Altus Insight: May, 2016
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: May 31, 2016
FR: Forrest Jinks
RE: Staring into the Abyss
My guess is that most readers of Altus Insight think I hate the stock market. This is not correct. The stock market, in its intended form, is a vital part of the economic growth of any economy. Yes, I dislike much of what the stock market has become and the industries that have been created around investing in the stock market. And yes, I do hate the stock market, RIGHT NOW. For most people marketing timing is an exercise in futility. Market studies have in fact shown that more experienced investors are in fact worse at market timing than those with less experience.
But there is a difference between market timing and understanding pricing within the bands of historical valuation. Retail investment theory du jour states that stock picking is an impossible art and the best way to invest is to buy shares of an S&P simulated fund and ride it for the rest of your investment in years. With a little bit of investment diversity built in as well of course. The argument against retail investing’s definition of diversity will have to wait for a future article. This article is about why a buy and hold forever model may not be a great strategy. Its success is so dependent on when you are doing the buying. Specifically, in the paragraphs below I lay out the reasons why I think the stock market on the whole is overpriced and why I think it is a terrible time to be buying into the market.
“I will tell you my secret if you wish. It is this: I never buy at the bottom and I always sell too soon.”
“Bulls make money, bears make money, but pigs get slaughtered.”
Old Wall Street Saying
To be very clear, this is NOT a call of the top of the market. I have no idea when the next bear market is going to begin (some have said it has already begun, others claim the most recent bull run is part of a longer structural bear market) nor do I have any idea how much higher the current market will go before turning over. Further, I can’t accurately predict how far the markets will fall the next time they do crash. What I can do, however, is provide context for where we currently are within the heavy shadow of history. For clarification the use of the term “valuation” in this article is common parlance and not the typical definition of “value” that Altus normally specifies as independent and different than “price”.
1.Valuations are very high:
Most readers know that a PE ratio is the measure of a stock’s (or market’s) price divided by its yearly earnings. As such, it measures the profit being returned for each dollar spent purchasing stock. Depending on whose calculation is used (and throwing out PE calculations based on forward guidance earnings because they are bogus) current PE ratios on the S&P in its entirety is somewhere between 24 and 26. That is to say for every $24 (or $26) spent buying the S&P $1 of profit should be expected to be produced by the 500 companies that make up the S&P 500.
A ratio without context is not of much use and the first place we can find context is comparing current PE ratios to history. According to Nobel Prize winning economist Robert Shiller (and as commonly accepted knowledge within the industry) there are only three instances in the history of the country where the stock market had higher PE ratios. Those three instances were directly prior to Black Tuesday in 1929 (PE of 30), the tech crash of 2000 (PE of an incredible 44), and the stock market crash of the Great Recession (PE of 27). None of those highs turned out so well for the investor holding stock at the peak, and even less well for those that bought anytime in the few months or years prior to the peak. The historical average Shiller PE is 16.7.
Additional context for the current PE ratios can be found by comparing stock valuations with valuations of other investments. No one would argue that bond prices are at historically high prices. Thus yields, or the “profit” produced by the bonds are in turn historically low. That means bonds currently have very, very high valuations.
A surprisingly low number of investment professionals have made the connection that PE ratio is the inverse of a capitalization (cap) rate. This means that a PE ratio of 25 is the same as a 4% cap rate. Think about that for a second…”A” quality investment real estate is more often compared to bonds than stocks but only real estate in the highest priced of markets (like Orange County) will sell with valuations higher than a 4% cap rate. We can easily buy high quality real estate in other parts of the country for above a 6% cap rate, equivalent to (get ready for it…) a 16.7 PE ratio, the same as the historical average of the Shiller PE ratio. There are a few that would argue stocks are a safer investment than real estate due the liquidity advantage of stocks over real estate, but most would agree that real estate is a safer investment due to it being “real property” that even in the most unfortunate of circumstances still maintains some value as real property. Something that can’t be said for stock in a company going through bankruptcy.
2.There is far more downside risk than upside opportunity:
After the 1929 high the stock market fell almost 90%. After the 2000 highs the S&P fell 46%. And after the 2007 highs the S&P fell 48%. Even the stock market correction in 1987 saw a 23% loss of value, and that at a time when valuations were well within one standard deviation of the historical norms. As with the first discussion point above, context helps paint the picture. A rather pedestrian drop in valuations of 23% requires 30% increase in price to get back to break even. A more likely drop in price of 40% would require gains of 67% from the bottom to get back to break even. I ask you this: How confident are you that the market will go up another 67% before the next correction? That would get the S&P from its current perch at 2099 to 3500 and the Dow Jones from where it currently resides at 17,873 to 29,847. These are huge increases to valuations.
3.There is little justification for further price increases:
Stock valuations (share prices) are based on only two things. Earnings per share and the PE ratio applied to those earnings. We have already seen above that current PE ratios are starting to bump up against historical highs. That means for share prices to increase earning must increase. Over time profits of all the companies in a country (and represented by the “stock market”) will grow at a roughly equivalent pace to the growth of the economy, which has been less than 3% in real terms for the past several years. Even using 5% as being more indicative of historical averages, it would take roughly 8.5 years of profit growth to bring PE ratios at current market valuation back into line with the historical mean.
To profit from stock ownership a stock price must increase or the stock must pay dividends. If stock prices are unlikely to move much higher, then more focus must be placed on dividends as a share of the total expected profits. Unfortunately, dividends at least as a percent return on an investment, are tied to the purchase price of the stock. The higher the purchase price (the higher the PE ratio) the lower the returns available from dividends.
4.Chinese debt has exploded:
A recent article by Ambrose Evans Prichard pointed out that debt in Japan rose by 50% in the lead up to the 1990 Nikkei crash (and the resulting decades of economic malaise). Chinese debt has increased by somewhere between 120 – 150%. China is the world’s largest economy and global trade is far too interconnected for an economic disruption in China not to impact other economies around the world. And with those economies the stock markets. Even the little bit of disruption coming out of China in late 2015 and early 2016 caused a sharp drop in the US markets. More severe turbulence in China would have a great impact in the US. Can Chinese authorities navigate a smooth landing? Possibly, but history tells us no. History also tells us we have no idea how long the merry-go-around can continue until the music stops.
5.Technical analysis points to a correction:
There is great debate over the usefulness of technical analysis. Being a value investor I tend to not buy into its usefulness but many people use it to guide their trades (as opposed to investments) and do quite well. This past month the S&P 100-day moving average crossed over the 50-day moving average. This has only occurred twice previously in the past 20 years. Both of the previous occasions immediately preceded intense bear markets.
6.You make your money when you buy, not sell:
Using the entire history of S&P performance may result in an expected return of investment of around 10%, but none of us have lived long enough to be invested for the S&P history. A thirty year investment period is commonly used to approximate a person’s active investing life. When those thirty years starts greatly impacts the returns achieved. People buying in closer to the bottom than the top do well, people buying in closer to the top than the bottom do poorly. Ten year annualized returns starting January 1, 1990 were a robust 15%. Ten year returns starting in 2000? Not so great (they were negative). In fact, ten year returns starting in any year from 2000 onward until 2008 produced returns lower than 6%. Considering that in many of those years valuations were not as rich as they are currently, what kind of ten year returns can be expected from our current lofty perch?
7.Consumers aren’t spending and inventory build ups are very high:
Consumer spending contributes approximately 70% of the US GDP. Any pull back in spending has a large impact on the overall economy. Retailer after retailer has reported Q1 results (following similar Q4 results) below expectations even though those expectations have been consistently lowered over the last 6 months. Macy’s, JC Penny, Kohls, Nordstrom, The Gap, Dicks Sporting Goods (and obviously Sport’s Authority who is going through bankruptcy), Target…all reported declining revenue or profits. And most were decidedly pessimistic on their earnings call. The outlier was Dick’s who blamed their rough quarter on Sport’s Authority’s liquidation sales but expects their business to increase when their competitor is gone. Consumer debt and the poor financial situation of a large portion of Americans is what caused the pessimism. A recent article in the Atlantic reported that only 50% of American’s could cover a $400 emergency without borrowing the money. When 50% of the population is living on the edge there isn’t as much money to be spent on discretionary consumer goods. And yes, Macy’s is discretionary. Walmart’s revenues were up year over year. When mainstream retailers revenues are dropping, but Walmart’s revenue is increasing, it isn’t a sign of robust economic activity.
The other half of the issue is the impact on inventory buildup at these same retailers. Increases to inventory push GDP higher. Retailers, expecting increased sales brought in more goods. Those goods didn’t sell and now are sitting in warehouses. Shrinking inventory negatively impacts GDP and…well I will leave the rest to MacroMavens:
The last four inventory cycles – none of which involved an [inventory] overhang this large saw profit growth flip from rising +18% y/y on average at the inventory peak to contracting -5% y/y at its lows. After four consecutive declines [in consumer goods profit growth], the weakest string since the Great Recession everyone thinks the worst is behind us. But if inventories have anything to say about it, we are just getting warmed up.
Oh, and did I mention that subprime auto loans, the quantity of which is up 118% since 2009, and roughly 25 – 30% of the total outstanding auto loans, now have a default rate of 11.2%? This is up from 8.8% last year and 7.8% two years ago.
8.Stan Drunkenmiller comments at Ira Sohn Conference 2016:
“I was bullish three years ago. Now I’m bearish. We’ve borrowed from our future. It’s hard to avoid comparisons to 1982. Market sold at 7x earnings with rising productivity and rate cuts on the horizon. Now we have declining productivity and no ammo on interest rates. Risk/reward is negative without lower prices or structural reform, and the second one ain’t happening. Policy makers have no end game. Markets do.”
9.The labor force is much weaker than headline numbers:
The labor force currently has the highest number of NILF (Not in Labor Force) ever, more even than 2009 when unemployment was twice what it is today. Almost 1/3 of American’s able to work are choosing not to do so. This has an obvious impact on the workforce participation rate, which has dropped to a 38 year low of 62.6%. For reference, 38 years ago was 1978 when women were just starting to come into the labor force en masse. In the first four months of 2016 the total layoff announcements were the highest since 2009.
The average time between US recessions (called expansions) since 1945 is 57 months. At the end of next month we will be at 84 months in the current expansion. This doesn’t mean a recession is imminent. While 84 months is the fourth longest expansion on record we still have a long ways to go to match the 120 months of the 1990’s expansion or 106 months of the 1960’s expansion. Additionally, this recovery has been the weakest on record so it well could be that this recovery could push the upper boundaries of history before the business cycle overcomes the Fed intervention. A recession is inventible. No one knows when. A recession does not cause a stock market correction nor does a stock market correction cause a recession, but there is correlation between the two.
While I was collecting information for this month’s article I received an article from Mauldin Economics on the same topic. If you want more reading, click here.
I should also be clear that in no way is this a recommendation to sell existing positions. Every investment comes with its own idiosyncrasies. Especially as relates to the tax treatment of the sale. If a sale results in a 20% reduction in net cash due to taxes, then riding out a 10 or 15% decline in the market may be the better option. This especially true for positions that are producing stable positive cash flow. If the reason for the investment is the cash flow, then the price at any particular time isn’t particularly important, only whether the asset can be sold and the funds redeployed into something with higher risk adjusted cash flow.
I will leave you with one last thought. With the knowledge that Federal Reserve is worse than pure chance at predicting economic turmoil, and with the caveat I am largely a Fed cynic. I present the following quote from Jeffrey Lacker, Governor of the Richmond Federal Reserve.
“…the case would be very strong for raising rates in June…[global economic and financial risks] have virtually entirely dissipated.”
About the Author: Forrest Jinks is a managing director of Altus Equity Group, LP and licensed real estate broker. Forrest has many years of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start up (online marketing and site retail). He can be reached at firstname.lastname@example.org.