Two Valuation Models That Scream Be Careful And Have An Exit Strategy…

There are many ways to determine if stock markets are cheap, fair value or expensive. Two very popular tools are the Shiller Cyclical Adjusted Price Earnings Level or PE 10 – average price-earnings level for the past ten years which eliminates short-term fluctuations. The second is what Warren Buffet stated was the best market timing tool – Corporate Equities to GDP.  This means the value of all the corporations divided by GDP, as corporations tend to go up in sync with economic growth. We will have a look at both and see how we are positioned in these two valuation tools based on history.

First, let’s look at the Shiller PE10 Ratio:

Let’s define what price-earnings ratio is. In a stock markets case, it is the price of all the companies in the index divided by their earnings. That provides a PE level for the market.  Average PE levels are usually in the 15 to 20 range.

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This is a busy chart, but we will try and break down the key data for your understanding:

  1. The blue line is the actual 10-year average price-earnings ratio which has fluctuated from below 5 to above 44
  2. We have noted at the bottom of the chart red and green lines which signify secular bear and secular bull markets in order. Since 1900, we have seen four secular bull markets, and we are in the 4th secular bear market
  3. During secular bull markets, PE10 tends to rise to a peak level before it comes down hard with a stock market crash moving into a secular bear
  4. Secular bear markets begin with a high PE 10 levels, as secular bull peaked, and finish at very low levels, many times less than 10
  5. At the peak of secular bull markets, PE10 levels tend to reach on average 23 to 30 levels with only one period exceeding this level in 2000 at 44
  6. Today we are over 32 which is the highest level ever excluding 2000. It is higher than 1929, just prior to the biggest stock market crash in history and before the Great Depression
  7. We have put purple stars at points just prior to all the major stock market crashes. As you can see, crashes have occurred in all cases with PE10 between 20 and 30 (again, other than 2000). Remember, we are at 32 today, which should create a level of concern for all of investors

Let’s now look at an indicator that Warren Buffett said is the best tool to time stock markets:

This indicator shows the ratio of total corporate capitalization (value of all US companies) to GDP (total US economic growth). The range in this indicator from 1950 until around 2000 was 32% to 90%.  Then the tech craze of the late 1990’s into 2000 came. This ratio soared to just over 150%, a level we did not think we would ever see again (we still may as we are only 7.6% off this level today).  The level before the last financial crash of 2007-09 was 110%, so we are 27% above that level today. That makes the markets extremely dangerous based on this indicator.

We do believe that this level should have a higher median that it was at in 1950 to 1995, which was around 60% but current levels are extreme.  A more comfortable level of 80% to 100% would be more realistic.  There are only two ways to get there:

  1. GDP would have to soar while at the same time, corporate values stagnate
  2. Stock prices would have to crash, as GDP would fall during the same period, but stock valuation would fall dramatically more

We inserted when market crashes have occurred.  The most crashes happened during the last two major secular bear markets of 1929 to 1949 (not on chart) and 1966 to 1982 where there were five crashes.  Here is a longer-term chart that shows stock market crashes and their magnitude since 1925:

The secular bear market of 1929 to 1949 saw ten market crashes, ranging from down 21% to down 83%.  This was a very nasty period, as the world was in a Great Depression.  So clearly secular bear markets are periods where stock market crashes are more prevalent, as these periods cleanse the inefficiencies and excesses from the previous secular bull market.

So, this should lead to the question ‘what is going on with the current secular bear market we are in?  It is called ‘desperate moves’ and ‘manipulation’ by Central Banks and Governments.  We have seen the lowest growth coming out of recession from 2009 from any point since WW II, even given the massive increase in debt and Central Bank quantitative easing programs.

To put perspective on the growth in stimulus, total world debt has gone up over the last ten years (pre-financial crisis to today) by $42 trillion to $217 trillion.  That is an increase of 24%.  Even more incredible is the growth in the balance sheets of major world Central Banks.  If you look at the top four Central Banks (US, Europe, Japan and China), their balance sheets have soared from $6.3 trillion to $19.6 trillion.  That is an increase of 211%.  Stimulus has soared, and it is not only via quantitative easing by these banks. They have also lowered interest rates to near zero and in some cases (much of Europe and Japan) lower than zero…. yes, negative interest rates.  And all we have gotten out of this is low growth that continues to be driven by debt that is not sustainable.

We believe that there have been fewer crashes in this secular bear market due to this, but crashes are bigger and uglier.  The 2000 crash shed 49% in the S&P500 (and over 80% in the NASDAQ) and 57% in the financial crash of 2007-09.  Those are painful and destroyed much wealth. We think a third phase is coming in order to bring price earnings levels back to 10 or lower so that we can see the next secular bull market begin.

It will be very painful to get there, but it is necessary as it always has been in history.  Central banks cannot avert such a period. We must shed low-quality debt via write-offs or re-structuring and ineffective, non-productive companies.  It will be a very difficult period, but the other side of it will make it all worthwhile.  You just must know how to manage through such cycles.
Here is a chart showing how the Buffett Indicator above has deviated significantly from GDP.  Stock markets tend to trade over a long period with the level of growth in the period. Periods of excess tend to be reversed back to the median or below as we saw in 2000 and 2007.  Today the gap is massive and will require a major correction in stock prices to bring sanity back to stock prices.

How close are we to the day of reckoning?  Nobody truly knows, so we use our objective market timing tools. We are still in the market today, but many warning signs are flashing at us. As always, our customers know that we will advise them when our indicators say SELL, as well as provide them with investment strategies to both protect and grow their wealth during the reset.

One other factor that also tells us that this cycle of growth and stock market gains is getting long in the tooth is the length of this cycle:

This chart was created as of September 2017, so the current expansion is now 99 months. There are only two periods of longer growth phases.  The 2nd longest was 1961 – 69, only seven months longer than today’s expansion.  The stock market began its crash prior to the economy rolling over and started falling in 1968 by 36%.  The longest period of growth was in 1991 – 2001, 21 months longer than today. This period saw the stock market begin to crash over a year before the economy stalled with stocks inevitably falling by 49% and the tech-heavy NASDAQ index crashing by 80%.

Does this mean that we are headed for a crash?  None of us know, but we must be prepared for history to repeat itself.  Factors today are much more dangerous than these periods including:

  • margin borrowing in stocks
  • outstanding derivative contracts
  • zero interest rates because any economic and stock market collapse cannot be stabilized by rapidly falling interest rates like in the past
  • demographics as we are in an aging society
  • the movement towards populism similar to what we saw in the 1930’s
  • massive debt levels at all levels including governments, households, financial companies, and corporations

We are ready…. are you?

Matt Sammut