Discover more from TKer by Sam Ro
The stock market's complicated evolving relationship with valuations 📈
Plus a charted review of the macro crosscurrents 🔀
Stocks climbed last week with the S&P 500 rising 0.7% to close at 4,536.34. The index is now up 18.1% year to date, up 26.8% from its October 12 closing low of 3,577.03, and down 5.4% from its January 3, 2022 record closing high of 4,796.56.
In the stock market, do valuation metrics like price-to-earnings (P/E) multiples matter?
Of course they do!
However, they don’t appear to be very helpful when predicting short term moves in prices.
…there is nothing that says that these metrics have to return to their long-term averages. In fact, I believe the opposite. Valuation multiples are likely to stay above their historical norms for the foreseeable future. Why?
Because investing is much simpler today than it used to be. With the rise of cheap diversification over the last half century, investors today are willing to accept lower future returns (i.e. higher valuations) than their predecessors. This has fundamentally changed valuation metrics and made historical comparisons less useful than they once were.
I think Nick’s right. And I think we sometimes take for granted how much the frictions and costs have come down for those seeking to trade or invest in stocks.
On Thursday, I joined Jack Raines, Josh Brown, and Michael Batnick on The Compound And Friends podcast (listen to it here!). We spent a good amount of time wrestling with issues related to valuations.
Jack pointed out that trading fees have been coming down for decades, which certainly justify higher valuation premiums — if it costs less to trade, then the returns you require should probably be lower.
Another critical point to remember is that interest rates have been trending lower for the better part of the past four decades. Experts ranging from Robert Shiller to Warren Buffett to Jeremy Grantham have argued lower rates justify higher average valuations.
Perhaps the most disturbing observation about P/E ratios comes from Goldman Sachs. In a research note published a little over a year ago, Goldman analysts concluded (emphasis added):
While valuations feature importantly in our toolbox to estimate forward equity returns, we should dispel an oft-repeated myth that equity valuations are mean-reverting… We have not found any statistical evidence of mean reversion… Equity valuations are a bounded time series: there is some upper bound since valuations cannot reach infinity, and there is a lower bound since valuations cannot go below zero. However, having upper and lower bounds does not imply valuations are stationary and revert to the same long-term mean.
So just because you can calculate an average does not mean what you’re observing has a tendency to gravitate toward that average over time.
For more on how P/Es are not mean reverting, read: Goldman Sachs destroys one of the most persistent myths about investing in stocks 🤯
Maybe you’re not willing to accept what we’ve discussed here so far. Then, at least consider this: While there is some historical evidence that valuations may tell you something about long-term returns, that data also shows valuations tell you almost nothing about where stocks will go in the following 12 months.
JPMorgan analysts ran the historical numbers. As the chart to the left shows, there is effectively no linear relationship between valuations and one-year returns. In other words, an expensive valuation doesn’t necessarily increase the likelihood that the following year’s returns will be weak. Similarly, a cheap valuation doesn’t necessarily increase the likelihood that the following year’s returns will be strong.
If this sounds familiar, it’s because it’s TKer Stock Market Truth No. 6: Valuations won’t tell you much about the next year.
To be fair, the chart on the right suggests there may be a relationship between valuations and longer term returns. Specifically, high valuations may mean lower average returns over rolling five year periods. But as Nick notes: “while future returns do seem lower, when we will experience them is anyone’s guess.“
The bottom line is that you should use valuation metrics like the P/E ratio with caution. Just because valuations are high at a given moment does not mean the next 12 months’ return will be weak.
Related from TKer:
Listen up! 🎧
I was on The Compound & Friends podcast on Thursday with the up-and-coming Jack Raines, the legendary Josh Brown, and the brilliant Michael Batnick. WOW. We covered a lot. Artificial intelligence, valuations, the earnings recession that’s happening, the economic recession that hasn’t happened, ambiguous investor sentiment signals, social media, and more! Listen on Apple Podcasts, Spotify, Google Podcasts, YouTube, and beyond!
Reviewing the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
🛍️ Consumers are still spending. According to Census Bureau data (via Notes), retail sales in June climbed 0.2% to $689.5 billion. While the pace of sales is off its record high, it continues to trend well above pre-pandemic levels.
From Wells Fargo: “Most remarkable is that control group sales, which feeds into estimates from PCE spending, came in +0.6%, or twice the 0.3% that had been expected. By excluding autos, gas, building materials and restaurants, this category gives a sense of the underlying trend in spending. The trend is stubbornly good. Credit ecommerce for that. The category that puts packages on porches was up 1.9% in June, the second largest increase of any store type… Slowing goods inflation is freeing up cash for consumers, and helping overall spending remain steady.“
For more on the resilience of the consumer, read: Don't underestimate the American consumer 🛍️
🛠️ Industrial activity cools. Industrial production activity in June declined 0.5% from May levels, with manufacturing output declining 0.3%.
For more on monthly economic reports, read: Let's not lose our minds over one month's economic data 😵💫
🏭 Manufacturing surveys are mixed. The New York Fed’s July Empire State Manufacturing Survey (via Notes) signaled a modest improvement in general business conditions during the month. Interestingly, prices paid and received cooled during the month while the number of employees and average workweek ticked higher.
The Philly Fed’s July Manufacturing Business Outlook Survey signaled declining activity in the region during the month. However, those surveyed were much more optimistic about the future. From the report: “The diffusion index for future general activity jumped from a reading of 12.7 in June to 29.1 in July, the index’s highest reading since August 2021. Nearly 40% of the firms expect an increase in activity over the next six months (up from 33% last month), and 11% expect a decrease (down from 20%); 46% expect no change (up from 44%). The future new orders index climbed 24 points to 38.2, while the future shipments index rose 9 points to 37.3. On balance, the firms continued to expect increases in employment over the next six months, and the future employment index increased from a reading of 13.1 to 21.3.“
Keep in mind that during times of stress, soft data tends to be more exaggerated than actual hard data.
For more on this, read: What businesses do > what businesses say 🙊
🏚 Home sales cooled. Sales of previously owned homes fell 3.3% in June to an annualized rate of 4.16 million units. From NAR chief economist Lawrence Yun: “Fewer Americans were on the move despite the usual life-changing circumstances. The pent-up demand will surely be realized soon, especially if mortgage rates and inventory move favorably.“
For more on housing, read: The U.S. housing market has gone cold 🥶
💸 Home prices ticked up. Prices for previously owned homes rose month over month and were up from year ago levels. From the NAR: “The median existing-home price for all housing types in June was $410,200, the second-highest price of all time and down 0.9% from the record-high of $413,800 in June 2022. The monthly median price surpassed $400,000 for the third time, joining June 2022 and May 2022 ($408,600). Prices rose in the Northeast and Midwest but waned in the South and West.”
🏠 Home builder sentiment improves. From the NAHB: “Low existing inventory that is keeping demand solid for new homes helped to push builder confidence up in July even as the industry continues to grapple with rising mortgage rates, elevated construction costs and limited lot availability.“
From NAHB Chief Economist Robert Dietz: “Although builders continue to remain cautiously optimistic about market conditions, the quarter-point rise in mortgage rates over the past month is a stark reminder of the stop and start process the market will experience as the Federal Reserve nears the end of the ongoing tightening cycle.”
🔨 New home construction ticks down. Housing starts declined 8.0% in June to an annualized rate of 1.43 million units, according to the Census Bureau. Building permits fell 3.7% to an annualized rate of 1.44 million units.
🍾 The entrepreneurial spirit is alive. From the Census Bureau: “June 2023 Business Applications were 465,906, up 6.2% (seasonally adjusted) from May 2023. Of those, 149,536 were High-Propensity Business Applications.”
😬 The pros are worried about stuff. According to BofA’s June Global Fund Manager Survey (via Notes), fund managers identified high inflation keeping central banks hawkish as the “biggest tail risk.”
The truth is we’re always worried about something. That’s just the nature of investing.
For more on risks, read: Sorry, but uncertainty will always be high 😰
💼 Unemployment claims tick down. Initial claims for unemployment benefits fell to 228,000 during the week ending July 15, down from 237,000 the week prior. While this is up from the September low of 182,000, it continues to trend at levels associated with economic growth.
💳 Card spending growth is positive. From JPMorgan Chase: “As of 16 Jul 2023, our Chase Consumer Card spending data (unadjusted) was 3.0% above the same day last year. Based on the Chase Consumer Card data through 16 Jul 2023, our estimate of the US Census July control measure of retail sales m/m is 0.40%.“
From Bank of America: “Total card spending per HH was up 0.8% y/y in the week ending Jul 15, according to BAC aggregated credit and debit card data. Airline, entertainment & transit spending picked up on a y/y basis in the last week, while most goods categories decelerated. The increase in online retail spending around Prime Day and related promotions was similar to last year.“
For more on spending, read: Don't underestimate the American consumer 🛍️
📈 Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.4% rate in Q2. While the model’s estimate is off its high, it’s nevertheless very positive and up from its initial estimate of 1.7% growth as of April 28.
For more on the forces bolstering economic growth, read: 9 reasons to be optimistic about the economy and markets 💪
Putting it all together 🤔
The Federal Reserve recently adopted a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“ On May 3, the Fed signaled that the end of interest rate hikes may be here. And at its June 14 policy meeting, it kept rates unchanged, ending a streak of 10 consecutive rate hikes.
In any case, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to keep monetary policy tight, which means we should be prepared for tight financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations) to linger.
At the same time, we also know that stocks are discounting mechanisms, meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 318 large-cap equity funds were in the top half of performance in 2020. Of those funds, 39% came in the top half again in 2021, and just 5% were able to extend that streak through 2022. If you set the bar even higher and consider those in the top quartile of performance, just 7% of 156 large-cap funds remained in the top quartile in 2021. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2022.
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.