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MacroView: Rationalizing High Valuations Won't Improve Outcomes



  • When discussing valuations, it is important to maintain a proper perspective.
  • Valuations are NOT a market-timing device to tell you to buy or sell stocks.
  • What valuations do provide is a framework for understanding forward returns over long periods of time.
  • Rationalizing high valuations today will likely lead to ultimately "losing the war."

Rationalizing high valuations won't improve future return outcomes.

The reason I say this is because of a tweet from Tom McClellan recently:

While I have an immense amount of respect for Tom, the exercise of manipulating valuation measures can lead to false conclusions. Take the following chart:

The dark blue line is Shiller's CAPE measure as compared to Tom's M2 measure and our CT measure. Clearly, both measures show the market is substantially cheaper than Shiller's smoothed price to earnings model. Moreover, both the M2 and CT measures have a very high correlation of nearly 90%.

Therefore, investors can rationalize that by using either M2 or CT, stocks should have higher return rates in the future.

The problem is that the CT model has nothing to do with asset markets. It's a measure of "College Tuition" expenditures. So, while there is a spurious correlation to both Shiller's CAPE and M2, the measure has little to do with forward return expectations or current valuations.

Why is this important?

While valuations can seem passive over short periods of time, and they are indeed horrible market timing measures, they have everything to do with future outcomes.

"Price is what you pay, value is what you get." - Warren Buffett.

Measuring Valuations The Correct Way

When discussing valuations, it is important to maintain a proper perspective. Valuations are NOT a market-timing device to tell you to buy or sell stocks. What valuations do provide is a framework for understanding forward returns over long periods of time.

Despite the market's outperformance over the last 10 years, such was due to the unprecedented monetary interventions by the Federal Reserve. Regardless, markets have a strong tendency to revert to their average performance over time, which is not nearly as much fun as it sounds.

As investors, our job

This article was written by

Lance Roberts profile picture

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; I have pretty much "been there and done that" at one point or another. I am currently a partner at RIA Advisors in Houston, Texas.

The majority of my time is spent analyzing, researching and writing commentary about investing, investor psychology and macro-views of the markets and the economy. My thoughts are not generally mainstream and are often contrarian in nature but I try an use a common sense approach, clear explanations and my “real world” experience in the process.

I am a managing partner of RIA Pro, a weekly subscriber based-newsletter that is distributed to individual and professional investors nationwide. The newsletter covers economic, political and market topics as they relate to your money and life.

I also write a daily blog which is read by thousands nationwide from individuals to professionals at www.realinvestmentadvice.com.

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Comments (45)

There's a lot of idle money still waiting to go into the market. Money managers that have been too cautious in the 2nd qtr. do not want to release their fund performance numbers after such a big run. I'm betting June will see a flood of money into this market...even at lofty valuations. July, on the other hand, could get ugly quick.
Laugh now cry later market
It's not a wedding cake @whatwedointheshadows .
Lance has always gotten a bad rap for being to cautious for the Buy and Holders. He provides analysis and they drag out the dead horse and start beating. There is nothing wrong with Buy and Hold. It's the easiest way to profit in a 12 year Bull Market. And they've been successful. Good On Em.

Times are a changin folks. This Bull, like all Bulls will run it's course. Those who have been around this game for a while know that all Great Markets go out with a Bang. IMO - this is what Lance has been trying to communicate.
Bull markets go out with a whimper @High Mountain Man .
@kimbillro - we'll have to agree to disagree on this one.

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria,” Sir John Templeton
LOL @High Mountain Man . I have got to get down out of these high mountains where the air is too thin @High Mountain Man .
Nostradumbass profile picture
In a market where the Fed has become the principal safety net, present and future valuations seem to be more or less irrelevant. Momentum is key. “Theses” of companies or sectors are key. Moneyed investors I know are motivated more by ideas than data and metrics. Sentiment is crucial. There’s little room for “fundamental” analysis in this market. I feel frustrated and obsolete!
Get with the new changes @Nostradumbass . Remember your ancestor Nostradamus @Nostradumbass !
Animal Spirit
I forgot to make a snowman last winter @Snow_man and it is too late now @Snow_man .
robertmliu profile picture
The stock market as a whole is richly valued with the best-known quality stocks all viewed as overvalued, but for that matter, bargains tend to disappear quickly and wait for no one. That's why stock investment is not a game for the faint of heart. Earlier in March 2020, amid a Covid 19-triggered market panic, each and every of the same best-known quality stocks was a great bargain, yet "experts" told us that there would be a second down leg to 18,300 on the Dow. O.K. Let's keep the powder dry and wait for that down leg to occur somewhere down the road!

Back to market reality, the Dow Jones Industrial Average has successfully held up at the support level of 23,500 despite repeated attempts to breach it. So, the Dow is likely to march upward towards the resistance zone at around 27,500 and test it repeatedly. I guess profit-taking is likely to happen here. Some may even consider selling short at this level. Chances are the Dow may consolidate within a narrow range between 26,500 and 27,500 until Election Day, November 2020. Then, depending on who wins, Trump or Biden, the Dow and the S&P 500 may rise or fall sharply. Well, life is a gamble, or like a gamble. Make a bet, win or lose. Otherwise, nothing venture, nothing gain. Never envy any winner his winnings, for he deserves his reward for his risk-taking, which is what American capitalism is all about. Personally, I respect and admire the winners, for they are just much smarter than I am.
I relate to the numbers of the SP500, not the Dow @robertmliu , therefore I can't help you since you are Dow focused.
Its not capitalism when the central bank funds the markets thru ever increasing amounts of debt
Sure it is @JuiceBoxHero . It's just not the form of capitalism that you like.
shackmaster profile picture
Spot on once again. Obviously, fundamentals don't support the market's current prices, and the FED liquidity is pumping markets up. We're living in one great big party. Nobody wants it to end, but it will, and the hangover is going to be awful. The two questions I ponder are when does it end, and how do we recover?
At this big party of which you speak they only gave me one bottle of Coronabeer @shackmaster .
Since when are valuations rational? The Fed has distorted the economy and the financial picture and will continue to do so. This is the last attempt to save a totally corrupted system. Take out the Fed and it all comes crashing down. The Fed is buying time but eventually within the next 2-3 years, time will run out.
Are you predicting the end of the world in 2-3 years @nestor7 ?
hawkeyec profile picture
@Lance Roberts

Another great post. You noted several times: "Lastly, one figure that is hard to fudge or manipulate is sales." Right on. And for those who love to talk about cash flow, remember, gross operating cash flow is the same as sales. In the intermediate to long run cash flow is absolutely restricted by sales. And, even then, of course, sales revenue is reduced by actual expenses -- those can't go away. So a market growing faster than sales and or GDP. is pure folly.

I can't really speak to Shiller's CAPE indicator, although it has always struck me as something most beloved because it makes people who use it feel better (FB) about the market -- an important metric (FB) since 1999-2000. Tobin's Q is even worse. As you note when the market is growing at many times corporate sales it has essentially lost its sense of reality. And the Q ratio, who knows what asset replacement values are? Q, IMHO, is just nonsense. Rationalizing something you like when there is no solid underlying reason is whistling past the graveyard.
Buyandhold 2012 profile picture
"Rationalizing high valuations won't improve outcomes."

It's a market of stocks. Not a stock market, as Chuck Carnevale is so fond of saying.

And not all stocks are overpriced at the moment.

Berkshire Hathaway is not overpriced.

I pity the poor fool who stayed out of the stock market since March 23, 2020.

Check out these returns since then.

SPY: up 43.23%

QQQ: up 40.91%

DOW: up 46.25%

XOM: up 72.10%

MKTX: up 75.78%

LULU: up 85.59%

AAL: up 81.37%

RCL: up 146.33%

BA: up 94.50%
High Yield Cash Flow profile picture
And my BDC stocks up 82% along with my mREITs up 52% since March 23rd, S&P 500 lags with only 43%. Fear is a powerful motivator, not for this high yield investor. Not buying now, mostly fully invested, purchases were in March, April, May. Holding onto my incoming dividends at the moment to see how the second quarter shakes out. Good luck to all income seekers, cash-flow is king!
@Buyandhold 2012 Why do you insist on making misleading claims justify your perma bull view? What you fail to mention is that YTD AAL is down 37% and RCL is down 48%. Not only that, up until TWO DAYS ago, AAL was down 60% YTD and a month ago it was lower than it was on March 23rd. Boy, those bears are so stupid! For a guy who "never sells", it must be great to buy on the exact bottom and reap such stellar gains! Let's see what happens to these stocks in the coming months, because if you hold them forever that's what really counts. Also, most of the airlines have gone bankrupt at least once, how did that work out for investors!? Such BS you peddle.
Buyandhold 2012 profile picture

Since March 9, 2009, both RCL and AAL have outperformed SPY.

A $10,000 investment in RCL with dividend reinvestment on March 9, 2009 is now worth $142,638.96.

That same investment in AAL is now worth $98,145.28.
Jhalgren profile picture
Lance Roberts, this is a wonderful, realistic grasp of the situation we are experiencing. So how are you advising your clients: wait till lows before buying? But meanwhile, are you encouraging investments in any other security, like bonds (government/corporate) or gold or what to help tide people over since the marketplace will be operating at a crawl pace. Curious to know your view!
Interested in his response to your inquiry. Hopefully he has one.
His view is that the SP500 hits new highs by the end of June an then corrects @scoutyboy @Jhalgren .
crrj profile picture
Most cant understand the power of pro USA business policies, and the positive effects on economy and markets along with Fed help.

Positive presidential comments about US and US businesses.
Historic reductions in costly oppressive, Govt regulations.
Pro business, investment, risk on tax policies.
Pro US trade policies to bring manufacturing back to US from communist China or other countries.

Freedom in US energy supplies of oil n nat gas vs dependency.

Incintivizing onshoring of US manufacturing provides jobs.... people with job options are less dependent on govt welfare, and happier with HOPE.

Never pays to bet against US markets...unless we elect a socialist, anti business leftists.
06 Jun. 2020
Pure capitalism always sounds wonderful in theory. Can you point to a place in time in which it worked out so wonderfully well for everybody (owners, governments, workers, citizens/residents, the environment upon which we all depend)? I'm not socialist, by the way. We all live in the messy middle and as far as I can tell there has never been anything close to utopia.
Capitalism has devastated the world environment and ecosystem...and is leading to the 6th major mass extinction @7jm7 @chaptal .
shackmaster profile picture
To bad we don't have 100% pure capitalism now or any time in recent history. Fed actions are socialist by their very nature, where the collective is responsible for the risk losses, and not the rewards.
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