When Risk-Return Makes No Sense: How To Deal With An Overvalued Market
As SocGen's Dylan Grice points out, we have gotten to the point where the Shiller PE demonstrates S&P valuations are now back in the highest valuation quintile: in other words the market is now more expensive than during 80% of the time. The risk-return at this point makes little sense, because as Grice points out the 10 year return using this quintile as an entry point is just 1.7%, compared to 11% for the lowest quintile. So what should one do: "Go take a holiday if you can. Avoid the ?boredom trades?." If those two are not an option, Dylan provides some trade ideas.
But before we get into it, some amusing observations by Dylan on the Fed's track record of fixing the economy:
It seems central banks botch exit strategies more often than not. In 1994 Greenspan?'s cack-handed removal of the emergency stimulus implemented during the S&L crisis triggered a bond market collapse which severely dented that year?'s equity returns. In 1998, the tardy withdrawal of the emergency stimulus implemented during the Asian crisis created the tech bubble. And in 2004, a similarly delayed withdrawal of the emergency stimulus implemented to combat the tech bust spawned the housing/credit bubble.
Dylan is confident, as are we, that the QE end in less than 24 hour is just a temporary blip in an otherwise determined push to kill the US middle class and especially the savers among it.
Will the botched exit from this emergency stimulus resemble that of the 1994 vintage (bearish for risk) or those of 1998/2004 (bullish)? I suppose central banks might get lucky and smoothly engineer a ?normalisation? without any painful withdrawal symptoms ? but in the real world credit growth remains subdued, as it did in Japan. If the economy doubledips -? and Albert makes a convincing case it will - and fading stimulus leaves the economy in default-deleveraging mode, there won?t be any exit strategy. There will be more QE...
And here we get to the meat of the matter: the market is now way overbought.
If only my crystal ball was clearer ... fortunately though, no crystal ball is needed to see that equity markets are expensive. According to Robert Shiller?s latest data, the S&P500 is back in its highest valuation quintile. The risk is there - as it always is - but the returns aren?t. So what do you do? Go take a holiday if you can. Avoid the ?boredom trades?. But if you have to do something ? some cheap stocks and sectors to think about are given inside.
A way to visualize the expected returns from a trade inception point in any given quintile:
The chart above shows the 10y real returns which have accrued to investors using each valuation quintile as an entry point. If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.
The bottom-up picture tells the same story. Regular readers know that I use a residual income model to estimate the intrinsic value of each stock in our universe (developed market, large and medium cap non-financials in the FTSE World Index). I aggregate those into an intrinsic value for the market. A more detailed discussion of the calculation is given here, but all I really do is assume that a company which earns only its required return is worth no more than its book value. By capitalising expected excess returns (defined as RoE less required return) onto book value I arrive at an intrinsic value which I can compare to the market price. This gives me an intrinsic value to price (IVP) ratio, the market aggregate for which is given below. When the IVP ratio is 1.0, estimated intrinsic value equals market price. The market is ?fair value? which means it can be expected to deliver the required return (which I set at 10%). This was where we were a year ago. Today, the market is roughly as expensive as it?s recently been.
With Ben Graham investment principles now completely useless courtesy of momentum chasing algos, could the IVP be the next most useful way to shotgun investing?
The IVP ratio isn?t the perfect model by any means and there are a few things about it which make me uncomfortable (e.g. using forecasts to calculate future excess returns). But on balance I think it ticks more boxes than it misses. For one, I like the absolute (as opposed to relative) nature of valuations thrown out. For another, it seems to work. The following left chart shows the performance of stocks over time when sorted into deciles according to their IVP ratios: the higher the IVP ratio, the higher the returns. The right chart shows cumulative returns since 1986 of a hypothetical long-short strategy in which we buy the highest IVP decile stocks and sell the lowest. Both show that there is some sort of ?edge? to be had in purchasing stocks with higher IVP ratios.
Where should investors focus for potential cheap IVP values:
The next chart shows where the geographical value is. The UK has an aggregate intrinsic value above its market capitalization, while the Eurozone looks less egregiously expensive than the rest. I also find it interesting that Japan looks so expensive using an IVP framework. Funnily enough, I think there may be good speculative reasons for owning Japan (which I?ll try to write up shortly) but the investment case is weak. Even though PB and PE ratios are historically low, the earnings power of Japanese assets is even lower and by anchoring valuation on the earnings power of assets the IVP framework picks this up.
And if investing in "cheap" Chinese stocks is not the most appealing options, here are the sectors which make the most compelling investment proposition.
The following chart shows the sectors trading below intrinsic value. Although a cursory look reveals a heavy resource bias, some interesting sub-sectors emerge. For example, integrated oils are cheap. True, they always seem to be. They?re ?too big? and have gone ?ex-growth.? But the long-term growth numbers I'?ve used for them (e.g. Royal Dutch Shell) are actually negative so they allow for this. And if we overpay for strong growth, mightn'?t we underpay for weak growth? According to Factset, Integrated Oils have been one of the best-performing sectors over the last 15 years returning 12.3% annualized, against 8.5% for the World.
Refiners and construction materials are interesting too, with names like Valero and Lafarge operating in depressed sectors in sluggish developed markets. Surely these are interesting places to look? Among the drillers, Transocean ? the market leading deep-sea driller in an oil market increasingly reliant on deep-sea fields for future growth ? is trading below estimated intrinsic value on our IVP analysis and as such, statistically, it has a higher ?expected return? than other stocks in the market.
Although I exclude financials from my screen (as I?m not sure screening is the right way to look at financial stocks) it?s an interesting sector so I'?ve run the numbers. ?Diversified Financials? includes guys like ING, JP Morgan and BoA, the rest are self explanatory ? the results suggest potentially lucrative pickings here if you can get comfortable with the balance sheets. A big if, I know, but I guess fortune favours those who do their homework.
And finally, here are the names of the individual companies thrown up as having estimated intrinsic values higher than their market values. The names help show who?s driving the sector numbers above, but some notable names from sectors which don’t stand out as cheap include Kingfisher, Finmeccanica, AstraZeneca and Western Digital.
Our caveat: any valuation metric is ultimately merely an affirmative bias for an investor to proceed with putting down capital after already having decided to do so. Our contention, as has been for the past 12 months, is that the only real metrics investors should keep an eye out on are the Fed's H.4.1 and H.3 statements. Everything else is a first through 100th derivative of the greatest excess liquidity flood in the history of the world. When that dries out, babies and bathwaters will get the same March 2009 treatment as they always do when the market realizes the utopia of Dow 36,000 will not occur absent hyperinflation.