Risks Are Piling Up - That’s A Huge Red Flag For Stocks

March 7, 2018

Risks Are Piling Up – That’s A Huge Red Flag For Stocks

Last week I discussed how the risk are piling up on the debt side of the equation. However, those aren’t the only risks piling up which isn’t uncommon for humans. When we stray, we usually stray in a big way.

So, on top of the debt, there are other huge risks and today the discussion will be about valuations:

  • Debt is being used recklessly.
  • Valuations don’t matter as growth is the key and profitability will come.
  • Book values are so old fashioned.
  • Stocks can only go up and corrections and bear markets don’t last long.
  • Real estate can only go up.
  • If you invest in index funds, you will do well.

Now, I’ll discuss a lot of macro, and even some politics on Monday, but such factors might be insignificant or very significant depending on market valuations. High market valuations make stocks fragile, while low valuations make them more robust as once stocks are low, there is little room to go lower. However, when stocks are high, a lot of bad things can happen. The sad thing is that we have been there and we are doing the same mistakes all over again. 

Valuations Are Sky High

Warren Buffett has stopped bothering us with one key factor: long term investment returns are perfectly correlated with the earnings corporations deliver. What does this mean?

Well, if the price to earnings ratio (PE) of a company is 10, you can expect the long term returns from your investment to be around 10%. If the company manages to grow those earnings each year, your returns should grow alongside the growth rate. However, if we look at things from a static perspective and exclude for a moment the growth expectations as we are in the late part of the current economic cycle, we can see that stock market returns won’t be stellar.

Figure 1: The current S&P 500 PE ratio is 25. Source: Multpl.

So the earnings return that stocks are going to deliver now are around 4%. You get to the earnings yield by dividing 100 with the PE ratio (100/25=4%). So if you are happy with a long term return of 4% per year, you can invest in the S&P 500. There will definitely be volatility, so expect that.

I have to warn those who expect the earnings growth to increase returns because corporate earnings are slow to grow, especially in the late part of the economic cycle.

Figure 2: S&P 500 earnings growth is always volatile. Source: Multpl.

As you can see above, never in history has earnings growth been stable. Therefore, take with a grain of salt all the optimistic forecasts you see about earnings because they won’t grow at 20% over the next few years, not even over the next year probably.

Putting the above in a better perspective, S&P 500 earnings were at 50 in 1980. They are now, 38 years later, at 106.95. This means that average real S&P 500 earnings growth over the last 38 years was 2%, which is below economic growth.

Figure 3: S&P 500 earnings growth is around 2%. Source: Multpl.

Further, the main risk with valuations is the risk parity. As an investor, you can invest either in bonds or stocks and most professional money managers look at the risk reward of each and allocate the money accordingly.

Now, if stocks offer 4% per year for the long term while bonds offer 1%, many will be overweight stocks. But, if bond yields rise, many will prefer bonds over risky stocks. Let me explain in depth the valuation risk which might seem irrelevant at the moment, but the impact can be huge.

How Slight Changes Have Huge Impacts

Let’s say that I can buy a 10-year Treasury with a 5% yield (current yield close to 3%), or stocks that offer 4% and a dividend yield of 1.8%. Well, as Treasuries are almost risk free, the choice is easy. Therefore, the market will expect higher returns from stocks.

Let’s say that the market expects a 6% return from stocks, the S&P 500 would drop to 1,782 points at current earnings.

Figure 4: S&P 500 level and price to earnings ratio. Source: Author’s calculation.

On the other hand, to keep itself at the current level while the required earnings yield increases from 4% to 6%, S&P 500 earnings would have to grow 52% which is highly unlikely.

My fear is that we will see higher interest rates which will lead toward a recession and that the reckless global lending atmosphere leads to higher interest rates in general which would also require higher earnings yields.

People often forget that risk is a function of the prices paid when investing. The higher the price, the more things can go wrong. After a 9-year 230% bull market, there is a lot that can go wrong especially since S&P 500 earnings are up just 6% from 2007 levels.

Global Valuations

The situation isn’t much better on the global field. Valuations are sky high and only risky markets like Russia and China have lower price to earnings ratios.

Figure 5: Developed markets valuations are stretched globally. Source: StarCapital.

Further, the CAPE—or cyclically adjusted price to earnings ratio which uses 10-year average earnings—is even higher than the PE in most cases. Given that we are in the late part of the economic cycle, which means that the likelihood of earnings being lower in the next few years is higher, doesn’t give a good outlook for stocks.

It’s very simple, when the CAPE ratio is above 20, as it is now in most cases, 15-year subsequent returns will hardly be positive.

Figure 5: 15-year returns and the CAPE ratio. Source: StarCapital.

Now, if you want low CAPE ratios, you need to go to Russia but investing in Russia requires knowing exactly what you are doing and this is something most investors aren’t up to. Therefore, I hope I gave you enough data to analyze the risk reward of your investments from a valuation perspective. Sometimes, just holing cash or short term bonds is the wisest thing one can do in relation to investing risk reward.