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The Market Valuation Debate

“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” This famous quote is attributed to Benjamin Graham, father of value investing and mentor to Warren Buffett. Graham’s quote simply but ably encapsulates the truism that financial markets eventually return to fair value but can deviate quite significantly along the way. This insight is also at the heart of our 2014 Capital Markets Forecast: what returns are available over the long run, defined here as a seven-year cycle, and when will financial markets again be weighing machines? Sooner or later, the fundamentals have always, and will always, reassert themselves. In fact, a common feature of asset price bubbles is widespread acceptance of the idea that “this time is different.” Yet sooner or later, some catalyst occurs that demonstrates the falsity of this thought.

At Balentine, we believe an objective, repeatable process designed to show fundamental valuation over the full investment cycle is a critical tool for investors. If the starting point of an investment horizon begins at historically high valuations, the best course is to acknowledge and prepare for this reality, as opposed to accepting higher risk in an effort to generate returns. Today, our analysis of major asset classes points to an unattractive starting point for fixed income and equity investors. For investors, this means controlling risk tightly, even at the cost of “missing” some upside in the short run. The very strong returns of both equity and bond markets in the last few years may have artificially raised investors’ expectations of what is possible, based on the very long-term record of the financial markets. When these markets inevitably correct and better opportunities become available, investors who have preserved buying power will be prepared to take advantage of more sustainable and attractive returns going forward.

Market valuation: the current debate

Recently, a great debate has raged in regard to equity market valuation. Broadly speaking, bearish investors point to long-term valuation metrics, the sub-par economic recovery and historically high profit margins as reasons for caution. In contrast, more bullish investors argue that the economy is set to recover, that valuation based on forecasted earnings is not demanding and that low interest rates make equities relatively more attractive than other asset classes. Who is right?

In the short run, momentum and investors’ misconceptions can certainly result in markets further decoupling from fundamentals. At a minimum, we believe long-term metrics of equity and bond market valuations are elevated. For equity markets, price to sales, price to dividend yield and Tobin’s Q metrics (a measure of the replacement cost of corporate assets) all point to an expensive market. Notably, these valuation metrics are less subject to manipulation than reported earnings, which have some accounting interpretation leeway.

The cyclically adjusted price-to-earnings ratio (or CAPE), one of the metrics we follow closely, currently has a large controversy surrounding it. The CAPE, also known as the Shiller P/E in honor of its Nobel prize-winning creator, measures stock prices against average earnings over the past 10 years, in an effort to smooth out earnings booms and busts. Currently, the ratio is in the ninth decile of historical valuation, meaning stocks are near the top of their historical valuation range. If history is any guide, returns from this point will be poor and, more notably, have some episodes of extremely negative outcomes in the following years.

Jeremy Siegel, another well-known academic, has criticized the CAPE for using negatively-biased earnings figures. He argues that accounting standards in the 1990s at times forced companies to charge large write-offs against their earnings without corresponding write-ups when their assets rose in value. Siegel also argues that corporate profit margins can remain high in the future. He points out that companies now generate more profits from overseas, where taxes are lower, and that many companies have locked in low interest rates by issuing long-term debt.

However, even using measures of corporate profits that exclude write-offs does not change the basic message of an expensive market.[1]  The advent of options compensation in recent decades likely has biased corporate earnings higher, not lower, than the historical trend, as evidenced by a wider gap between revenue and earnings during that time frame. That means the earnings comparison would be favorably skewed, just the opposite of the Siegel argument.

Implications for Investors

Regardless of methodology quibbles, there are two important insights behind the CAPE valuation metric. First, while investors are intuitively attracted to earnings as a valuation tool, they are often volatile in the short term, not always due to “fundamental” reasons. Accordingly, it makes sense to look at a time horizon longer than 12 months.  Second, while CAPE is not a useful predictor of short-term results, it does quite well over longer periods. Relative to its long-run average, the ratio was quite low in the early 1980s, signaling that stocks were attractively priced. The ratio was shockingly high in the late 1990s, correctly signaling massive equity market overvaluation.

Balentine invests with a full market cycle in mind, investing based on objective measures of the available risk-adjusted returns. At present, valuations are stretched; therefore, investors are assuming high levels of risk for potentially below normal market returns. Over a full cycle, returns from the current valuation level are more frequently negative than positive. a minimum, investors should consider lowering their equity return expectations and investing accordingly.

For more on market valuations and the impact on future returns, please see our 2014 Capital Markets Forecast.

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