Thursday, May 25, 2017

Bubble Watch

Shiller said the other day that the market can go up 50% from here. OK, so I fell for it and clicked to watch the CNBC video. This was sort of a surprising comment coming from the creator of the CAPE ratio, one of the main indicators bears use to argue that the market is way overvalued.

Of course, this is not Shiller's forecast or expectation. In fact, he says that this is very unlikely, but it is possible. His point was simply that the CAPE ratio is 30x now, and in the 1990's it went up to 45x. So if that happened again, that's a 50% increase.

This is totally possible, especially now. I would not invest in the market with that expectation, of course. Actually, I would invest with the opposite expectation (when pressed, Shiller said the market is more likely to go up 50% than down 50%).

Trailing P/E
Let's put the CAPE aside for now and just look at regular trailing P/E's. Back in 1999, that went up to 30x, and in 1987, it went up to 21.4x (this is from the Shiller spreadsheet).

We keep hearing from the bears that the market is as expensive as it was during previous peaks, so we are in dangerous territory; they say we are in a bubble.

OK. That is possible.

But in previous posts, I argued that if 10 year rates stabilize at 4% over time (it's at 2.3% now), it is possible that the market P/E can average 25x during that period. Maybe the market fluctuates around that average, so the market can easily trade between 18x and 33x P/E without anything being out of whack. (Buffett also said at the recent annual meeting that if rates stay around this area, then the stock market could prove to be very undervalued at current levels.)

So we have a problem. This 18-33x P/E range puts the market in bubble territory according to the bubble experts. But we are saying here that if rates stay at 4%, that's the normal range the market should trade at.

So then, how can we tell when we are in bubble territory?

Since we are using interest rates to value the stock market, we will have to interest rate adjust our bubble levels too.

Interest Rate Adjusted Bubble P/E
So just looking back at 1999 and 1987, here are the indicators at the time:

               PE          EY       10yr
1987      21.4x      4.7%     8.8%
1999      30.0x,     3.3%     6.3%

Both 1987 and 1999 had the feel of a rubber band stretching and then snapping. You will see that the earnings yield was 4.1% lower than the 10 year rate in 1987 and 3% lower in 1999.

Right now, the P/E ratio is 23.4x, for an earnings yield of 4.3% versus the 10-year rate of 2.3%. So it's a full 2.0% higher, not lower. But even I think 2.3% on the 10 year is too low. I use 4.0% these days for what I think is a non-bubbled up, unmanipulated-by-the-Fed, sustainable, normalized rate.

Using this spread, long term rates would have to go up to 7-8% for me to worry about an overstretched rubber band snapping.

How about the stock market? How high would it have to go before I think we are really in bubble territory?

With interest rates at 2.3%, we can't deduct 3% or 4% from it to get a bubble-level earnings yield.
So we'll look at it as a ratio.  In 1987, earnings yield got to as low as 0.53x the bond rate (4.7%/8.8%) and in 1999 it got to 0.52x (3.3%/6.3%)

Using the current 2.3% 10-year rate, earnings yield would have to get to 1.2% for me to really think that maybe we are in a stock market bubble.  That comes to 83x P/E!  At that level, trust me, even I won't be talking much about long term investing, and would probably be net short with a bunch of put options too.

But wait, let's not use 2.3% because we all know that's too low. Let's use my normalized 4%.  Even with a 4% bond yield, earnings yield would have to get to 2% to be considered really bubble level.  That is a P/E ratio of 50x.   That's more than a double from here.

So for me, the market would have to actually more than double from here before I see it as really bubbly. (If you want to see what a real bubble is like, look at Bitcoin!)

Narrow Market
The other thing I hear a lot is that the market is up only because of the very few hot tech stocks like the FANG stocks. They make it sound like the market would be doing nothing without them. Maybe.

But just as a quick check, I compared the S&P 500 index (ETF: SPY) to the S&P 500 equal-weighted index (ETF: RSP); the super-large caps would have no more impact than the smallest S&P 500 companies.

Check this out:
  (The blue line is the RSP, green is SPY)

SPY versus RSP Long Term

SPY versus RSP 10 Years

SPY versus RSP 5 Years


In all of the above time periods, the RSP outperforms SPY, which I don't think would be the case if it was only a few of the super-large caps that is pulling the S&P 500 index up.

Just for fun, I looked at the S&P 500 index versus the Russell 2000 index too. If only a few super-large caps were pulling up the averages, then obviously, the S&P 500 index should be outperforming the Russell 2000 too.  The blue line is the Russell 2000, and the green line is the S&P 500 index.


S&P 500 Index versus Russell 2000 - 5 Years

S&P 500 Index versus Russell 2000 - 10 Year


Here too, I don't see the S&P 500 outperforming in a big way lead by the supers.  To the contrary, the S&P 500 index is behind the Russell in the 10 year period.

I had no idea what I would see when I put up these comparisons. Looking at them now, I am a little disappointed in active managers who claim that they are underperforming because they don't own the FANG stocks; the above shows that maybe that's not the issue.

Anyway, that's another ongoing topic here.

Conclusion
All of this stuff, I just do sometimes to satisfy my own curiosity; not to make any claims either way. I have no idea what the market will do, but I don't believe we are in a stock market bubble at all. OK, if interest rates got up to 7-8% and valuations are still here in the 23-24x P/E area (trailing basis), then yes, I would agree we have a valuation problem.

Otherwise, it would take a market P/E of 50-80x for me to think we are in a stock market bubble (and I would put on shorts and load up on puts! But even then, I wouldn't expect an immediate payoff. If the market took off like that, it would be very hard to pick the top).

Otherwise, we are just, in terms of stock market valuation, in the "zone of reasonableness", to borrow Buffett's phrase from a few years ago.

Also, keep in mind, this 50-80x P/E ratio range is not a target, of course. That's where it has to go before you convince me we are in a stock market bubble.

Also, this doesn't mean the market can't enter a bear market at any time. There was no interest rate / earnings yield rubber band in 1929 and 2007.

39 comments:

  1. Thank you for posting. Can you help explain to me why interest rates would affect the market PE so much? I understand how interest rates may affect the PE for certain companies, but why is it used to adjust the PE of the entire market?

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    1. In general, asset prices are determined by interest rates as the value of assets are the sum of all future cash flows they are expected to generate. If interest rates are lower, discount rate is lower, so asset prices are higher. There has been discussion/debate about that here in previous posts about market valuation. But the general gist is that lower interest rates => higher asset prices, and P/E ratio is a common yardstick of stock prices.

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    2. http://www.philosophicaleconomics.com/2017/04/diversification-adaptation-and-stock-market-valuation/

      has a new post that touches on your question and this topic. the author does a good job I think of explaining theoretically the risks involved in certain securities and how they affect the pricing of the security. the author also provides a pretty persuasive argument as to why the ease and low cost of diversification could lead to a systematically higher pricing of equities.

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    3. Very good analysis. Excellent article!

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  2. Great blog post. I believe Buffett in the past has also mentioned 2 other important variables. Economic growth and the % of economic growth that is captured or derived from the Corporate sector. I am no economist but I would guess one couldn't expect below average interest rates and above average growth to be sustained for very long. I guess low economic growth is possible and the corporate sector continues to gain a higher and higher % of that growth, but the current levels look pretty high vs. history. The appealing thing of a PE or Shiller PE is that in theory, that metric captures all 3 of these variables. How would you think about including these components in the current environment? I believe Buffett wrote an article/speech in 1999/2000 and gave his estimates of each of these variables. He was right that the market was too high but for the wrong reasons. He thought interest rates at the time couldn't go much lower than 4%. Thanks for your blog. I really enjoy it.

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    1. Hi, good points. The model Buffett used in 1999/2000 was the same one he used back in 1969, I think. He said something to the effect that stock market returns is basically dividend yields plus real GDP growth plus inflation. That's also where I get my 5-6% equity market expected return (2% dividend yield + 2% real GDP growth + 2% inflation; others will argue that including share repurchases would make 'real' dividend yield more like 3-4%).

      As for share of profits to GDP, I don't know really how to parse that as the S&P companies get 40-50% of sales and/or profits from outside the U.S. If Kraft-Heinze bought Unilever, it would boost that ratio but not really change the market valuation, right? Google, Apple and many others make tons of money outside the U.S., so comparing corporate profits to GDP doesn't make too much sense to me.

      As for CAPE and other things, Buffett did say at the recent annual meeting that people always try to simpilify things to a single model, ratio or indicator, and that things are not so simple.

      Thanks for dropping by...

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  3. Great post! Thanks for doing this. I won´t mention his name, but someone well know just commented about the frothiness of the mkt and the ¨distortions¨ caused by quant trading in large cap tech names. This post seems to make a good argument against that theory.

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  4. Great comparison with 1987 and 1999 earnings yields, really helpful! But I'm not sure you can draw any meaningful conclusions from comparing SPY to RSP, over time you would expect any equal-weighted indexes to outperform the value-weighted versions:

    https://greenbackd.com/2012/05/17/why-does-an-equal-weighted-portfolio-outperform-market-capitalization-and-price-weighted-portfolios/

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    1. Good point. That makes total sense. On the other hand, if it was true that a few mega-caps rallied and other stocks did nothing or declined, the above wouldn't be true; the market-cap-weighted index should outperform, at least in the short term while they are the market leaders.

      Over time, though, market leaders switch etc. so the constant rebalancing would enhance the return of the equal-weighted.

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  5. My personal belief fwiw is that huge % of the mkt still has post crisis disorder. Its very normal, they think what happened recently will happen again soon. As a result, I think the mkt will continue to climb the wall of worry for many yrs, maybe even 10 more. People compare past multiples without any regard to interest rates. I remember people talking about the mkt not being cheap because its not at 8x earnings like in early 80´s, cmon. I think Buffett will be proven right again 10 yrs from now.

    Btw did you see the response from the FOF about the Buffett bet. I thought it was pretty weak. He basically said Buffett was kinda lucky that he ¨actively¨ picked the s&p in his bet. Then he says he would likely like to repeat the bet since the mkt is much higher now and think he has better odds to win. First I would say there is still a good shot the s&p could be beat a basket of hedge fund over next 10 yrs, also his logic makes no sense. If you wanted to be accurate you would have to calculate the returns for the whole 20 yr period including the first 10 that have already passed not just the next 10 yrs. The holes in his logic were kinda cringe worthy for a hedge fund guy, but I suppose they are paid to sell you something so he had to come up w something.

    https://www.bloomberg.com/view/articles/2017-05-03/why-i-lost-my-bet-with-warren-buffett

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    1. Hi, thanks for the link to the FoF article. He says that large cap returns distorted results, but in my chart, the Russell 2000 outperformed the S&P 500 in the last decade so he is totally wrong on that. How do these people raise money? It's a mystery.

      And yes, I do believe people still have post-crisis syndrome and that's why they have been saying 'bubble, bubble!!' ever since 2011.

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    2. Oh, and by the way, if the FoF thinks Buffett got lucky, he can just show us longer term returns of his Fof going back further than the 10 years. No need, even, for a new bet; he is just trying to time the peak of the market (didn't work last time). Show us the returns going all the way back to inception versus the S&P 500 index. I bet they underperform. Or else they would have published it saying they had a bad luck decade, but are much better over longer time periods.

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    3. Great point! Yeah they are pretty shameless. Took me too long to realize how much of what you read from advisors or investors is carefully crafted marketing. Maybe one day his crash scenario will play out but he probably will continue to underperform. It will probably never make up for the 20 yrs of under performance so far, that is their main flaw.

      That would be sweet of Buffett calls him out on that. But he probably wont because there seemed to be no other takers for the bet so he probably feels lucky anybody took it.

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    4. The FoF manager demonstrated in that op-ed he is blind to the basics in terms of fees and returns. HFs charge 2/20 which basically equates to 5% fees or higher. If you have $100 and a fund manager generates 25% on a gross basis, that $125 would have been assessed 2% which based on average capital for the year is $2.25. Then the $25 would be subject to 20% carry, or $5. You paid the manager over 7% in management fees for a net return of 17% or better yet, you gave away 30% of your gross gains of 25%, which accompanied risk levels tied to 25%, for returns of 17%. Most hedge funds are just lower beta long products, despite the BS and lake wobegon idea of managers making actual money on both sides of their book...So when it comes to lower beta long only, these guys will always lag an up market in terms of the SP500.

      The SP500 is up 10%, these guys on average will be up say 5%-7% gross. A 7% gross return gets taken down to about 4%. An LP's given up nearly 50% of gains for that. Upton Sinclair's quote is appropriate for Ted Siedes but it's more pathetic that LPs, particularly institutional ones have given so much capital to HFs.

      It seems Siedes FOF portfolio underperformed even a 60/40...

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    5. His case may be even worse since he runs a fund of fund. He takes fees after already paying fees on a collection of hedge funds. The chances a FoF outperforms over the long term are probably close to zero. But amazingly there are many large FoF collecting huge fees for just placing money w other hedge funds. I am sure they have great investment letters with all types of fancy metrics and doomer statistics to back up why they are doing a good job.

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  6. Thank you! Great post, as always. If you believe that market valuations should be linked to the level of interest rates, what to make of Japan?

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  7. I´d be curious to see what BI thinks. Personally I don´t think Japan is very comparable. I think many people made that incorrect comparison during the crisis. The economy is so different in Japan, its very closed and focused domestically w almost zero corporate governance and shareholder culture.

    I try to not focus on macro stuff since its usually a waste of time. However, I don´t really think interest rates are that out of whack. If interest rates were too low because of the Fed or something then inflation would get out of hand. I don´t think we see that now so its probably where it should be. Pull up that long term chart of the 10 yr interest rate. Rates have been going down for 30+ yrs, I don´t think that has been manipulated all the way down. I think its a good excuse for underperforming fund managers that some institution is distorting reality and that is why they are underperforming.

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    1. Japan, post 1989-bubble, has usually traded at 40x P/E. I always thought that was the limit for them; people won't chase stocks up all the way to where it should trade based on interest rates, or else 1% interest rates would lead to 100x P/E. So just like in the U.S., people didn't (yet) trade stocks up to 50x P/E with interest rates at 2%, in Japan they stopped chasing it at 40x. But the CAPE did get up to 100x there in 2007.

      Now markets are down and cheaper for all sorts of reasons; I'm not sure where Japan should trade. Plus Japanese companies are very different from U.S. companies; in Japan, companies are run for the employees and the government and customers, but not for shareholders. That is slowly changing; valuations may get back up if they really shift to shareholder friendliness.

      (For example, in the U.S., if you have an inefficient, bureaucratic company, it will be LBO'ed, oops, sorry, private equity'ed into efficiency. In Japan, that is still not possible; their answer to increase productivity/efficiency is to fake it.)

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  8. Why do you think 4% is a "normalized interest rate" instead of 3% or 5%?

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    1. Could be 3% or 5%. 10 year rate is usually close to nominal GDP growth, and I see 2% inflation and 2% real GDP growth as a good, sustainable pace.

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    2. Thanks for the reply. Wouldn't 3% or 5% give you dramatically different results using your method?

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    3. Oops, forgot to mention, you can do your own math with 3% or 5%... basically, bubble p/e would be 60x or 40x etc...

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  9. If valuation is driven by interest rates, what drives interest rates? Why might they move up from these levels?

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    1. Can be anything, but over time rates seem to track nominal GDP growth, and that has been trending sort of 4%-ish, and medium term expectation is around there too. We can have periods of disinflation/deflation or higher inflation, of course. People thought all this pump-priming / QE2 would cause inflation, but it hasn't; the excess cash piles up in bank deposits and then back to the Fed etc...

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  10. Valuation metrics can be ambiguous in use towards making asset allocation decisions and are best viewed as a curiosity. It's the use of tools that have been relatively accurate in signaling that can add value towards risk management / avoidance of a serious price reversion. Econometrically speaking, a negative rate of change in the LEI data series has foreshadowed portions of the largest, U.S. centric market declines. Undoubtedly, the economy ( underlying components of the leading index ) has had a key relationship to earnings and stock prices. THe use of a moving average heuristic ( trend following measure ) has helped with mechanical reentry / tilting back towards higher allocation of equity based assets. Both are objectively derived, non revised measures that together, have produced non trivial results towards risk management. One hasn't had to try to get out at the top most or get in at the bottom most 'ticks" in order to manage risk and a unambiguous process may help alleviate the uncertainty of what the market is "going to do".

    tinyurl.com/n2ouhr4 ( paste links into browser address bar )
    tinyurl.com/lfx7zhh

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  11. Serious question, Mark Map, are you trying to sound super verbose and academic? I don´t really know what you just said.

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  12. I can't believe not a single commenter has pushed back on requiring 50x+ market to be considered profoundly overpriced. That is nuts. Just trade rates...

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    1. Why don't you push back? Look forward to hearing the reasoning.

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    2. I welcome opposing views here. I think there isn't much pushback here because my post is sort of pushing back at all those people saying we are incredibly, historically, biblically overvalued. My point is simply that it may not be so. If interest rates are still relevant, if we adjust for the QE2 too-low interest rate, that the market is not overvalued at all. You can disagree on many levels. You can argue that interest rates don't matter and only absolute P/E's matter and therefore we are overvalued. You can argue that 4% normalized interest rate is too low so the market is overvalued etc...

      There are many things anyone can disagree about in the above (and other) posts.

      But I just laid out how I come to my conclusion with all the components so readers can make up their own mind; adjust various assumptions to what they may be comfortable with to see where they would think the market should be, or where it would be a bubble etc...

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  13. To be fair I think he was laying out a reasoning of a range of possibilities not a rule. Is it also nuts people were saying to not buy after the crisis because stocks were not at 8-10x earnings like in 1980 when interest rates were 3x higher? Interest rates are not everything but like Buffett said its a very important metric. It is what you discount all future cashflows at to arrive at a security price.

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  14. https://www.ft.com/content/cd516726-46d8-11e7-8d27-59b4dd6296b8

    GMO says no bubble fwiw

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  15. Thanks for the post. You reference that the current S&P earnings yield is 4.3% vs. 10-year rate of 2.3%. However, in comparing the two yields you are comparing a risk asset (stocks) against a risk-free asset (U.S. treasuries). I would argue that there should be an equity risk premium in the earnings yield (average ERP from 1960-2016 is ~4%), so by that standard we should be earning a 6.3% on stocks. The fact that we are not implies the market is overvalued relative to interest rates. You can argue what the ERP should be, but I think we can all agree it should be positive and personally I have a hard time believing it should be any lower than the current 2%.

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    1. Hi, interesting point. The above P/E versus interest rate is based on empirical experience. Here is a post I made a couple of year ago about it:

      http://brooklyninvestor.blogspot.com/2015/05/market-valuation-scatter-plot.html

      I don't know much about equity risk premiums, and Buffett/Munger has always answered that they don't know what it is and they'd never seen it before (the actual thing itself; I'm sure they've seen it mentioned in academic journals).

      The argument, usually, against P/E or dividend yields versus government bond yields is that one is real and the other is nominal. Bond yields don't change with inflation. If you own bonds yielding 2% and inflation goes up to 3% per year, you are screwed. If you own a stock with a 2% dividend yield and inflation goes to 3%, the assumption is that dividends will go up 3% too. Bond coupons don't change at all.

      So in that sense, the comparison is no good, they say. But in that case, it even more favors stocks than bonds as long as you have an inflationary outlook. A 2% bond can return 2% nominal and no more. If you own at 2% dividend stock (or basket), then you can possibly earn 2% divided + 2% inflation + 2% GDP growth, or 6% if the stock market moves up with the economy (assumes companies price to inflation, and grows at same rate as GDP).

      So to compare real vs. real, maybe we shoul compare dividend yields to treasury TIPS yields. That would be 0.4% on the ten-year. But then that would give a silly answer that the market would have to go up five-fold for it to be fairly valued (0.4% dividend yield). And stocks will *still* be better because TIPS only increase principle for inflation, but stock dividends will reflect inflation AND growth in economy...

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    2. 1) why should we make the assumption that the equity risk premium is a constant throughout time?

      2) should you be looking at the equity risk premium as a simple difference, i.e., +/- x%, or as a multiple, i.e., 2x or 3x the risk free rate?

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  16. Good point on inflation. So the expected return on stocks (including inflation) is 6% vs. 2.3% return on treasuries, so there is a 3.7% risk premium for investing in equities. A little under the historical average, but not terrible. If the Fed lets the interest rates revert to a normalized level of 4%, but our outlook for inflation and GDP growth remain the same at 2% each, that risk premium goes down to 2%. The last time it was that low was 1999. Even Buffet and Munger would have to think long and hard about putting more money in the S&P vs. treasuries at that level. Nonetheless, where rates are today equities still seem to offer an attractive alternative to bonds.

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  17. I think the attached lesson of Graham from 1963 will interest you.
    http://jasonzweig.com/wp-content/uploads/2015/03/BG-speech-SF-1963.pdf

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