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In regards to valuation models and their predictive ability Google Treasury Department Office of Financial Research Departments staff report “Quicksilver Markets.” I believe you have both seen this but I refer you to page three specifically because it pertains to this discussion. If you care to look at other valuation models John Hussman prefers Market Cap/GVA and discusses the nuances in the following commentary:
http://www.hussmanfunds.com/wmc/wmc150518.htm
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The S&P 500 was down 59% and the NASDAQ down 85% in the 2000-2002 downturn. The S&P 500 was down 59% in the 2007-2009 downturn. That is two drops of greater than 50% in the last fifteen years. The market is currently within a single digits of S&P 500 all-time highs. Yet, even with all the Federal Reserve market manipulation the 15 year return on the S&P 500 including dividends is a little more than 4% compounded annually.
The valuation of the S&P 500 may have been higher in in March of 2000, but the median stock value today is higher than it has ever been. That was result of the index being driven by large market cap technology stocks. I was an adviser in 2000 I remember how anything with a dividend was considered a fool’s investment. The mantra at that time was companies should be using free cash flow to grow their businesses. This time is different! And look at our companies today, loading up their balance sheet with debt to buy their stock back. It’s disgusting in my opinion and stock holders will pay a price for such imprudent behavior. All the while the CEOs line their pockets with stock options purchased with corporate debt and don’t forget inflating their earnings to the delight of Wall Street. And to complete the point, look at investors today gulping up anything with a dividend be it stocks, REITS or MLPs. Why because the Federal Reserve has driven investors out of a safe money alternative. This time is different! If you cannot see the risk here may God have mercy on your advisor soul. Sorry.
More facts, Wall Street's base case twelve month target for S&P 500 is approximately 2200. That is based on $132.53 in annual earnings per share and a multiple of 16.6 times. Funnily enough, at the end of the most recent reported quarter of June 2015 Last Twelve Month (LTM) net income per share was $97.32. The previous year, June 2014 quarter LTM net income per share was $103.12. The peak earnings in this cycle was LTM $106 net income per share at the end of the September 2014 quarter. So from the peak of September 2014 the LTM net income is down 8%. At the cycle low June 2009 quarter LTM was $8 a share. Earnings and profit margins mean revert and they do so with a vengeance. When they do, PEs compress in rapid succession.
Based on the current level of earnings, not using Wall Street forward earnings estimates, the market is trading at exactly 20 times. So, I ask how do we get to $132.53 from $97.32 with all that has happened in the domestic and global markets? It simply will not happen. The only way this market moves higher is based on the big money’s ability to continue to borrow money a zero and churn the market higher. Don’t kid yourself it is not the Muppet with an E-Trade account. That market action, if it happens, will only increase the risk to investors, not lessen it, despite the market move up. My sense is the game is up and the downward slope is in place.
High quality bonds have been a bane of analysts over the last several years. Early this year Wall Street was telling us to buy Europe and Japan. Several months ago we heard how good falling oil prices were going to be for consumers. We have also heard recently how China is not a risk for US investors. How has this advice worked so far? Not very well.
Personally I am amazed how willing people in our profession ignore the facts. And yes, I do believe we will be down not just 30% before this cycle is over.
So where does an investor go. Lower stock market exposure appropriate to risk preference and time horizon. Increase holdings of high quality short term bonds and cash.
That’s my story and I am sticking to it.
Igy