Don't Make A Sucker's Bet: The Market Is Set Up For Poor Returns

| About: SPDR Dow (DIA)

Summary

Market prices have recovered since the January lows, though overall movement over the past year and a half has generally been sideways.

In the interim, analyst earnings expectations--which, despite being high, were already largely baked into stock prices--are falling.

Investors buying the market now risk paying significantly more for future earnings, at a level historically associated with poor future returns.

A lot has happened since I wrote my last article for Seeking Alpha: the market has fallen, then risen again, and now appears to be trading a bit sideways with a few consecutive weeks of mild losses. And yet despite all the motion, prices as a whole don't appear materially different than they did several months ago:

Source: Finviz.com

The Dow Jones Industrial ETF (NYSEARCA:DIA) now trades roughly where it did back in January 2015. If an investor had purchased the Dow back then and walked away for a year and a half, they could be forgiven for wondering what all the fuss about stocks was about.

And yet, things have changed since then: earnings estimates keep falling, which means that despite the relative stability of prices over the past several months, investors now pay more per dollar of future earnings despite prices being the same. Moreover, trailing earnings haven't moved very much, and the market continues to trade a significant premium to historical norms. Despite this, the wider market seems to be baking in expectations for future growth that far exceed the growth seen in the past 10 years, and even these expectations seem to pale against analyst expectations. The future, these parties all seem to be saying, won't be the same as the past-it will be better.

I ran a quick analysis of current valuation ratios, analyst expectations, and historical averages to determine how reasonable all of this actually might be. What I found was:

  1. Analyst EPS growth expectations appear to exceed historical growth averages by wide margins;
  2. Analyst price targets are consistent with these EPS growth expectations;
  3. Stocks are about fairly priced, at best, relative to these optimistic expectations;
  4. Analyst EPS growth expectations are declining significantly; and
  5. That in the context of both historical norms and falling expectations, stocks are priced at levels historically associated with poor returns.

Point 1: Analyst expectations for growth exceed historical averages by a wide margin.

The degree to which analysts-and the market in general-seem to think that good times are just around the corner might be demonstrated by simply taking those expectations and applying them to individual stocks and then seeing what happens. To do this, I compiled 10-year earnings data for the 30 Dow Jones components, as well as analyst consensus opinions on expected revenue growth, earnings growth, and margin expansion. I went with the Dow because it offered an easily workable data set (only 30 stocks, relative to the S&P's 500) with stocks that offered a high degree of analyst followership. Individual components, historical earnings growth, and analyst expectations for growth are displayed below.

Company Name

Sector

Industry

Ticker

Price

Analyst Target

10-Y EPS CAGR

TTM EPS

FY1 Analyst EPS Expectation

FY2 Analyst EPS Expectation

Apple Inc.

Consumer Goods

Electronic Equipment

AAPL

$108.00

$124.96

13.37%

$8.97

$8.40

$9.41

American Express Company

Financial

Credit Services

AXP

$59.50

$63.31

5.64%

$5.00

$5.46

$5.64

The Boeing Company

Industrial Goods

Aerospace/Defense Products & Services

BA

$126.85

$144.80

10.73%

$7.40

$8.46

$9.35

Caterpillar, Inc.

Industrial Goods

Farm & Construction Machinery

CAT

$73.63

$70.82

-2.42%

$1.90

$3.68

$3.70

Cisco Systems, Inc.

Technology

Networking & Communication Devices

CSCO

$27.69

$29.10

17.26%

$2.02

$2.29

$2.41

Chevron Corporation

Basic Materials

Major Integrated Oil & Gas

CVX

$96.33

$102.92

-6.57%

$0.69

$1.21

$3.57

E.I. du Pont de Nemours and Company

Basic Materials

Agricultural Chemicals

DD

$62.83

$71.44

-1.86%

$2.40

$3.00

$3.70

The Walt Disney Company

Services

Entertainment - Diversified

DIS

$96.42

$110.00

13.54%

$5.43

$5.80

$6.28

General Electric Company

Industrial Goods

Diversified Machinery

GE

$30.79

$33.44

-5.78%

$0.75

$1.50

$1.75

Goldman Sachs Group, Inc.

Financial

Investment Brokerage - National

GS

$150.28

$194.36

-5.89%

$8.84

$14.71

$17.64

The Home Depot, Inc.

Services

Home Improvement Stores

HD

$133.62

$140.13

8.46%

$5.46

$6.19

$6.99

International Business Machines

Technology

Information Technology Services

IBM

$147.92

$146.67

9.82%

$13.20

$13.50

$14.05

Intel Corporation

Technology

Semiconductor - Broad Line

INTC

$31.36

$36.14

10.21%

$2.35

$2.38

$2.70

Johnson & Johnson

Healthcare

Drug Manufacturers - Major

JNJ

$109.10

$116.08

5.03%

$5.48

$6.56

$7.04

JP Morgan Chase & Co.

Financial

Money Center Banks

JPM

$57.74

$69.71

3.56%

$5.90

$5.79

$6.49

The Coca-Cola Company

Consumer Goods

Beverages - Soft Drinks

KO

$46.87

$47.21

5.84%

$1.66

$1.95

$2.09

McDonald's Corporation

Services

Restaurants

MCD

$127.96

$130.00

8.53%

$5.20

$5.54

$6.20

3M Company

Industrial Goods

Diversified Machinery

MMM

$166.63

$165.00

5.67%

$7.79

$8.24

$9.05

Merck & Company, Inc.

Healthcare

Drug Manufacturers - Major

MRK

$55.36

$62.92

-0.29%

$1.63

$3.70

$3.86

Microsoft Corporation

Technology

Business Software & Services

MSFT

$54.42

$58.05

5.54%

$1.30

$2.69

$2.89

Nike, Inc.

Consumer Goods

Textile - Apparel Footwear & Accessories

NKE

$59.42

$70.55

13.18%

$2.16

$1.99

$2.44

Pfizer, Inc.

Healthcare

Drug Manufacturers - Major

PFE

$32.21

$38.88

-4.73%

$1.11

$2.40

$2.60

The Procter & Gamble Company

Consumer Goods

Personal Products

PG

$82.52

$83.23

4.22%

$3.08

$3.63

$4.09

The Travelers Companies, Inc.

Financial

Property & Casualty Insurance

TRV

$115.23

$112.11

6.58%

$10.65

$9.51

$9.87

UnitedHealth Group Incorporated

Healthcare

Health Care Plans

UNH

$125.68

$148.32

10.61%

$6.22

$7.85

$8.85

United Technologies Corporation

Industrial Goods

Aerospace/Defense Products & Services

UTX

$101.32

$106.33

8.89%

$8.53

$6.57

$6.91

Visa Inc.

Financial

Credit Services

V

$77.89

$88.44

27.20%

$2.82

$2.80

$3.23

Verizon Communications Inc.

Technology

Telecom Services - Domestic

VZ

$52.18

$52.37

5.92%

$4.40

$3.96

$4.10

Wal-Mart, Inc.

Services

Discount, Variety Stores

WMT

$67.57

$66.35

6.81%

$4.57

$4.14

$4.29

Exxon Mobil Corporation

Basic Materials

Major Integrated Oil & Gas

XOM

$82.52

$86.30

-2.67%

$3.85

$2.58

$4.07

Click to enlarge

Sources: 10-year financial data from Morningstar. Analyst consensus data from Zacks.

One initial observation that might be made is that-in general-analysts seem to have a pretty favorable view of stocks' earnings prospects, especially in comparison to the past 10 years. For the next year, analysts seem to think that stocks' earnings will grow by roughly 8%, and then another 13% in the year following. This looks fairly optimistic considering that actual earnings growth for these companies has been somewhere along 6% or so over the past 10 years.

Point 2: Analyst price targets are consistent with these elevated EPS growth expectations.

Are analyst price targets consistent with their growth expectations? To figure this out, I applied analyst expectations for revenue and earnings growth for each individual stock to build a discounted cash flow model. I then applied a Monte Carlo simulation to each stock using historical distributions for tax rates, interest income, depreciation, and capital expenditures; for companies currently in heavy investment cycles I assumed that capital expenditures would revert to lower historical means. Weighted average costs of capital were calculated using 10-year pricing data and a normalized risk-free rate of 4.75%.

The data that resulted was a distribution of possible valuations for each company; the wider the distribution, the greater the uncertainty surrounding the valuation. Here, for example, was the distribution of possible DCF valuations using analyst expectations for Pfizer:

Sources: DCF Monte Carlo simulation model by author. 10-year financial data from Morningstar. Analyst consensus data from Zacks. Price history data from Yahoo!Finance. Interest rate forecast data from Forecasts.org.

The Monte Carlo simulation shows a fairly tight cluster of values in the $30-$40 range, with some upside uncertainty; the median fair value derived from these simulations was about $37-$38. I then ran similar simulations for each of the Dow components:

Company Name

Price

Analyst Target

Forward EPS

FY2 EPS

DCF

Apple Inc.

$108.00

$124.96

$8.40

$9.41

$161.69

American Express Company Common

$59.50

$63.31

$5.46

$5.64

$73.77

Boeing Company (The) Common Stock

$126.85

$144.80

$8.46

$9.35

$170.90

Caterpillar, Inc. Common Stock

$73.63

$70.82

$3.68

$3.70

$51.62

Cisco Systems, Inc.

$27.69

$29.10

$2.29

$2.41

$36.07

Chevron Corporation Common Stock

$96.33

$102.92

$1.21

$3.57

$113.18

E.I. du Pont de Nemours and Company

$62.83

$71.44

$3.00

$3.70

$76.52

Walt Disney Company (The) Common Stock

$96.42

$110.00

$5.80

$6.28

$83.19

General Electric Company Common

$30.79

$33.44

$1.50

$1.75

$27.34

Goldman Sachs Group, Inc. (The)

$150.28

$194.36

$14.71

$17.64

$228.33

Home Depot, Inc. (The) Common S

$133.62

$140.13

$6.19

$6.99

$186.01

International Business Machines

$147.92

$146.67

$13.50

$14.05

$133.68

Intel Corporation

$31.36

$36.14

$2.38

$2.70

$35.64

Johnson & Johnson Common Stock

$109.10

$116.08

$6.56

$7.04

$197.00

JP Morgan Chase & Co. Common St

$57.74

$69.71

$5.79

$6.49

$63.75

Coca

$46.87

$47.21

$1.95

$2.09

$33.08

McDonald's Corporation Common S

$127.96

$130.00

$5.54

$6.20

$130.01

3M Company Common Stock

$166.63

$165.00

$8.24

$9.05

$122.14

Merck & Company, Inc. Common St

$55.36

$62.92

$3.70

$3.86

$60.92

Microsoft Corporation

$54.42

$58.05

$2.69

$2.89

$28.75

Nike, Inc. Common Stock

$59.42

$70.55

$1.99

$2.44

$46.74

Pfizer, Inc. Common Stock

$32.21

$38.88

$2.40

$2.60

$37.93

Procter & Gamble Company (The)

$82.52

$83.23

$3.63

$4.09

$72.90

The Travelers Companies, Inc. C

$115.23

$112.11

$9.51

$9.87

$67.63

UnitedHealth Group Incorporated

$125.68

$148.32

$7.85

$8.85

$155.91

United Technologies Corporation

$101.32

$106.33

$6.57

$6.91

$97.87

Visa Inc.

$77.89

$88.44

$2.80

$3.23

$70.18

Verizon Communications Inc. Com

$52.18

$52.37

$3.96

$4.10

$51.92

Wal-Mart, Inc.

$67.57

$66.35

$4.14

$4.29

$66.93

Exxon Mobil Corporation Common

$82.52

$86.30

$2.58

$4.07

$76.20

Click to enlarge

Source: 10-year financial data from Morningstar. Analyst consensus estimates from Zacks.

There are quite a few caveats to this sort of analysis. For one thing, the DCF model generally takes a dim view of commodity-based companies (Exxon, for example), and overly values companies with more predictable earnings histories (Johnson & Johnson) or liberal amounts of cash flow. Unpredictability in earnings cycles causes the model to generate a huge variance in valuations, which ought to be expected. The model assigns higher implied valuations for companies with predictable earnings histories, which-though it strikes me as reasonable-may not be the case moving forward.

Furthermore, the model assumes that companies will eventually revert back to historical norms and that growth rates and performance in the future will largely resemble those of the past. History teaches that while things tend to revert to the mean in the aggregate, they rarely do on a case-by-case basis. Nevertheless, despite the DCF model being generally way more optimistic than might be deemed reasonable by the casual observer, the prices generated don't appear wildly different than current analyst targets. Given the relative consistency of the price targets with the DCF-generated fair value estimates, the data suggest that analyst expectations are largely reflected in the price targets they assign to individual stocks.

Point 3: Stocks are about fairly priced, at best, relative to these optimistic expectations.

Price

Analyst Target

DCF Model

Dow Jones Industrials Cap-Weighted Average

$80.88

$87.69

$91.02

Click to enlarge

This point is relatively straightforward. With the market trading only about 7-8% less than analyst targets (and 8-9% less than the more optimistic DCF model based upon earnings expectations), it seems fair to say that the market is-at best-fairly valued.

Point 4: Analyst earnings expectations are falling while prices are rising.

If stocks are fairly priced relative to optimistic earnings expectations, what does it mean when that optimism dries up? Looking at consensus forward EPS expectations over the past few months reveals a disturbing downtrend in outlook.

Source: Zacks

In the space of only about 3 months, consensus expectations for growth have fallen 4%, while the DIA itself has actually gotten more expensive-hardly a winning combination for long-term investors. What about the following year? Things look a tad bit better, but not by much:

Source: Zacks

Again, these falling expectations are occurring in the context of a relative recovery in prices since February. One might reasonably surmise that as earnings expectations decrease, fair value estimates ought to follow suit. And perhaps they have. But even if this were the case, the sideways to upward motion of prices recently suggests that the market's march to full valuation is only accelerating.

Point 5: In the context of both historical norms and falling expectations, stocks are priced at levels historically associated with poor returns

Does history give us a guide to where we are in terms of valuation? To help answer this, I ran Monte Carlo price simulations for each stock, using a weighted average of 10-year Price-to-Earnings, Price-to-Book, and Price-to-Sales ratios for each. I also calculated a median price for each stock using median 10-year valuation data.

Company Name

Price

Analyst Target

DCF

Historical Monte Carlo

Historical Median

Apple Inc.

$108.00

$124.96

$161.69

$123.72

$118.24

American Express Company

$59.50

$63.31

$73.77

$75.83

$70.89

The Boeing Company

$126.85

$144.80

$170.90

$94.67

$99.21

Caterpillar, Inc.

$73.63

$70.82

$51.62

$59.45

$64.89

Cisco Systems, Inc.

$27.69

$29.10

$36.07

$28.51

$28.78

Chevron Corporation

$96.33

$102.92

$113.18

$59.64

$88.11

E.I. du Pont de Nemours and Company

$62.83

$71.44

$76.52

$33.18

$34.20

The Walt Disney Company

$96.42

$110.00

$83.19

$65.56

$68.16

General Electric Company

$30.79

$33.44

$27.34

$32.56

$33.64

Goldman Sachs Group, Inc.

$150.28

$194.36

$228.33

$137.71

$152.08

The Home Depot, Inc.

$133.62

$140.13

$186.01

$61.09

$76.20

International Business Machines

$147.92

$146.67

$133.68

$140.53

$140.33

Intel Corporation

$31.36

$36.14

$35.64

$27.59

$27.67

Johnson & Johnson

$109.10

$116.08

$197.00

$75.68

$75.81

JP Morgan Chase & Co.

$57.74

$69.71

$63.75

$53.09

$52.78

The Coca-Cola Company

$46.87

$47.21

$33.08

$29.25

$29.57

McDonald's Corporation

$127.96

$130.00

$130.01

$57.15

$68.78

3M Company

$166.63

$165.00

$122.14

$94.33

$92.79

Merck & Company, Inc.

$55.36

$62.92

$60.92

$83.64

$85.04

Microsoft Corporation

$54.42

$58.05

$28.75

$31.47

$34.63

Nike, Inc.

$59.42

$70.55

$46.74

$33.71

$34.92

Pfizer, Inc.

$32.21

$38.88

$37.93

$33.99

$35.67

The Procter & Gamble Company

$82.52

$83.23

$72.90

$53.28

$52.32

The Travelers Companies, Inc.

$115.23

$112.11

$67.63

$83.38

$83.30

UnitedHealth Group Incorporated

$125.68

$148.32

$155.91

$80.35

$77.33

United Technologies Corporation

$101.32

$106.33

$97.87

$94.25

$95.21

Visa Inc.

$77.89

$88.44

$70.18

$58.87

$56.50

Verizon Communications Inc.

$52.18

$52.37

$51.92

$40.95

$27.89

Wal-Mart, Inc.

$67.57

$66.35

$66.93

$66.74

$65.65

Exxon Mobil Corporation

$82.52

$86.30

$76.20

$68.07

$44.09

Click to enlarge

The data are less optimistic than industry analysts. Though there are exceptions, stocks generally trade at a significant premium to historical averages-or, in the case of the Monte Carlo simulations, where they should most of the time if history were to repeat itself. Dividend Aristocrats like McDonalds' and Procter & Gamble look to be highly overvalued in this sort of analysis. Overall, the market trades nearly 25% higher than it has about 90% of the time over the past 10 years. This doesn't mean that the market is due to fall 25%-- just that we are in territory that has rarely been seen over the past decade, and at levels associated with poor future returns.

Source: Multipl.com

A simple look at the correlation between the average 5-year returns based upon starting Price-to-Earnings ratios offers a stark conclusion: higher PE's are associated with lower returns. The data aren't perfect, by any means-read literally, the chart might suggest that returns would double at PE's in the mid-20's versus the high teens-but the conclusion that ought to be most reasonably drawn is that the bulk of high returns typically associated with stocks-in the 8-10% range-are historically seen in the 11-15 range, or less.

Of course, it's hard to ignore the fact that we have been living in a fairly unprecedented low-rate environment. A look at 10-year yields shows a weaker though still positive correlation between lower interest rates and higher stock valuations:

Source: Multipl.com

This visual demonstration of what's already taken for granted does suggest that if rates were to stay low for some time, then valuation ratios in the 20-25 range might not be unreasonable. And indeed, the market appears to be baking in the expectation of not just higher growth rates than history suggests are likely but also that interest rates will remain at historic lows for the foreseeable future. Historical data suggest that if the market is wrong about this, multiple compression is highly likely.

Conclusion: Investors buying in at these levels should expect sluggish returns for the next few years.

Current Price

Analyst Consensus Price

DCF Model Price

Historical Average Price

P/E TTM

18.35

19.90

20.65

14.69

P/E Fwd

16.96

18.38

19.08

13.57

P/E 2Y

14.97

16.23

16.84

11.98

Click to enlarge

That's not to say that the market can't irrationally go higher in the short term. It certainly can. But if multiples compress back to historical norms, then even analysts are correct in their outlook, stocks will have already priced in 2 years' worth of earnings growth. That is to say, if everything goes to plan, and absolutely nothing goes wrong except reversion back to the historical mean, that investors buying the DIA at these levels should expect to come back in a couple years' time to find that their money has done exactly-well, nothing, probably.

Of course, there are a lot of assumptions in that statement. Rates might not normalize for quite some time, and the low-rate environment may persist if the economy slows and the Fed avoids shocking the system too much. But the market has already priced persistent low rates as well at this point; the risks of any amount of interest rate increases are not reflected at all in current valuations.

Wikipedia defines a "sucker's bet" as a "gambling wager in which the expected return is significantly lower than the wager(s)." Buying particular stocks might not be a sucker's bet-there are surely some pockets of value out there, particularly in Financials and certain Healthcare companies-but buying the broader market without regard to historically high valuations and falling earnings certainly is. While I'm holding onto my stocks, I'm in harvesting mode, trimming my fully valued positions and accumulating cash.

Disclosure: I am/we are long PFE,MRK,DIS,MSFT,V,AXP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.