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Eric Parnell is the Founder & Director of Gerring Wealth Management (http://www.gerringwm.com/), a Registered Investment Advisor based in Pennsylvania and serving clients nationwide. Eric founded Gerring Wealth Management in 2005 with the mission to provide clients with personalized... More
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  • Valuation Headwinds for Stocks

    Stocks continue to celebrate the survival of the global financial system.  The change in investor sentiment has been dramatic. As recently as early March, the market was deeply troubled that the banking system and the worldwide economy may be grinding to a halt. But in the few months since, this Armageddon view has been swiftly replaced by euphoria that the global financial system will not only survive but may be poised to thrive once again. This dramatic shift in sentiment along with initial signs of stabilization in the global economy and improvement in the credit markets have helped stocks explode +40% higher from the bottom in early March. But while the recent rally has been intoxicating, the investment environment is likely to become more sobering from here with a mounting valuation headwind as a major constraint. 

    The current rally is showing some signs of fatigue. The stock market as measured by the S&P 500 reached a closing bottom on March 9 at 677 and has rallied nearly +40% through June 9. Dissecting the path of this rally, a large percentage of the gains were registered in the first stage as would be expected. From its closing low on March 9 to March 26, stocks gained +23%. In the weeks since March 26, stocks extended their rally but at a slower pace. By May 8, stocks tacked on another +12% and were up +37% overall from their March 9 lows. But in the weeks since May 8, the pace of the rally has diminished considerably. Des... setting a new high on June 2, stocks have been choppy along the way in gaining just +1% from May 8 to June 9. This most recent stage of the rally has also included several retests of the previous May 8 peak in recent days. So although the media conversation about the current rally remains enthusiastic, underlying stock performance is becoming far more measured. Of course, any such consolidation phase following the dramatic rally in the last few months is certainly expected. But it is worthwhile to raise a critical question at this time – do stocks have the ability to extend the advance meaningfully higher from here, or is the current market rally close to exhaustion?
     
    Stocks face mounting challenges in trying to extend the current rally.  Typical bear market rallies are driven less by fundamentals and more by sentiment. And while the fundamentals behind the current rally are subject to great debate, it is clear that the global environment remains fraught with considerable risks. First, economic conditions continue to deteriorate albeit at a slower pace and the subsequent recovery is likely to be subdued at best. Second, the government faces a high wire act in attempting to finance its massive stimulus efforts while managing inflation expectations and keeping foreign buyers sufficiently interested in our debt. Third, we continue to navigate unchartered waters with the unprecedented participation of the U.S. government in the private sector and capital markets, which will likely result to unexpected turbulence along the way and conclude with the extremely delicate challenge of successfully withdrawing liquidity without sparking a new crisis. Lastly, geopolitical and financial conditions remain fragile in many regions of the world and the potential for a crisis erupting that results in larger domino effects is still meaningful.
     
       
     
    Valuations will also be primary headwind for stocks both today and in the years ahead.  Even if one believes that many of the underlying fundamentals behind the current rally are strong and that prevailing risks are manageable, valuations alone are becoming a mounting obstacle that will likely place a heavy restraint on stocks in the months and years ahead. Even after the recent rally, it is still very common to hear expressions such as “the buying opportunity of a lifetime” when discussing stocks. But just because stocks are still down –40% from their record highs in October 2007 does not necessarily mean that they represent a good value. This is due to the fact that stocks valuations are not only based on price but also underlying earnings. At first glance, stocks are actually in line with their historical average value at present. When examining the price-to-earnings ratio on stocks based on the 10-year moving average of trailing reported earnings (P/E ratio), we see that stocks are currently trading at a P/E ratio of 16.3 versus the historical average (1900-present) of 16.2 (see chart). However, when dissecting this data, one might reasonably conclude that stocks may actually be trading at a premium beyond the high end of their valuation range going forward. If this were the case, it would imply a meaningful headwind and considerable downside pressure for stocks in the years ahead.
     
    The threat to price stability has major implications for stock valuations.  Relative price stability implied by low and stable inflation provides the idea environment for stock investors. Price stability is positive for stocks because it provides the flexibility for central banks such as the Fed to keep interest rates low. Such conditions help foster strong and sustainable economic growth, which in turn supports accelerating corporate earnings growth and higher stock prices, as investors are willing to pay more for these earnings. This leads to higher than average P/E ratios and is essentially the investment environment we have until recently been operating in since the mid 1980s, which helps explain why the U.S. economy experienced its longest expansion in history and the stock market gained +1,000% over this time period. But since the eruption of the financial crisis in late 2008, price stability is now facing a massive test that is likely to continue in the years ahead. The threat of deflation, or falling prices, is a worse case scenario for an economy and is the primary battle that the Fed has been currently waging by flooding the financial system with liquidity. While initial indications suggest the Fed is winning its fight against deflation, lingering risks still remain that could ultimately lead to a Great Depression/Japan style deflationary spiral. In addition, the cost of aggressively fighting deflation today is that the economy is left exposed to the threat of hyperinflation in the future, as it will be difficult to both properly time and efficiently extract the unprecedented amounts of liquidity currently being injected into the system. Thus, whether it is deflation today (less probable) or inflation down the road (more probable), we are more than likely to experience relative price instability going forward, which is negative for stocks due to the associated impact on valuations.
     
    Investors require lower than average valuations during periods of deflation and inflation. We will begin by examining deflation since it remains the current threat. The last time we experienced extended price deflation in this country was during the Great Depression in the 1930s. During this time period, the P/E ratio for stocks dropped significantly below their historical average levels to the 5x to 12x range for an extended period due primarily to expectations for declining future earnings growth. If a similar deflation outcome were to occur today, this would imply a price on the S&P 500 anywhere between 280 and 680, which is –20% to –70% below current levels. While such a negative outcome now seems extreme given diminishing deflation risks, it was a very real concern as recently as March. But given that the threat of hyperinflation is now becoming the more pressing concern, we will shift our focus to higher prices. The most recent period that we experienced a major inflation outbreak was from the mid 1970s to the early 1980s. During this time period, the P/E ratio for stocks was significantly below historical average levels in the 6x to 11x range due primarily to the fact that investors were willing to pay less for earnings and required a higher rate of return on their investment to maintain purchasing power. Such an inflation outbreak would imply a price on the S&P 500 of 640 or lower, which is at least –30% below current levels.
     
    Even the best-case pricing scenarios offer limited upside based on valuation. Suppose all deflationary risks are averted, commodity prices remain reasonable, U.S. Treasury yields remain low and the Fed is able to successfully drain liquidity from the system while returning the economy to relative price stability. In a financial system that will be far less leveraged going forward, this would imply a P/E ratio for stocks in the 15x to 20x range. Also suppose that the S&P 500 12-month operating earnings per share estimates provided by Standard & Poor’s prove correct at $54.09 per share for 2009 and $73.56 per share in 2010. This implies +9% earnings growth for this year and +36% earnings growth next year in an economy that is projected by the Congressional Budget Office to experience a real GDP contraction of –2.2% in 2009 and growth of +1.5% in 2010. This highly favorable scenario would imply a price on the S&P 500 at the end of next year in the range between 880 and 1170, which is –7% below to +24% above current levels. While it would certainly be a desirable outcome, it would be considered a low probability outcome at present and still implies that valuations are somewhat rich at current prices.
     
    Conclusion: Stocks face a valuation headwind going forward at current prices. Stocks are already at historical average valuations at present. An outbreak of either deflation or inflation going forward would likely lead to an extended period of below average valuations, which would place meaningful downside pressure on stocks from current price levels.
     
    Disclosure: No positions 
    Tags: SPY
    Jun 10 12:02 am | Link | Comment!
  • Beware the Ides of May

    The stock market rally since early March has been impressive, but only on the surface.  Since the market bottom on March 9, stocks as measured by the S&P 500 have rallied nearly +30% through the end of April.  This has understandably raised hopes that the worst is now behind us and a sustained long-term rally is fully taking hold.  Unfortunately, a closer look suggests that investors are likely to grapple with more downside in the months ahead before the current bear market is finally over.

     

    The length and magnitude of the recent stock advance is typical of a bear market rally.  When the stock market navigates through a major bear phase such as today, it does not move lower in a straight line.  Instead, the broader down trend is characterized by violent corrections followed by sharp rallies.  For example, stocks have endured several episodes over the last century - 1929-32, 1937-42, 1973-74, 2000-02 and today - where the market has declined by –40% or more from its peak.  During these past “great bear market” episodes, the stock market managed to post 17 double-digit bear market rallies that lasted an average of 44 trading days.  Gains during these bear rallies averaged +22% and reached as high as +48%.  But after each of these 17 past instances, the stock market rolled back over to set new lows.  So while today’s rally is promising, the +29% rebound over 36 trading days is still well within the norms of a typical bear market rally.  Putting the current rally in a different perspective - despite its recent strength off of its March 9 lows, the stock market is only back to where it was on January 28.  So while things have certainly improved from recent depths, stocks are still far from out of the woods just yet.

     

    Current fundamentals also do not suggest a sustained rally is underway.  A variety of economic and market indicators have merited monitoring to suggest that liquidity is starting to increasingly flow through the veins of investment markets to support a stock rally.  Yet many of these leading indicators either remain locked up or are still sending warning signals.  This includes short-term Treasury yields that remain virtually at zero, still heightened currency volatility, corporate bond spreads that remain elevated, a VIX that is well above 30 and LIBOR spreads that while improved are still disjointed from normal levels.  Beyond these indicators, the broader economic outlook remains cloudy at best with no clear sign yet emerging as to when the economy is set to trough and enter a recovery phase.  Although it may not be necessary for all of these signals to read green before the market exits its bear phase and enters a sustained recovery, at the least they provide reasons to continue to proceed with caution in the current environment.

     

    A retest of March 9 lows is a minimum requirement to declare a bottom in stocks.  Even if it turns out that March 9 is the final bottom of the current bear market cycle, the rally from this bottom is unlikely to be a straight line higher.  Examining each of the “great bear markets” over the last century (1929-32, 1937-42, 1973-74 and 2000-02), the stock market rolled back over and moved lower over a period averaging nearly two months to retest its final bottom before exiting each bear phase and beginning a sustained rally higher.  Unless the current bear market breaks with historical precedence, the market will likely retest its March 9 low of 667 on the S&P 500 during the summer before a final bottom in the market is set.  As a result, if during a retest stocks can hold in the 690 to 740 range on the S&P 500 and rally decisively higher, this would be a positive signal suggesting that a bottom in the current bear market may have been set.  However, if the market rolls back over in the coming weeks and breaks decisively below its March 9 bottom, it will be likely that another retest of fresh new lows set during the summer would be required once again during the fall.

     

    Beware the Ides of May.  So when might we expect the market to roll over and retest new lows?  History suggests that a new stock down leg may be set to begin in the coming weeks.  In nearly every calendar year during past “great bear markets”, stocks traded sharply lower over the period from mid May to mid July, posting an average decline of –17% and a maximum decline of –30%.  The only exceptions to this rule occurred during the 1937-42 bear market in 1938 and 1939, but stocks had just completed declines in excess of –20% in the weeks leading up to May during these two years.

     

    Conclusion:  While the recent stock market rally has raised optimism that the bear market may be behind us, numerous factors suggest that the market may need to retest March 9 lows before a final bottom can be declared.  Thus, it is important to continue to proceed with caution when managing stock portfolios in the coming months.  This is particularly true since the period from mid May to mid July has traditionally been a difficult stretch for stocks during major bear markets.

     

    Disclosure: No positions

    Tags: SPX
    May 01 11:10 am | Link | Comment!
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