VALUATION UPDATE 2019 Q4
A client called me on the Warren Buffett article that I sent out this month, his basic comment was that the CNBC article referenced the PE Ratio and Price to Sales Ratio, but is that all that there is to be concerned about? Are there other ways to look at the U.S. stock market that might be less concerning, just as concerning, or more concerning? If we looked at valuations broadly would we agree with Warren Buffett?
For a refresher on the CNBC article please Google search: “Warren Buffett is sitting on $128 billion, raising questions about whether the market is overvalued”
Cumulative Fund Flows: The mutual fund and ETF community tracks fund flows closely, they know what products are attracting sales and whether or not monies are flowing out of or into the stock or bond markets. The following chart from Topdown Charts and Refinitive Datastream shows us that while the price of the S&P 500 has advanced money has been coming out of the market.
This has been possible because of the ‘expansion of the Price/Earnings multiple’, meaning that even though money has left stocks on a net basis the remaining investors are willing to pay a higher and higher price for stocks. Given the fundamental dynamics of supply and demand it would make sense that at some point in the future this divergence will rectify itself.
The second chart from FactSet illustrates that fund flows, since January 2018, has gone into the bond market and out of the stock market.
Source of Investment Returns: The following chart from Goldman Sachs shows us what has contributed to S&P 500 returns; going back to 2009 68% of the return of the S&P 500 has been due to earnings growth and 32% due to P/E expansion (i.e. investors are willing to pay a higher multiple for stocks). In 2019 so far 8% of the return of the S&P 500 price change has been attributed to EPS growth (earnings growth) and 92% has been attributed to P/E expansion (meaning that investors are paying a lot more for U.S. stocks even though the earnings growth has been minimal).
Value versus Growth: The following chart, from Merrill Lynch and FactSet, outlines the relationship between ‘value stocks’ (think manufacturing or transportation companies) and ‘growth stocks’ (think software). When this ratio is on top (see 2001 and the 0.7 value) this means that value stocks have been doing better than growth stocks -which is generally indicative of the beginning of the business cycle. Growth typically does better than value at the end of the business cycle.
Looking at this chart we see growth leadership today, in 2008/2009, and in 2003. The 2008/2009 and the 2003 time periods (at the 2 standard deviation level) represent time periods where the market has generally gotten overvalued.
PEG Ratio: The Price to Earnings Growth Ratio, made famous by Fidelity’s Peter Lynch, tells us ‘how much investors paying for earnings growth’. Instead of looking at price, how much are investors paying for the ‘rate of growth’. The logic being that investors should be paying more for a company if it is growing at a fast pace and less if it is growing at a slow pace.
This graph, provided by I/B/E/S and Bloomberg, shows us that investors are paying a lot for earnings growth. You can see where we are today (red dot upper right) is higher than the valuation levels in 2015, 2009, and 1998/1999. During two of those time periods the S&P 500 experienced a notable correction.
S&P 500 Valuations: The table below from Crescat Capital, LLC gives us an update relating to many valuation metrics for the S&P 500, noting the most recent value (column 2) and their historical percentile (column 3). The table tells us that valuations, broadly speaking, are very elevated.
Commodities: Crescat Capital, LLC provides the following table illustrating the ratio of the value of commodities versus the S&P 500. The chart shows that bad things can happen when commodities have a high valuation and a low valuation, when compared to U.S. stocks. So commodities having a high or low value doesn’t tell us much on a year to year basis but when the value reaches an extreme level significant events can happen. Are we at such a point today?
Utilities: The value of utilities tend to get extended at the end of the business cycle, investors pay more for stable earnings and utilities stocks become expensive. The following table from Crescat Capital, LLC and Bloomberg measures the price of utilities stocks on a ‘free cash flow’ basis. We can see that today valuations are similar to 1999 and 2009.
Stocks versus Bonds: The Leuthold Group out of Minneapolis published the following graph, giving us the historical relationship between the values of stocks and bonds. The last time that we were at this level was 1999.
Corporate Profits and the S&P 500: Stock prices are fundamentally driven by earnings and profits. Datastream provides the chart below that shows us the relationship between the two. Over the past 5 years corporate profits have been flat. This has happened before, in the late 1990’s. In the 1990’s prices kept moving up, but eventually corrected. Does today’s situation looks similar?
U.S. Stocks versus International Stocks: Merrill Lynch provides the following two charts giving us the relationship between the returns of U.S. Stocks versus European Stocks (first table) and then international stocks broadly (second table).
We can see that ‘leadership changes over time’. Today it is thought that it makes sense for investors to consider pivoting towards European and International stocks in order to find better valuations as well as participate in what is likely going to be a leadership change, where international stocks likely outperform U.S. stocks.
Many investors might look at this analysis and conclude that the valuations in the United States are extended and find themselves in agreement with Warren Buffett.
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DEFINITIONS
Bloomberg - Bloomberg provides financial software tools and enterprise applications such as analytics and equity trading platform, data services, and news to financial companies and organizations through the Bloomberg Terminal (via its Bloomberg Professional Service), its core revenue-generating product. Bloomberg L.P. also includes a wire service (Bloomberg News), a global television network (Bloomberg Television), websites, radio stations (Bloomberg Radio), subscription-only newsletters, and two magazines: Bloomberg Businessweek and Bloomberg Markets.
Factset – FactSet provides financial information and analytical applications to global buy and sell-side professionals, including portfolio managers, market research and performance analysts, risk managers, sell-side equity researchers, investment bankers, and fixed income professionals. FactSet's software platform, also called FactSet, includes real-time news and quotes, company and portfolio analysis, multi-company comparisons, industry analysis, company screening, portfolio optimization and simulation, predictive risk measurements, alpha testing and tools to value and analyze fixed income securities and portfolios.
I/B/E/S – Institutional Brokers’ Estimate System (IBES) - is a database that gathers and compiles the different estimates made by stock analysts on the future earnings for the majority of U.S. publicly traded companies.
MSCI EAFE Index: The index is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
Price-to-Book Ratio: An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Price-to-Earnings Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
Price-to-Sales Ratio: The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value placed on each dollar of a company’s sales or revenues. The ratio can be calculated by dividing the company’s market capitalization by its total sales or on a per-share basis by dividing the stock price by sales per share.
Refinitive/Datastream: A global provider of financial markets data and infrastructure. The company was founded in 2018. It is jointly owned by Blackstone Group LP which has a 55% stake and Thomson Reuters which owns 45%.
S&P 500 Index: The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90.
The index is a capitalization weighted index of the 500 large companies listed on various stock exchanges (such as the NYSE or NASDAQ). The S&P 500 was developed and continues to be maintained by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global. The S&P 500 differs from the Dow Jones Industrial Average and the NASDAQ Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market.
S&P 500 Growth Index: The index is a market-capitalization-weighted index developed by Standard and Poor's consisting of those stocks within the S&P 500 Index that exhibit strong growth characteristics.
S&P 500 Value Index: The index is a market-capitalization-weighted index developed by Standard and Poor's consisting of those stocks within the S&P 500 Index that exhibit strong value characteristics.
Stoxx Europe 600 Index: The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
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