If stocks aren’t overvalued, where are the opportunities for 2017?
* Stock valuations may not be as escalated as some suggest
* Regardless, market momentum can carry prices further
* There are potential high-growth opportunities for patient investors
There is an excellent movie starring Gene Hackman and Will Smith, called ‘Enemy of the State’ (this isn’t my intended connection to Donald Trump!). At one point Gene Hackman’s character (‘Brill’) delivers the line:
You’re either very smart… or incredibly stupid.
(This is my intended connection to Donald Trump.)
Donald Trump is, first and foremost: a deal-maker, a businessman, a capitalist. The world in which he has become successful is not a political one. Political games are played with different rules, that can change or reverse overnight according to what is ‘trending’ on social media. Trump’s blunt exaggerated bravado, that is his comfort zone, does not make sense for many. But they are learning.. People are already referring to his ‘alternative facts’ as not really lies, but just the way he speaks.
Let’s face it, you don’t get to run a corporation the size of ‘Trump’, let alone become President of the USA, if you are stupid. But how much of his rantings are simply personal outbursts, and how much is in-built negotiation style? Upsetting the balance, unsettling the opposition and disturbing the status quo are great ways to start off in a negotiation. ‘Playing hardball’ right from the outset is how tough deal-makers make their name. What is the title of his book (the one you can remember)?: “The Art of the Deal.”
You want to shake up the Chinese? Take a call from the premier of Taiwan. Suddenly you have something to negotiate about. You want to show you mean business on immigration? Sign a broad, blunt, executive order. Sure, it’ll get watered down later, but it’s the starting position that sets the boundary of any negotiation.
In terms of personal style, grace and courteousness, Trump is not to the taste of many. But we recall one the benefits of being a businessman rather than a politician - he doesn’t have to care what people think about him. In his mind he was voted in to get things done, to make changes, and that’s what he’s doing.
Of course, we might find that his self-important bullying becomes so unpalatable that the political system chews him up and spits him out.
In the meantime, the world goes round….
Was there really a ‘Trump Rally’?
There was much talk of a ‘Trump rally’ as the US stock markets pushed higher after the US election. But the US economy was already doing fine, as evidenced by the Federal Reserve feeling comfortable to raise interest rates again. In my view a factor of the rally was similar to that after the Brexit vote - a collective thought of ‘Oh, maybe it won’t be so bad after all,’; the removal of uncertainty on the outcome immediately boosted short term market confidence.
Figure - Two-year performance of key market indices, as at end of 2016.
In the table above is interesting to look at the change ‘Since Trump’ versus the 1-Year change for many of the indices. For example, Japan and Eurozone dipped in 2016 but ended almost level for the year, with most of the recovery coming after the US election. USA and the Dow Jones Global both received a nice boost post-Trump, equivalent to almost half the total gains for the year. Broad emerging markets on the other hand were badly knocked in the final two months of the year (the exception being Russia that reaped the benefit of the OPEC production cap deal).
The new President likes to position himself as ‘pro-growth’ - clever electioneering terminology that indirectly suggests his competitor was somehow anti-growth. His policies of corporate and private tax cuts, regulatory loosening, elements of his ‘America First’ trade policy, infrastucture expenditure, and his support for the US energy sector all have potential to boost the US economy in the short term.
The World Bank roughly estimates that the combined measures of tax cuts and infrastructure upgrades could add between 3.4% and 4.4% to US GDP by 2018. This is without consideration to other policy changes, and will of course depend on timing of implementation. Though the World Bank also highlights that without all the details ‘it is difficult to rigorously examine’ the net effect on the outlook for the US economy.
Protectionism on the other hand - pulling out of the TPP (Trans-Pacific Partnership), and Trump’s desire to renegotiate NAFTA (North American Free Trade Agreement), for example - may have unintended consequences in the medium to longer term. The USA pulling out of the TPP creates a vacuum that China will be pleased to fill. Protectionism can lead to tit-for-tat responses by trading partners, as well as encouraging laziness in industry, with national businesses ending up less efficient and less capable to compete in global markets.
This ‘Trump Effect’ globally has the potential to be ultimately far more significant than a shorter term home-grown rally. The US economy is the largest in the world and interconnects with the global economies at innumerable levels. As the World Bank says:
Uncertainty surrounding global growth projections has increased and risks continue to be tilted to the downside. This reflects the possibility of a prolonged period of heightened policy uncertainty following recent electoral outcomes in key major economies, mounting protectionist tendencies, and potential financial market disruptions associated with sharp changes in borrowing costs or exchange rate movements.
Are stocks overvalued? Actually, … what does that even mean?
With markets maintaining a string of new highs, there has been a lot of discussion in the financial media on whether US stocks are overvalued. Investors get nervous because ‘nothing last forever’. It’s probably helpful, therefore, to take a more detailed look at this subject.
When we buy shares, we buy a piece of the company. If the business profitability grows nicely in the future, then we are likely to benefit from an ongoing income stream of dividends. We use the Price-Earnings ratio (‘P/E ratio’ or ‘PE’) to measure whether the current price of the shares is good value compared to the recent actual profitability (earnings) of the company. As an option, instead of actual reported earnings data, we could also use the analysts’ consensus of future earnings, in which case we are looking at the ‘Forward PE’, which may (or may not) give us some insight into the future.
We can look at PEs of companies in the same industry sector as a way to compare between peers. A high PE can mean that a stock is popular, and hence demand is pushing up the price. It could alternatively mean that the company has had a recent run of poor earnings. PEs of different sectors will generally vary per the nature of the industry, for example a glamourous technology company might have a PE several times higher than a cement manufacturer. A real example: as I write this in January 2017, the (US) Biotechnology sector has a current PE of 321 and the US Water Utilities sector PE is 27.
The PE ratio of a single company will vary over the years signalling the fortunes of the business at the time; similarly so with industry sectors or stock market indices. One of the most analysed PE ratios is of course that of the S&P500, which represents five hundred of the largest US companies, about 70-80% of the total US market capitalisation, and about a quarter of the world’s total listed equity by value.
With help from a chart of the S&P500 PE ratio, we can identify major historical market events such as the dot-com boom or the global financial crisis. The chart below shows the S&P500 PE based on twelve-month trailing ‘as reported’ earnings (i.e. the Trailing PE) since 1926.
Figure - S&P 500 trailing PE. Shaded bands are recessions.
From the chart we see that the current value of the S&P500 PE is around 25, an uncommonly high figure rarely matched in the last ninety years.
When we look at this chart we should remember the two reasons why a PE might be high - either because the popularity of stocks is pushing prices up, or because earnings are poor. The second reason explains why PE might peak after a market recession or business downturn, rather than directly in sync with it. In this light, the current S&P500 PE is close to the highest it’s ever been, if we exclude periods post earnings crashes.
As we see above, the PE can swing wildly due to short term earnings shocks. Some experts, notably Nobel prize-winning economist Robert Shiller in his book ‘Irrational Exuberance’, suggest that the calculation of the PE can be tweaked to resolve this problem, and potentially give us more meaningful insight. Shiller proposes using an average of ten years’ of earnings data, and adjusting for inflation. Shiller’s PE method is variously referred to as the Shiller PE, the PE-10, or the CAPE ratio (Cyclically Adjusted PE Ratio).
Below is chart with the Shiller PE compared to the regular PE. It’s interesting to note that at the time of the dot-com bubble Shiller’s PE peaked in the late nineties - two years in advance of the regular PE, by which time markets had already taken a beating. We can also see that as the global financial crisis unfolded, Shiller’s PE dipped to a long term low, correctly indicating a good time to buy stocks.
Figure - S&P 500 Shiller PE vs regular trailing PE.
So how much prediction power does the Price-Earnings ratio offer us? Well, at present both the above PE measures are substantially above their long term means (regular PE = 16, Shiller PE = 6.7). This tells us that possibly stocks are at the high end of valuations, but it does not necessarily signal any kind of reversal or inflection point. Stock markets can continue to rise for a long time after analysts start talking about valuations being high.
In terms of practical investment strategy, rising PEs suggest increasing caution and watching for the downside. Even though the S&P 500 may be reaching a series of new highs, it is perhaps not the time to be gung-ho about equities in general, because earnings have not been following the same trend - in fact, they are down 14% in two years. (The divergence between stock price behaviour and earnings I discussed deeper here).
A look at earnings (specifically the EPS - earnings per share - of the S&P500) is interesting because of the usually good correlation between the S&P500 price and reported earnings.
Figure - S&P500 Historical Earnings (GAAP, TTM) and Price
Of course we expect earnings to generally rise over the long term, in tandem with a rise in stock prices. Hence the predictive value of looking at earnings growth in isolation is limited. Another tool that analysts use to get a meaure of value is to look at the Price-to-Book of the market. This is a simple multiple, in a similar theme to Price-Earnings, but the PB looks at the price as a multiple of the net book value of a business (i.e. all the assets less all the laibilities).
Figure - S&P500 Price to Book - Dec-1999 to Dec-2016
The chart above shows that the current PB of the S&P500 is not remarkably different to it’s long term average over the previous 17 years, indicating that by this measure, prices may not be unrealistically high. Perhaps more useful is to look at how well those assets are being applied to create returns. The chart below shows productivity of the S&P500 - i.e. earnings as a percentage of shareholders equity.
Figure - S&P Return on Equity - Dec-1999 to Dec-2016
Yet again, shareholders return on equity does not seem to be so far away from the average over the last 17 years. Separately, PB (valuation) and ROE (productivity) are interesting but don’t tell us much we don’t know already. However, when we plot PB against ROE, the outcome seems more helpful.
Figure - S&P500 Valuation vs Productivity (PB vs ROE) - Dec-1999 to Dec-2016 (Quarterly Data Points)
In a perfect market, there would be a straightforward relationship between productivity and valuations. We could make a theoretical best fit linear trendline (though note, R-squared is low at only 0.2 in the above data). A data point above the trendline indicates that stocks are potentially overvalued, whilst a data point below the trendline indicates that stocks are potentially undervalued. Indeed the extreme high points such as Mar-02 and Jun-01 were good times to sell the S&P500, and the extreme low of Sep-11 was a good time to buy. We also note that the chart nicely highlights market anomalies such as the dot-com boom and the global financial crisis.
Right now, the (estimated) data point for Dec-16 is in the middle of the chart and has been close to the trendline for several quarters - telling us that present valuations are in the expected range, and certainly not out of the ordinary for this measure.
Warren Buffet’s favourite way to value the stock market
Another way to look at valuations is to follow Warrant Buffet’s recommendation for “probably the best single measure of where valuations stand at any given moment”, being the ratio of market capitalisation of listed equity to national gross domestic product (GDP). [Source.]
Intuitively from looking at the chart below, it’s easy to see why Mr Buffet is so keen on this ratio. In both 1999/2000 and 2006/07 the market-cap-to-GDP ratio peaked and then turned downwards, as a precursor to the markets plummeting and recession in the following years. 2010 shows similar behaviour, though less in magnitude, in advance of the pull-back in 2011.
Bearing in mind that some observers consider a market-cap-to-GDP of 100% as representing ‘fair’ stock value, then the current 140% could well indicate that stocks are expensive. Furthermore, we see that in 2014/15 the ratio also exhibits the same peak-and-downturn as prior to the two previous periods of recession. We eagerly await full data availability for 2016.
Figure - USA Market Capitalisation to GDP Ratio
So, that’s the USA. What about the world overall?
Figure - World Total Market Capitalisation to GDP Ratio
The shape of the chart is similar (though a little more ‘spikey’ perhaps). However, the level of the most recent data point (2015) has not reached previous peaks, and the 2015 ratio at 97% for the World is low compared to 139% for USA. Interpreting the World chart, maybe the ‘fairly priced stocks’ ratio is somewhat lower than 100%. It’s interesting to note that 100% was only breached twice in the last forty years - both times a harbinger of major recessions.
Just maybe, global stocks overall are better value than they are specifically in the USA (per the market-cap-to-GDP measure). If this is the case, it might indicate there are some potential bargain markets around the world. When available, adding the 2016 data point to the chart will also be useful.
Summary: The Answer to the question on stock valuations
As illustrated above, stock valuations by measures such as PB (price to book), EPS (earnings per share) and ROE (return on shareholders’ equity) are currently unremarkable, whilst the elevated PE (price-earnings ratio) and market-cap-to-GDP figures sound a note of caution. However, as mentioned earlier, market momentum can keep prices rising for quite some time even though PE already looks high.
So where are the opportunities?
Here is the headline summary of the World Bank Global Economic Prospects report dated January 2017, and titled ‘Weak Investment In Uncertain Times’:
Stagnant global trade, subdued investment, and heightened policy uncertainty marked another difficult year for the world economy. A moderate recovery is expected for 2017, with receding obstacles to activity in commodity-exporting emerging markets and developing economies. Weak investment is weighing on medium-term prospects across many emerging markets and developing economies. Although fiscal stimulus in major economies, if implemented, may boost global growth above expectations, risks to growth forecasts remain tilted to the downside. Important downside risks stem from heightened policy uncertainty in major economies. (Emphasis added.)
Low prices have hurt commodity exporting nations in the last couple of years. There is hope for prices to rise in 2017, but if we want to be selective then net commodity importing nations would be preferred.
The World Bank data helpfully divides countries into ‘Advanced economies’ and ‘EMDEs’ (Emerging Markets and Developing Economies):
EMDE's are those countries not classified as Advanced.
The analysis also splits EMDE’s into ‘Commodity Importing’ and ‘Commodity Exporting’; these are defined as follows:
Commodity importers are all EMDE economies that are not classified as commodity exporters.
The following charts present GDP growth information taken from the referenced World Bank report.
Figure - Global GDP Growth
Figure - Contribution to Global Growth
Figure - GDP Growth Projections - Advanced Economies
Figure - GDP Growth by Country Groups
Figure - GDP Growth by Commodity Import/Export Country Group
Figure - EMDE (Emerging Market and Developing Economies) GDP Growth
Figure - Commodity Importer EMDE countries as defined by World Bank (highlights added).
The World Bank’s detailed analysis feeds into their projections for 2017, presented in the table below.
Figure - GDP Growth
Investment Strategy for 2017
Long term regular savings plans, such as for retirement planning, benefit from dollar cost averaging (DCA). DCA means that the discipline to keep regularly buying into markets, even as prices go down, will create enhanced profits when prices recover. We ‘buy in’ to a market bottom without having to attempt market timing. Hence for regular savings plan we might choose to take a slightly more adventurous investment policy (i.e. a larger proportion of higher volatility holdings) than would be indicated by individual risk profile.
For lump sums, if we have a long term view then similarly we might choose to accept more volatility holdings in expectation of ultimately higher returns. Though if our time horizon is shorter then a less risky portfolio is the way to go. This would mean a higher allocation to bonds and fixed income investments.
The preceding analysis guides us to a view that for 2017, the equity part of our portfolio might be allocated as follows: split between USA, Europe (inc. UK), and broad Asia-Pacific (ex. Japan) by the ratio of 50%:30%;20% or to 50%:20%:30% for an increased accent on developing Asia. Whilst several measures of stock valuations are unremarkable, the S&P500 PE and the market-cap-to-GDP data emphasises we should be on the watch for downside risks.
In terms of currencies, the strength of the USD is expected to continue during 2017, with further policy increases in US interest rates during the year.
If you have any comments about this article, please do contact me.