I’ve recently discussed investor concerns related to fallout from a global trade war and to a potential inversion of the yield curve. Today I’ll discuss a third concern on many investors’ minds: the high valuations of U.S. equities.
Before delving into the issue, it’s important to note that, while U.S. equity valuations are well above their long-term historical averages, valuations of international equities are both lower and closer to their historical averages.
For example, as of June 30, 2018, the earnings yield (E/P) of the Shiller CAPE 10 (the best predictor of future real returns we have) for the U.S. was just 3.2%. It was 5.2% for non-U.S. developed markets and 6.6% for emerging markets (data provided by AQR Capital Management).
With the CAPE 10 currently at about 33, more investors are worried about the outlook for future equity returns and the possibility of mean reversion in valuations, which could lead to a bear market. Jeremy Grantham, the highly regarded chief investment strategist at GMO, has been warning investors about this scenario since 2013, when he declared all global assets were once again becoming “brutally overpriced.”
We know today that the market ignored Grantham’s warning. Instead of collapsing, from February 2013, when Grantham made the preceding assertion, through June 2018, the S&P 500 Index posted a total return of 103% and an annualized return of 14%, almost 40% above its long-term average of 10.1%.
If you were inclined to believe that such high valuations meant U.S. stocks were doomed to a bear market, Crescat Capital’s third quarter 2017 investor letter provided plenty of acid for your stomach. The letter began by noting, “US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000.”
The authors of the Crescat letter went on to “prove it conclusively” by showing various valuation metrics related to price-to-sales (P/S); price-to-book (P/B); enterprise value-to-sales (EV/S); enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA); price-to-earnings (P/E); and enterprise value-to-free cash flow (EV/FCF).
They then noted—and recall this was in November 2017—that, “Brutal bear markets and recessions have historically followed from record valuations like we have today, and this time will almost certainly be no different.” They also noted:
- The median P/S ratio for the S&P 500 at the time was the highest ever, by a wide margin: more than 60% greater than the tech bubble peak.
- S&P 500 companies were more leveraged than ever before, and this was true for the entire corporate world.
- The median EV/S for the S&P 500 was at a record level.
- The median EV/EBITDA for the S&P 500 was at a record level.
- Profit margins were at all-time, unsustainable highs, and surges in profit margins occur at the end of the business cycle, before bear markets. A margin-adjusted measure of the CAPE 10 increased it to 43—greater than the ratio’s 41 in 1999 and 40 in 1929. The margin-adjusted CAPE 10 predicted negative average returns for the following 12 years (John Hussman developed this measure).
- The median cyclically adjusted EV/FCF for nonbanks in the S&P 500 was an insanely high 41, the highest ever.
The letter went on to add that, while P/E multiples tend to be higher when inflation is at low, positive levels, multiples (at the time) were among the highest P/Es ever for a 2% inflation environment. They suggested that “we could see a 50% decline in stock prices just to get back to mean historical P/E multiples for this level of inflation.”
They then added that they saw the Federal Reserve’s tightening of credit (both raising interest rates and unwinding its balance sheet) as the main catalyst that will burst global asset bubbles.
If you were already worried about the aforementioned risks of a global trade war and an inverted yield curve, Crescat’s quarterly letter, had you read it, might have provided the tipping point leading to panicked selling. The market continues to ignore such clarion calls. For the nine-month period from October 2017 through June 2018, the S&P 500 Index ignored Crescat’s warning and provided a total return of 9.5%.