply rule!  Supply is constrained, while demand remains.  Prices go up!

Now what?  There is nothing in today’s valuations in the US stock market to say you should not average in.  There certainly could be a 10% correction.  But, there would seem to be no bubbles to cause a 20% selloff.  If anything. The “bubble” could be in the private market where managers are chasing the unicorns and reporting market valuations that have no real market check!

Everyone will be hurt if interest rates go back to “normal.”  Bonds, stocks, real estate, private equity, etc. are all inversely correlated to interest rates.  US stocks are at all time highs, US bonds are close.  Move a little money to foreign stocks and cash just to hedge.  But the market is sufficiently different from the past to make draconian changes based on valuation alone.

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