The markets are wildly irrational
The first objection I frequently see from readers is that genuine investors should disregard the daily fluctuations in the markets that preoccupy traders and instead adopt a strategy of purchasing and retaining stocks. There is a small but significant truth in this statement: the majority of fund managers fail to outperform the market, so what likelihood do individuals who casually engage in trading have? It is advisable to purchase the index.
Nevertheless, even those who prioritize long-term planning should make changes to their investment portfolios when prices deviate significantly from their actual value. This includes instances such as the dot-com bubble or the economic downturn caused by Covid-19, as well as situations where bond yields are near to zero or during the recent period of excessive speculation in SPACs, cannabis, and clean energy in 2020-2021. The question pertains to the method of evaluating or determining.
Three metrics that will be taken into consideration are the CAPE, the future PE, and the Fed Model. It is evident that the current offers being provided by Mr. Market, as exemplified by the renowned investor Benjamin Graham, are not appealing for significant U.S. equities at this time. They are not just pricey relative to previous prices, but also compared to smaller stocks, overseas equities, corporate bonds, and Treasurys.
If these indicators are accurate, the recent recovery in the past few weeks might be considered a deceptive rally, indicating that it is advisable to divest from the largest stocks.
Many long-term investors often refer to CAPE, which is Yale Professor Robert Shiller’s cyclically adjusted price-earnings index. The S&P 500 is currently valued at 35 times the average earnings of the last decade, after adjusting for inflation. This valuation is the third highest since the 19th century and is even higher than the valuation during the peak of 1929. The evident inference is that the S&P is excessively overpriced, and the largest stocks are much more so.
The future price-to-earnings ratio originated in 1985 with the compilation of consensus analyst projections by IBES, which is now a member of the London Stock Exchange Group. Similar to the CAPE ratio, it indicates that stocks are highly overpriced, although slightly less so than in 2000 or late 2020.
The Fed Model, coined by strategist Ed Yardeni in the late 1990s, aims to assess the relative value of stocks and bonds by comparing the earnings yield, which is the ratio of profits per share to price, with bond rates. It is commonly employed to determine if equities are overpriced or underpriced in comparison to the more secure option, Treasurys. Currently, according to the Fed Model, they are excessively expensive. A month ago, the prices of these items were higher. This was before the 10-year yields experienced a significant decrease and when the S&P 500 was the most costly compared to bonds since 2002.
Thus far, the process is uncomplicated: engage in selling! Regrettably, long-term investing is not as simple as it may seem. Each of the indicators has advantages and disadvantages, and the disadvantages have already resulted in some disastrous investment choices.
In July 1997, the CAPE (Cyclically Adjusted Price-to-Earnings) index hit its highest level since 1929. This occurred shortly after Federal Reserve Chairman Alan Greenspan cautioned against the presence of “irrational exuberance” in the market, and the index surpassed its previous peak from the Roaring Twenties. Despite the exuberance, an investor who purchased stocks when Greenspan made his statement has achieved an annualized return of 7% over the inflation rate. According to Elroy Dimson, Paul Marsh, and Mike Staunton, academics and market historians, the performance of U.S. equities since 1900 has been surpassed by this.
Furthermore, the CAPE has gone below its long-term average only once since that time. Indeed, the purchase signal in March 2009 proved to be highly successful. However, investors who relied on this indicator were unlikely to have maintained their positions as the S&P quickly rebounded and reached a state of perceived overvaluation.
In order for the CAPE to return to its long-term average, an extremely severe drop would need to occur. A plausible reason for the levels of CAPE is that stocks have experienced an upward shift in valuations in the last century due to the improved accessibility and affordability of purchasing equities through mutual funds and ETFs. Additionally, the rise in wealth and the significant decline in inflation-adjusted interest rates since 1980 have also contributed to this phenomenon.
The conventional critique of prospective price-to-earnings (PE) ratios is that they are dependent on analysts, primarily those working at large financial institutions. Consequently, any metric derived from the consensus of Wall Street should be approached with caution by investors with long-term perspectives. I concur.
The Fed Model utilizes the aforementioned projected earnings provided by analysts. In addition, it has sometimes conveyed extremely negative signals, such as indicating in November 2007 that equities were at their lowest prices relative to bonds since the data started being recorded in 1985. Amidst the imminent global financial crisis and approaching recession, it was an inopportune time in history to purchase stocks and dispose of Treasurys.
Nevertheless, the precautions are beneficial. When the indicators indicate that stocks are overvalued, the subsequent returns over the following ten years typically exhibit a lack of strength. When equities are described as “screamingly cheap,” it means that their future returns are expected to be higher. The observed pattern remains consistent for the majority of the period starting from 1985, where both CAPE (Cyclically Adjusted Price-to-Earnings) and forward PE (Price-to-Earnings) ratios exhibit a strong correlation with S&P 500 returns in the subsequent 10 years. The relationship between the Fed Model and S&P 500 returns is slightly weaker in comparison. Empirically, the combination of CAPE (Cyclically Adjusted Price-to-Earnings) and forward PE (Price-to-Earnings) accounts for around 85% of the variation in returns. Similarly, the Fed Model has been able to explain 74% of the performance of the S&P (Standard & Poor’s) index relative to Treasuries since 1991. However, it should be noted that the Fed Model was not successful in predicting market behavior during the dot-com boom, as the outcomes during those years dramatically deviated from its projections.
It is justifiable to nitpick. These methods that have been effective since the 1980s may be a result of a specific market context and may not succeed if circumstances change. Their performance is not as impressive when considering time periods other than 10 years, since their effectiveness is exaggerated by the historically poor decade from the dot-com boom to the financial catastrophe. Additionally, it is not possible to conduct tests on them beyond 2014 due to the absence of a 10-year record.
While factors such as the economy, politics, and geopolitics are undoubtedly important, the three approaches mentioned provide a general orientation without considering any of these additional elements.
Ben Graham spoke to individual stocks and bonds when he stated that a margin of safety is “the essence of prudent investment condensed into three words.” However, this theory is applicable to the entire market. When the valuations of investments do not provide any margin of safety, it is advisable to refrain from making purchases. In such cases, it should not come as a surprise if your portfolio does not perform exceptionally well. Currently, there is a limited margin of safety.
