Tag Archives: Jeremy Grantham

Broken Record II

As the S&P500 hit an intraday all-time high yesterday, it’s been nearly 9 months since I posted on the valuation of the S&P500 (here). Since then, I have touched on factors like the reversal of global QE flows by Central Banks (here) and the lax credit terms that may be exposed by tightening monetary conditions (here). Although the traditional pull back after labor day in the US hasn’t been a big feature in recent years, the market feels frothy and a pullback seems plausible. The TINA (There Is No Alternative) trade is looking distinctly tired as the bull market approaches the 3,500-day mark. So now is an opportune time to review some of the arguments on valuations.

Fortune magazine recently had an interesting summary piece on the mounting headwinds in the US which indicate that “the current economic expansion is much nearer its end than its beginning”. Higher interest rates and the uncertainty from the ongoing Trump trade squabble are obvious headwinds that have caused nervous investors to moderate slightly valuation multiples from late last year. The Fortune article points to factors like low unemployment rates and restrictions on immigration pushing up wage costs, rising oil prices, the fleeting nature of Trump’s tax cuts against the long-term impact on federal debt, high corporate debt levels (with debt to EBITDA levels at 15 years high) and the over-optimistic earnings growth estimated by analysts.

That last point may seem harsh given the 24% and 10% growth in reported quarterly EPS and revenue respectively in Q2 2018 over Q2 2017, according to Factset as at 10/08/2018. The graph below shows the quarterly reported growth projections by analysts, as per S&P Dow Jones Indices, with a fall off in quarterly growth in 2019 from the mid-20’s down to a 10-15% range, as items like the tax cuts wash out. Clearly 10-15% earnings growth in 2019 is still assuming strong earnings and has some commentators questioning whether analysts are being too optimistic given the potential headwinds outlined above.

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According to Factset as at 10/08/2018, the 12-month forward PE of 16.6 is around the 5-year average level and 15% above the 10-year average, as below. As at the S&P500 high on 21/08/2018, the 12-month forward PE is 16.8.

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In terms of the Shiller PE or the cyclically adjusted PE (PE10), the graph below shows that the current PE10 ratio of 32.65 as at the S&P500 high on 21/08/2018, which is 63% higher than 50-year average of 20. For the purists, the current PE10 is 89% above the 100-year average.

click to enlargeCAPE Shiller PE PE10 as at 21082018 S&P500 high

According to this very interesting research paper called King of the Mountain, the PE10 metric varies across different macro-economic conditions, specifically the level of real interest rates and inflation. The authors further claim that PE10 becomes a statistically significant and economically meaningful predictor of shorter-term returns under the assumption that PE10 levels mean-revert toward the levels suggested by prevailing macroeconomic conditions rather than toward long-term averages. The graph below shows the results from the research for different real yield and inflation levels, the so-called valuation mountain.

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At a real yield around 1% and inflation around 2%, the research suggests a median PE around 20 is reasonable. Although I know that median is not the same as mean, the 20 figure is consistent with the 50-year PE10 average. The debates on CAPE/PE10 as a valuation metric have been extensively aired in this blog (here and here are examples) and range around the use of historically applicable earnings data, adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation).

One hotly debated issue around CAPE/PE10 is the impact of the changing profit margin levels. One conservative adjustment to PE10 for changes in profit margins is the John Hussman adjusted CAPE/PE10, as below, which attempts to normalise profit margins in the metric. This metric indicates that the current market is at an all time high, above the 1920s and internet bubbles (it sure doesn’t feel like that!!). In Hussman’s most recent market commentary, he states that “we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index”.

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Given the technological changes in business models and structures across economic systems, I believe that assuming current profit margins “normalise” to the average is too conservative, particularly given the potential for AI and digital transformation to cut costs across a range of business models over the medium term. Based upon my crude adjustment to the PE10 for 2010 and prior, as outlined in the previous Broken Record post (i.e. adjusted to 8.5%), using US corporate profits as a % of US GDP as a proxy for profit margins, the current PE10 of 32.65 is 21% above my profit margin adjusted 50-year average of 27, as shown below.

click to enlargeCAPE Shiller PE PE10 adjusted as at 21082018 S&P500 high

So, in summary, the different ranges of overvaluation for the S&P500 at its current high are from 15% to 60%. If the 2019 estimates of 10-15% quarterly EPS growth start to look optimistic, whether through deepening trade tensions or tighter monetary policy, I could see a 10% to 15% pullback. If economic headwinds, as above, start to get serious and the prospect of a recession gets real (although these things normally come quickly as a surprise), then something more serious could be possible.

On the flipside, I struggle to see where significant upside can come from in terms of getting earnings growth in 2019 past the 10-15% range. A breakthrough in trade tensions may be possible although unlikely before the mid-term elections. All in all, the best it looks like to me in the short term is the S&P500 going sideways from here, absent a post-labor day spurt of profit taking.

But hey, my record on calling the end to this bull market has been consistently broken….

Hindering the Hothouse

It’s been over a year since I posted on climate issues (last post here after Trump’s withdrawal from the Paris Agreement). A recent study by a group of scientists warned that even if the carbon emission reductions called for in the Paris Agreement are met, there is a risk of Earth entering “Hothouse Earth” conditions. A “Hothouse Earth” climate will in the long term stabilize at a global average of 4-5°C higher than pre-industrial temperatures with sea level 10-60 m higher than today according to the scientists.

Human emissions of greenhouse gas are not the sole determinant of temperature on Earth. Our study suggests that human-induced global warming of 2°C may trigger other Earth system processes, often called “feedbacks”, that can drive further warming – even if we stop emitting greenhouse gases,” says lead author Will Steffen from the Australian National University and Stockholm Resilience Centre, adding that “avoiding this scenario requires a redirection of human actions from exploitation to stewardship of the Earth system”.

The best-selling author of “Sapiens” and “Homo Deus”, Yuval Noah Harari, makes the observation that “the hand of the market is blind as well as invisible, and left to its own devices, it may fail to do anything at all about the threat of global warming or the dangerous potential of artificial intelligence”. This is one of the themes he returns vigorously to in his new book “21 Lessons for the 21st Century”, a collection of previously published essays.

It is therefore heartening to see such an influential and intelligent financial professional as Jeremy Grantham of GMO pushing the issue as an important one for investors to consider in our daily activities. This talk from Grantham and the accommodating presentation are well worth spending some time on. His arguments are articulated further in this August GMO white paper, The Race of Our Lives Revisited, an update on his 2013 paper.

Grantham states that “the truth is we’ve wasted 40 or 50 years since the basic fact about manmade serious climate damage became known” and “we’re moving so slowly that by the time we’ve fully decarbonized our economy, the world will have heated up by 2.5ºC to 3ºC, and a great deal of damage will have been done”.

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Grantham highlights the declining costs of alternative energy like solar and wind and the advances made in battery costs. Notwithstanding these advances, progress is too slow, as the graphs below show.

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Depressingly Grantham concludes that “in all probability we will reach our 2ºC target by 2050, and we will be fighting tooth and nail – with any luck, with carbon taxes and an improved attitude – to keep it below 3ºC by 2100”. Compounding the climate issue is continued population growth, declining agricultural productivity and increased soil erosion.

Like Harari, Grantham argues that “the greatest deficiency of capitalism is its complete inability to deal with any of these things that we are talking about even though it can handle the millions of more mundane factors that go into producing a workable economy, far better than planned economies”. Grantham makes a passionate argument for investors to divest themselves of negative climate impact firms, such as the oil producers, and to do more in our personal lives to promote green changes, like buying electric cars.

In the absence of real political leadership in our world, which looks likely to continue for some years yet as the populist and nationalistic political dead end we are currently travelling on plays out, voting with our actions seems the only thing we can do. As Grantham concludes, we all need to “get to it”.

Broken Record

Whilst the equity market marches on regardless, hitting highs again today, writing about the never-ending debates over equity valuations makes one feel like a broken record at times. At its current value, I estimate the S&P500 has returned an annualised rate of nearly 11%, excluding dividends, since its low in March 2009. As of the end of September 2017, First Trust estimated the total return from the S&P500 at 18% since March 2009, as per the graph below.

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Goldman Sachs recently published an analysis on a portfolio of 60% in the S&P 500 and 40% in 10-year U.S. Treasuries, as per the graph below, and commented that “we are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a Goldilocks backdrop of strong growth without inflation”. They further stated that “it has seldom been the case that all assets are expensive at the same time—historical examples include the Roaring ‘20s and Golden ‘50s. While in the near term, growth might stay strong and valuations could pick up further, they should become a speed limit for returns”.

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My most recent post on the topic of US equity valuations in May looked at the bull and bear arguments on low interest rates and heighten profit margins by Jeremy Grantham and John Hussman. In that post I further highlighted some of the other factors which are part of the valuation debate such as the elevated corporate leverage levels, reduced capital expenditures, and increased financial risk taking as outlined in the April IMF Global Financial Stability report. I also highlighted, in my view, another influential factor related to aging populations, namely the higher level of risk assets in public pensions as the number of retired members increases.

In other posts, such as this one on the cyclically adjusted PE (CAPE or PE10), I have highlighted the debates around the use of historically applicable earnings data in the use of valuation metrics. Adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation) are just some examples of items to consider.

The FT’s John Authers provided an update in June on the debate between Robert Shiller and Jeremy Siegel over CAPE from a CFA conference earlier this year. Jeremy Siegel articulated his critique of the Shiller CAPE in this piece last year. In an article by Robert Shiller in September article, called “The coming bear market?”, he concluded that “the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets”.

The contribution of technology firms to the bull market, particularly the so-called FANG or FAANG stocks, has also been a much-debated issue of late. The graph below shows the historical sector breakdown of the S&P500 since 1995.

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A recent article from GMO called “FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology” tried to quantify the impact that the shift in sector composition upon valuations and concluded that “today’s higher S&P 500 weight in the relatively expensive Information Technology sector is cause for some of its expensiveness, but it does not explain away the bulk of its high absolute and relative valuation level. No matter how you cut it, the S&P 500 (and most other markets for that matter) is expensive”. The graph below shows that they estimate the over-valuation of the S&P500, as at the end of September 2017, using their PE10 measure is only reduced from 46% to 39% if re-balanced to take account of today’s sector weightings.

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In his recent article this month, John Hussman (who meekly referred to “his incorrectly tagged reputation as a permabear”!!) stated that “there’s no need to take a hard-negative outlook here, but don’t allow impatience, fear of missing out, or the illusion of permanently rising stock prices to entice you into entrusting your financial future to the single most overvalued market extreme in history”.

As discussed in my May post, Hussman reiterated his counter-argument to Jeremy Grantham’s argument that structurally low interest rates, in the recent past and in the medium term, can justify a “this time it’s different” case. Hussman again states that “the extreme level of valuations cannot, in fact, be “justified” on the basis of depressed interest rates” and that “lower interest rates only justify higher valuations if the stream of future cash flows is held constant” and that “one of the reasons why reliable valuation measures have retained such a high correlation with subsequent market returns across history, regardless of the level of interest rates, is that the impact of interest rates and growth rates on “terminal” valuations systematically offset each other”.

Hussman also again counters the argument that higher profit margins are the new normal, stating that “it’s important to recognize just how dependent elevated profit margins are on maintaining permanently depressed wages and salaries, as a share of GDP” and that “simply put, elevated corporate profit margins are the precise mirror-image of depressed labour compensation” which he contends is unlikely to last in a low unemployment environment.

Hussman presents a profit margin adjusted CAPE as of the 3rd of November, reproduced below, which he contends shows that “market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs”.

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However, I think that his profit margin analysis is harsh. If you adjust historical earnings upwards for newer higher margin levels, of course the historical earning multiples will be lower. I got to thinking about what current valuations would look like against the past if higher historical profit margins, and therefore earnings, had resulted in higher multiples. Using data from Shiller’s website, the graph below does present a striking representation of the relationship between corporate profits (accepting the weaknesses in using profits as a percentage of US GDP) and interest rates.

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Purely as a thought experiment, I played with Shiller’s data, updating the reported earnings for estimates through 2018 (with a small discount to reflect over-zealous estimates as per recent trends of earnings revisions), recent consensus end 2018 S&P500 targets, and consensus inflation and the 10-year US interest rates through 2018. Basically, I tried to represent the base case from current commentators of slowly increasing inflation and interest rates over the short term, with 2018 reported EPS growth of 8% and the S&P500 growing to 2,900 by year end 2018. I then calculated the valuation metrics PE10, the regular PE (using trailing twelve month reported earnings called PE ttm), and the future PE (using forward twelve month reported earnings called PE ftm) to the end of 2018. I further adjusted the earnings multiples, for 2007 and prior, by applying an (principally upward) adjustment equal to a ratio of the pre-2007 actual  corporate profits percentage to GDP divided by a newly assumed normalised percentage of 8.5% (lower than the past 10-year average around 9% to factor in some upward wage pressures over the medium term). The resulting historical multiples and averages are shown below.

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Based upon this analysis, whilst accepting its deeply flawed assumptions, if 2018 follows the base case currently expected (i.e. no external shocks, no big inflation or interest rates moves, steady if not spectacular earnings growth), the S&P500 currently looks over-valued by 50% to 20% using historical norms. If this time it is different and higher profit margins and lower interest rates are the new normal, then the S&P500 looks roughly fairly-valued and current targets for 2018 around 2,900 look achievable. Mind you, it’s a huge leap in mind-set to assume that the long-term average PE is justifiably in the mid-20s.

I continue to be concerned about increasing corporate leverage levels, as highlighted in my May post from the IMF Global Financial Stability report in April, and the unforeseen consequences of rising interest rate after such a long period of abnormally low rates.

In the interim, to paraphrase an ex-President, it’s all about the earnings stupid!

Still Dancing

The latest market wobble this week comes under the guise of the endless Trump soap opera and the first widespread use of the impeachment word. I doubt it will be the last time we hear that word! The bookies are now offering even odds of impeachment. My guess is that Trump’s biggest stumble will come over some business conflict of interest and/or a re-emergence of proof of his caveman behaviour towards woman. The prospect of a President Pence is unlikely to deeply upset (the non-crazy) republicans or the market. The issue is likely “when not if” and the impact will depend upon whether the republicans still control Congress.

Despite the week’s wobble, the S&P500 is still up over 6% this year. May is always a good month to assess market valuation and revisit the on-going debate on whether historical metrics or forward looking metrics are valid in this low interest rate/elevated profit margin world. Examples of recent posts on this topic include this post one highlighted McKinsey’s work on the changing nature of earnings and this post looked at the impact of technology on profit profiles.

The hedge fund guru Paul Tudor Jones recently stated that a chart of the market’s value relative to US GDP, sometimes called the Buffet indicator as below, should be “terrifying” to central bankers and an indicator that investors are unrealistically valuing future growth in the economy.

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Other historical indicators such as the S&P500 trailing 12 month PE or the PE10 (aka Shiller CAPE) suggest the market is 60% to 75% overvalued (this old post outlines some of the on-going arguments around CAPE).

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So, it was fascinating to see a value investor as respected as Jeremy Grantham of GMO recently issue a piece called “This time seems very very different” stating that “the single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage” and that “pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower”. Graham argues that low interest rates, relative to historical levels, are here for some time to come due to structural reasons including income inequality and aging populations resulting in more aged savers and less younger spenders. Increased monopoly, political, and brand power in modern business models have, according to Graham, reduced the normal competitive pressures and created a new stickiness in profits that has sustained higher margins.

The ever-cautious John Hussman is disgusted that such a person as Jeremy Grantham would dare join the “this time it’s different” crowd. In a rebuttal piece, Hussman discounts interest rates as the reason for elevated profits (he points out that debt of U.S. corporations as a ratio to revenues is more than double its historical median) and firmly puts the reason down to declining labour compensation as a share of output prices, as illustrated by the Hussman graph below.

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Hussman argues that labour costs and profit margins are in the process of being normalised as the labour market tightens. Bloomberg had an interesting article recently on wage growth and whether the Phillips Curve is still valid. Hussman states that “valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average [profit margin] would easily take the S&P 500 35-40% lower over the completion of the current market cycle”. Hussman favoured valuation metric of the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), shown below, predicts a rocky road ahead.

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The bulls point to a growing economy and ongoing earnings growth, as illustrated by the S&P figures below on operating EPS projections, particularly in the technology, industrials, energy, healthcare and consumer sectors.

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Taking operating earnings as a valid valuation metric, the S&P figures show that EPS estimates for 2017 and 2018 (with a small haircut increasing in time to discount the consistent over optimism of analyst forward estimates) support the bull argument that current valuations will be justified by earnings growth over the coming quarters, as shown below.

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The IMF Global Financial Stability report from April contains some interesting stuff on risks facing the corporate sector. They highlight that financial risk taking (defined as purchases of financial assets, M&A and shareholder pay-outs) has averaged $940 billion a year over the past three years for S&P 500 firms representing more than half of free corporate cash flow, with the health care and information technology sectors being the biggest culprits. The IMF point to elevated leverage levels, as seen in the graph below, reflective of a mature credit cycle which could end badly if interest rates rise above the historical low levels of recent times.

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The report highlights that debt levels are uneven with particularly exposed sectors being energy, real estate and utilities, as can be seen below.

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The IMF looked beyond the S&P500 to a broader set of nearly 4,000 US firms to show a similar rise in leverage and capability to service debt, as illustrated below.

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Another graph I found interesting from the IMF report was the one below on the level of historical capital expenditure relative to total assets, as below. A possible explanation is the growth in technology driven business models which don’t require large plant & property investments. The IMF report does point out that tax cuts or offshore tax holidays will, based upon past examples, likely result in more financial risk taking actions rather than increased investment.

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I also found a paper referenced in the report on pensions (“Pension Fund Asset Allocation and Liability Discount Rates” by Aleksandar Andonov, Rob Bauer and Martijn Cremers) interesting as I had suspected that low interest rates have encouraged baby boomers to be over-invested in equities relative to historical fixed income allocations. The paper defines risky assets as investments in public equity, alternative assets, and high-yield bonds. The authors state that “a 10% increase in the percentage of retired members of U.S. public pension funds is associated with a 5.93% increase in their allocation to risky assets” and for all other funds “a 10% increase in the percentage of retired members is associated with a 1.67% lower allocation to risky assets”.  The graph below shows public pension higher allocation to risky assets up to 2012. It would be fascinating to see if this trend has continued to today.

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They further conclude that “this increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 75 basis point increase in their discount rate” and that “our regulatory incentives hypothesis argues that the GASB guidelines give U.S. public funds an incentive to increase their allocation to risky assets with higher expected returns in order to justify a higher discount rate and report a lower value of liabilities”. The graph below illustrates the stark difference between the US and Europe.

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So, in conclusion, unless Mr Trump does something really stupid (currently around 50:50 in my opinion) like start a war, current valuations can be justified within a +/- 10% range by bulls assuming the possibility of fiscal stimulus and/or tax cuts is still on the table. However, there are cracks in the system and as interest rates start to increase over the medium term, I suspect vulnerabilities will be exposed in the current bull argument. I am happy to take some profits here and have reduced by equity exposure to around 35% of my portfolio to see how things go over the summer (sell in May and go away if you like). The ability of Trump to deliver tax cuts and/or fiscal stimulus has to be question given his erratic behaviour.

Anecdotally my impression is that aging investors are more exposed to equities than historically or than prudent risk management would dictate, even in this interest rate environment, and this is a contributing factor behind current sunny valuations. Any serious or sudden wobble in equity markets may be magnified by a stampede of such investors trying to protect their savings and the mammoth gains of the 8 year old bull market. For the moment through, to misquote Chuck Price, as long as the music is playing investors are still dancing.

Something is not right

An article on inflation from the Economist two weeks ago has been freaking me out. By now, with the biggest experiment in loose monetary policy the world has ever known, we should be happily inflating our way out of the overleverage aftermath of the 2008 crisis. Yet here we are with core inflation at 1.4%, 1.2% and 0.8% for the G7, US and the Euro zone respectively.

It seems like the air is coming out of the balloon faster than the central bankers can fill it. An article in today’s FT pointed out that real incomes in the average US family are less today than they were in 1989. No matter how much the central bankers want us to go back to the Mall and shop our way out of the current climate, there is something that just doesn’t add up.

Against the background of loose monetary policy and weak underlying fundamentals, I am becoming more convinced that the stock market is overvalued today (which doesn’t mean it will necessarily stop going up!) with the Dow topping 16,000 and S&P500 nearing 1,800 at a PE of 20 (& 15 times 2014 estimated earnings) and the Shiller PE at 24.7.

With my thanks to Fast Eddie, here are some articles on valuations that I have been reading which provide food for thought:

GMO November letter by Ben Inker & Jeremy Grantham

Chumps, Champs, and Bamboo by John Hussman

and the thought provoking

The paradox of wealth and the end of history illusion by William Bernstein