Bullish Viewpoint on Equities

After looking at why I think US equities are overvalued in my last post, I thought I’d take a look at the opposing view here. I haven’t found many credible views arguing that equities are cheap, but there are many who view them as reasonable. That viewpoint is generally based on expectations of improving economic conditions and reasonable valuations.

Stronger economic growth, lower unemployment, and rising corporate profits are expected to provide a benign environment for stocks. Bill McBride, who runs the Calculated Risk Blog, came out last year and said he’s the most optimistic on the economy that he’s been since the 90’s. He points to “a combination of growth in the key housing sector, a significant amount of household deleveraging behind us, the end of the drag from state and local government layoffs (four years of austerity nearing the end), some loosening of household credit, and the Fed staying accommodative.” For those interested in economics I’d highly recommend checking out his blog. The factors Mr. McBride mentions are among those driving a number of forecasts of future economic growth in the 3-4% range. Coincidentally the Commerce Department just revised 3rd quarter GDP growth to 3.6% annualized growth on Thursday.

In terms of valuation, much of the consensus seems to be that equities are reasonably or appropriately valued. The trailing p/e ratio on the market stands at 18.5 versus its historical average of around 15. In an interview over at Advisor Perspectives, Wharton Professor and Author Jeremy Siegel recently said that when you’re in a low-to-moderate interest-rate environment, the average p/e ratio for stocks has been 18 to 19 historically. Thus the current level of ~18.5 would appear appropriate given that interest rates are currently near their historic lows.

BofA Merrill Lynch US Equity & US Quant Strategy produced the table below back in August. It looks at 15 different valuation metrics for the S&P 500, of which only one shows any significant overvaluation (Shiller PE). The remaining 14 show the market’s valuation near its average.


Finally, there are respected investors who say that equities are appropriately valued. In an interview with CBS This Morning, Warren Buffett recently stated that equities are “in a zone of reasonableness.” He went on to say “they’re definitely not way overpriced. They’re definitely not underpriced.”

Echoing Buffett’s sentiment, Howard Marks stated in his latest memo that “most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs.” He goes on to suggest taking a normal stance on equities and not being overly cautious or aggressive.

My Counterpoints:

First, for an investor such as Warren Buffett, I have a hunch he’s not looking at broad equity valuations. These days he traffics in a small group of high-quality large cap companies. Think along the lines of Coca-Cola and Wal-Mart, which trade around 20 and 16 times earnings, respectively. In GMO’s latest 7-year real return forecast, produced as of October 31, US High Quality was the only US equity class expected to produce a positive real return over the next 7 years. GMO forecasts a 2.7% real annualized return for US High Quality versus real annualized losses of 1.3% for US Large and 4.2% for US Small stocks. I think this reinforces my notion that the stocks Buffett is talking about are more attractive than the market at large.

I highly doubt Buffett considers the Russell 2000 trading for 87 times trailing twelve month earnings or 28 times forward earnings in his ‘zone of reasonableness.” Especially when the one market valuation metric he’s mentioned in the past, market cap to GDP, is at levels only surpassed once in history (during the tech bubble of the late 90’s).

Improved economic growth has not had much correlation with equity returns in the past. Studies have shown that the correlation between real quarterly GDP and the S&P 500 is virtually zero. Global markets have even shown negative correlation between GDP growth and stock market returns. Thus i’m not really worried about economic forecasts, one way or another. For instance recessions have often been very fruitful times for investing in the past.

Valuation is what really concerns me. I’m not exactly revealing anything earth shattering here when I say that the prices we pay for investments matter.

The big point of contention between those who view market valuations as appropriate and those who are bearish boils down to profit margins. The reason the trailing p/e ratio is closer to its historical average than other valuation metrics such as the Shiller P/E, Market Cap/GDP, or the Q Ratio is that corporate profit margins are currently at all time highs, as seen in the chart below:

Profit Margins

 Some contend these profit margins will remain at these elevated levels due to a combination of increased overseas profits, which are taxed at lower rates, and more technology companies in equity indices (which have higher profit margins than other sectors). Even if those factors were to push up the mean profit margins going forward, i’m highly skeptical they would do so to this degree. Historically profit margins have been a mean reverting series and I have a hard time believing that they won’t continue to be mean reverting in the future. Unless the forces of capitalism and competition have suddenly vanished, it seems likely to me that profit margins will revert to some lower level. If one normalizes profit margins to lower levels, the market no longer appears reasonable based on current earnings but instead show the same overvaluation as other long-term valuation metrics.

As for the other valuation metrics presented in the Merrill Lynch table, outside of the trailing PE and Shiller PE, most of the metrics are based on a short window of time, dating back to only 1986. Thus the majority of their data encompass a period of some of the highest sustained valuations in the history of the US market, including the late 90’s and ’07.  If you extend their valuation data back further the averages would be much lower than the averages of the past 20-30 years. For instance the P/BV ratio presented in the table captures similar data to the Q ratio. The data captured by the Q ratio extends all the way back to 1900 and makes valuations look very high today (and shows how extreme it was in the late 90’s). If you looked at data from the Q ratio from only 1986 to today, suddenly its average valuation would take a huge jump and it too would deceivingly make the market appear reasonable.

Of course I could be wrong. Maybe the high valuations seen in the past 20 years are here to stay. In his recent Financial Analysts Journal article The Paradox of Wealth, William Bernstein argues “in the very long run, an increase in societal wealth and well-being carries a paradoxical cost, namely a reduction in the expected return on both risky and riskless assets.” It’s a scary thought especially in light of persistently high valuations in the past decade. The article is worth a read but I believe human nature and the manic behavior of Mr. Market will continue in the future (and not just manic behavior on the upside as it seems to be now!).