Are Valuations Really Too High?

By John Mauldin

The older I get and the more I research and study, the more convinced I become that one of the more important traits of a good investor or businessman is not simply to come up with the right answer but to be able to ask the right question. The questions we ask often reveal the biases in our thinking, and we are all prone to what behavioral psychologists call confirmation bias: we tend to look for (and thus to see, and to ask about) things that confirm our current thinking.

I try to spend a significant part of my time researching and thinking about things that will tell me why my current belief system is wrong, testing my opinions against the ideas of others, some of whom are genuine outliers.

I have done quite a number of media interviews and question and answer sessions with audiences in the past few months, and one question keeps coming up: “Are valuations too high?” In this week’s letter we’re going to try to look at the various answers (orthodox and not) one could come up with to answer that basic question, and then we’ll look at market conditions in general. This letter may print a little longer as there are going to be a lot of charts.

I am back in Dallas today, getting ready to leave Monday for San Diego and my Strategic Investment Conference. I’m really excited about the array of speakers we have this year. We’re going to share the conference with you in a different way this year. My associate Worth Wray and I are going to do a brief summary of the speakers’ presentations every day and send that out as a short Thoughts from the Frontline for four days running. Plus, for those who are interested in my more immediate reactions, I suggest you follow me on Twitter. There are still a few spots available at the conference, as we have expanded the venue, and if you would like to see who is speaking or maybe decide to show up at the last minute (which you should), just follow this link. Now let’s jump into the letter.

Take It to the Limit

First, let’s examine three ways to look at stock market valuations for the S&P 500. The first is the Shiller P/E ratio, which is a ten year smoothed curve that in theory takes away some of the volatility caused by recessions. If this metric is your standard, I think you would conclude that stocks are expensive and getting close to the danger zone, if not already in it. Only by the standards of the 2000 tech bubble and the year 1929 do you find higher normalized P/E ratios.



But if you look at the 12 month trailing P/E ratio, you could easily conclude that stocks are moderately expensive but not yet in bubble territory.



And yet again, if you look at the 12 month forward P/E ratio, it might be easy to conclude that stocks are fairly, even cheaply priced.



In a Perfect World

Earnings are projected to grow rather significantly. Let’s visit our old friend the S&P 500 Earnings and Estimate Report, produced by Howard Silverblatt (it’s a treasure trove of data, and it opens in Excel here.

I copied and pasted below just the material relevant for our purposes. Basically, you can see that using the consensus estimate for as-reported earnings would result in a relatively low price to earnings ratio of 13.5 at today’s S&P 500 price. If you think valuations will be higher than 13.5 at the end of 2015, then you probably want to be a buyer of stocks. (Again, you data junkies can see far more data in the full report.)



But this interpretation begs a question: How much of 2013 equity returns were due to actual earnings growth and how much were due to people’s being willing to pay more for a dollar’s worth of earnings? Good question. It turns out that the bulk of market growth in 2013 came from multiple expansion in the U.S., Europe, and United Kingdom. Apparently, we think (at least those who are investing in the stock market think) that the good times are going to continue to roll.



The chart above shows the breakdown of 2013 return drivers in global markets, but this next chart, from my friend Rob Arnott, shows that roughly 30% of large cap U.S. equity (S&P 500) returns over the last 30 years have come from multiple expansion; and recently, rising P/E has accounted for the vast majority of stock returns in the face of flat earnings.



The Future of Earnings

What kind of returns can we expect from today’s valuations? There are two ways we can look at it. One way is by looking at expected returns from current valuations, which is how Jeremy Grantham of GMO regularly does it. The following chart shows his projections for the average annual real return over the next seven years.

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The article Thoughts from the Frontline: Are Valuations Really Too High? was originally published at Mauldin Economics

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What You and Monica Lewinsky Might Have in Common

By Dennis Miller

Collateral damage can assume many forms—and though some may be more newsworthy than others, the latter are no less real, nor any less frightening.


On Tuesday, controversial radio talk show host Rush Limbaugh called Monica Lewinsky “collateral damage in Hillary Clinton’s war on women,” saying that President Bill Clinton and his wife destroyed the former White House intern “after he got his jollies, after he got his consensual whatevers.”

Last month, Jeremy Grantham, cofounder of GMO, a Boston based asset management firm that oversees $112 billion in client funds, dubbed savers “collateral damage” of quantitative easing and the Federal Reserve’s continued commitment to low interest rates.

Would it be worse to be known as the “president’s mistress” for more than a decade and, as Lewinsky claims, to be unable to find a normal job? Maybe. But it’s no laughing matter either to find yourself penniless in your “golden years.”

Signs of Monetary Collateral Damage Among Seniors

 

The 55-plus crowd accounts for 22% of all bankruptcy filings in the U.S.—up 12% from just 13 years ago—and seniors age 65 and up are the fastest growing population segment seeking bankruptcy protection. Given the wounds bankruptcy inflicts on your credit, reputation, and pride, it’s safe to assume those filing have exhausted all feasible alternatives.

But even seniors in less dire straits are finding it difficult to navigate low interest rate waters. Thirty seven percent of 65 to 74 year olds still had a mortgage or home equity line of credit in 2010, up from 21% in 1989. For those 75 and older, that number jumped from 2% to 21% during the same timeframe—another mark of a debt filled retirement becoming the norm. With an average balance of $9,300 as of 2012, the 65 plus cohort is also carrying more credit card debt than any other age group.

While climbing out of a $9,300 hole isn’t impossible, the national average credit card APR of 15% sure makes it difficult. For those with bad credit, that rate jumps to 22.73%—not quite the same as debtor’s prison, but close.

None of this points to an aging population adjusting its money habits to thrive under the Fed’s low interest rate regime.

Minimize Your Part of Comparative Negligence

 

A quick side note on tort law. Most states have some breed of the comparative negligence rule on the books. This means a jury can reduce the monetary award it awards a tort plaintiff by the percentage of the plaintiff’s fault. Bob’s Pontiac hits Mildred’s Honda, causing Mildred to break her leg. Mildred sues Bob and the jury awards her $100,000, but also finds she was 7% at fault for the accident. Mildred walks with $93,000. (Actually, Mildred walks with $62,000 and her lawyer with $31,000, but I digress.)

Comparative-negligence rules exist because when a bad thing happens, the injured party may be partly responsible. For someone planning for retirement, the bad thing at issue is too much debt and too little savings. Through low interest rates, the Federal Reserve is responsible for X% of the problem.

Though ex-Fed chief Bernanke doesn’t seem to see it that way—in a dinner conversation with hedge fund manager David Einhorn, he asserted that raising interest rates to benefit savers wouldn’t be the right move for the economy because it would require borrowers to pay more for capital. Well, there you have it. And there’s nothing you can do about that X%. You can, however, reduce or eliminate your contribution.
In other words, you don’t have to be collateral damage; you can affect how your life plays out.

Money Lessons from Zen Buddhism

 

This might sound like a “duh” statement, but it bears repeating from time to time. Inheritance windfall from that great-aunt in Des Moines you’d forgotten about aside, there are two ways to eliminate debt and retire well: spend less or make more.

Rising healthcare costs, emergency car repairs, and the like are real impediments to reducing your bills. Costs rooted in attempts to “keep up with the Joneses,” however, are avoidable. Those attempts are also futile. A new, even richer Mr. Jones is always around the bend.

Instead of overspending for show, make like a Buddhist and let go of your attachment to things and your ego about owning them. Spring for that Zen rock garden if you must and start raking.

One of the wealthier men I know drove around for years with a gardening glove as a makeshift cover for his Peugeot’s worn out, stick shift knob. It looked shabby, but this man wasn’t a car guy and had no need to impress. As far as I know, the gardening glove worked just fine until he finally donated the car to charity and happily took his tax deduction. Maintaining your car isn’t overspending, but you catch my drift. Dropping efforts to show off can benefit us all.

That said, keeping up isn’t always about show. You may feel pressure to overspend just to be able to enjoy time with your friends and family. Maybe you can no longer afford the annual Vail ski week with your in laws or the flight to Hawaii for your nephew’s bar mitzvah. Maybe your friends are hosting caviar dinners, but you’re now on a McDonald’s budget and can no longer participate.

Spending less in order to stay within your budget can mean missing out on experiences, not just stuff. If you’re in this camp, there’s no reason to hang your head. As I mentioned above, you can spend less or you can make more. The latter is far more fun.

An Investment Strategy to Prevent You from Becoming Collateral Damage

 

While it’s tempting to start speculating with your retirement money, resist. If you have non-retirement dollars to play with and the constitution to handle it, carefully curated speculative investments can give you a welcome boost. However, if all of your savings is allocated for retirement, just don’t do it.

Unless you’re still working, how, then, can you make more money in a low-interest-rate world? At present, my team of analysts and I recommend investing your retirement dollars via the 50-20-30 approach:

• 50%: Sector diversified equities providing growth and income and a high margin of safety.
• 20%: Investments made for higher yield coupled with appropriate stop losses.
• 30%: Conservative, stable income vehicles.

No single investment should make up more than 5% of your retirement portfolio.

Whether you’re designing your retirement blueprint from scratch or want to apply our 50-20-30 strategy to your existing plan, the Miller’s Money team can help. Each Thursday enjoy exclusive updates on unique investing and retirement topics by signing up for my free weekly newsletter.

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The article Collateral Damage: What You and Monica Lewinsky Have in Common was originally published at Millers Money

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