“I think the public is walking into a trap again as they did in 2007… I think it almost the duty of well-respected investors, like myself I hope, to warn people, to tell people, that you are making errors.”
—Carl Icahn, CNBC, June 25, 2015
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Steve Blumenthal, chairman and chief executive officer of King of Prussia (greater Philadelphia area), Pennsylvania-based CMG Capital Management.
The market is expensive and the risk is great. You wouldn’t get that impression listening to many Wall Street sell-side analysts. Today let’s take a look at valuation and two simple ideas that may help you navigate the bumpy road ahead.
I scratch my head when I hear an analyst say the stock market is fairly priced since the forward price/earnings multiple (P/E) ratio is “only” 17. The forward P/E was 14.1 at the October 2002 low, and 15.2 at the October 2007 peak, according to a composite of estimates from First Call, Compustat, FactSet and JPMorgan Asset Management as of June 30.
So, what makes 17 such a good value? Frankly, Wall Street analysts have a very bad habit of overestimating forward earnings. To me, forward P/E is an unreliable measurement.
A Better Metric Than Forward P/E
A better valuation measure, I believe, is median P/E. It looks at reported earnings (not forward estimates) and is an approach that limits the impact of special “one-time” write-offs and other accounting gimmicks.
If we were to break all of the monthly median P/E readings since 1984 into five quintiles, today’s median P/E would fall into “quintile 5”; in other words, the most expensive category.
Interestingly, the least expensive quintile—that is, the one with the best value for your investment dollar—produced subsequent 10-year S&P 500 Index gains per year of 15.91 percent. The most expensive quintile produced S&P 500 Index gains of just 2.94 percent over the subsequent 10-year period, according to data from Ned Davis Research as of May 31, 2015.
Translation: Ichan’s warning should not go unheard.
Heed Buffett Too
Warren Buffett is quoted as saying: “When hamburgers go down in price, we sing the "Hallelujah Chorus" in the Buffett household. When hamburgers go up, we weep. For most people, it's the same way with everything in life they’ll be buying—except stocks. When stocks go down and you can get more for your money, people don't like them anymore.”
Let’s just say, in looking at most valuation measures today, it is not the time to sing.
Finding A Way Out
So what is an ETF investor to do? In the following section, I share two tactical trend-based processes that may keep you invested in the assets that are moving up in price. Both measure price momentum to determine trend.
Let’s first take a look at a three-way asset strategy (large-cap stocks, long-term bonds and gold) and then take a look at a simple moving average “stop loss” process that you may apply to most individual securities, including ETFs.