You cannot make this stuff up. The median stock in the S&P 500 has never been more overvalued on price-to-earnings growth (PEG) and price-to-sales (P/S). On a forward price-to-earnings (P/E) basis – where profitability expectations already reflect pie-in-the-sky speculation – the median company’s shares trade in the 96th percentile. That’s pretty darn pricey!
Credit Goldman Sachs for the assessment. For that matter, give the financial conglomerate kudos for acknowledging the strong possibility that one might be wise to “sell in May” after all.
Hedge fund legend Stanley Druckenmiller, who spoke at an investment conference in New York last week, forcibly advised exiting stocks as well. One of his reasons? The stock market in 1982 versus the stock market in 2016. He said, “It is hard to avoid the comparison with 1982 when the market sold for 7-times depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18-times inflated earnings, productivity declining and no further ammo on interest rates.”
Granted, overpriced stocks cannot and will not tell anyone the near-term direction of the market. What’s more, ultra-low borrowing costs a la zero percent interest rate policy largely drove risk assets like stocks to unbelievable extremes. On the other hand, front-loading investment returns over the past seven years has pilfered the potential gains one might have anticipated over the next seven years. The Federal Reserve’s own Richard Fisher confirmed the central bank’s front-loading endeavors back in January.
Consider an analysis by Steve Sjuggerud. He analyzed data going back to 1870 with respect to what happened to annualized returns after seven incredible years like the current bull market. The anticipated gains over the next one, three, five and seven years were not particularly promising. In essence, the past’s remarkable returns confiscated the prospects for the future.
In contrast, the worst decile rank for seven-year periods served up enhanced annualized gains going forward. Are these results surprising? Not really. It tells investors what they should already know; that is, the rewards for holding stocks at higher elevations are dismal, whereas the rewards for acquiring stocks at lower elevations are admirable.
Virtually everyone who has ever looked at the relationship between high valuations and future returns understands that higher prices today imply lower future outcomes (and vice versa). Quantitative easing (QE), zero percent rate policy (ZIRP), negative rate policy (NIRP) did not alter the long-standing relationship; rather, central bank shenanigans pulled the gains from the future into the present, while decimating the hold-n-hope possibilities for the future.
If I readily acknowledge that valuations alone do not predict the near-term and that stocks could “grind higher,” why have I been so adamant about maintaining a lower risk equity profile over the last 12 months? Weakness in the global economy, deterioration in market internals (including credit spreads) and the Fed’s directional shift since QE ended (December 18, 2014) have combined to create a toxic brew for “risk on” asset performance.
Is it true that riskier stock assets have bounced back from two corrective beatings? In August-September of 2015 and again in January-February of 2016? Yes. Still, the percentages do not lie. Less risky asset types are clearly outperforming riskier ones… and that does not happen in powerful bull market uptrends.
We should also be cognizant of the reason(s) for risky asset recovery. Is it because there has been widespread buyer demand from “mom-n-pop” retail investors, institutional advisers, pensions, mutual fund managers and/or hedge funds? On the contrary. Each of these groups have been “net sellers” for 16 consecutive weeks. Corporations are the only net buyers of their own shares and they remain the biggest source of stock demand.
However, that dynamic may be changing. Corporations have started to slash spending due to revenue and profit weakness. Not only did the number of firms that cut dividends reach a seven-year high, but according to Bloomberg, corporate buybacks are set to fall below $600 billion for the first time in three years. Get a gander at the table below that shows the possibility of a slowdown based on announced buybacks over the first four months.
In earlier commentary, prior to the available buyback data from Bloomberg, I suggested that corporations would be incapable of perpetually spending 100% of free cash flow after dividends to artificially support share prices. The practice of ignoring capital expenditures has almost certainly hindered business growth for years to come.
Take a look at the chart on corporate borrowing below. Corporations spent the majority of borrowed money on buying or maintaining land, buildings, and equipment in the 90s. Today? Most of the debt was spent on non-productive financial engineering. In other words, not only did corporations double their total debt levels since the Great Recession ended, but they barely spent any of that debt on anything other than stock buybacks or acquisitions.
Let’s review. Valuations sit at historic extremes. “Risk-off” has outperformed “risk-on” for an entire year. Buybacks have been remarkably influential in propping up the benchmarks, but may be less likely to do so for the remainder of 2016. Factor in global economic weakness that is showing little signs of turnaround as well as election uncertainty, and it is easy to see why preservation may be more critical than appreciation pursuits.
I do not advocate getting out of stock assets completely. A tactical asset allocation shift that lowers one’s risk exposure is typically more beneficial than an “all-in” or “all-out” approach. That said, if you have not reduced your exposure yet, you might want to do so now. Otherwise, there’s a good chance the stock market door will hit you on the backside when you eventually scamper for cover.