OK, so this is a continuation of the scary chart series (not really intended to be a series, and not really intending to be so actively posting!).
Whenever I see these big charts showing how the markets are overvalued and whatnot, I usually just go back to looking under the hood on what’s really going on. Sometimes the P/E charts look crazy (like it did in 2000 and now), stock market to GDP is off the charts etc.
But at the end of the day, most of us here are not S&P 500 index futures traders; we are investors. And we at least pretend to be owners in businesses and not shufflers of pieces of paper. In that sense, all of these macro forecasting charts should be totally irrelevant. OK, so maybe we should be aware of some of this stuff. But as far as what to do about it, unless you have strong odds of something happening, it shouldn’t really drive any action on the part of business owners.
Speaking of odds, odds are often misused (or unused) in finance. I can’t claim to not misuse them either. But here’s what I mean. So often you hear people say the market is overvalued so they are going to short the market.
One thing that struck me is that every time Joel Greenblatt is on TV, he tends to tell us what percentile of valuation we are in and what the year-forward expected return for the market from that valuation level is. Now, that has problems too as you can argue that all of that data is based on a bull market period when interest rates were going down. But as flawed as it is, it is still much better, I think, than just shorting the market because it is overvalued and therefore thinking it must go down. If the market is overvalued, then the expected return going forward is going to be low, but not necessarily negative (over time).
Plus, for those calling a turn in interest rates, look at the long term chart of interest rates that go back 100 years or more, and you can see that these major turns don’t happen very often. So basically, the odds of calling the turn in any given year is not very high.
Anway, what you never hear from the “I’m short cuz the market is expensive” is something like that; from these levels, the probability of a crash or bear market within the next year is xx%”.
What you do hear is that when markets are this expensive, things don’t end well. And they are often right. Things often don’t end well. But then again, it all depends on what your definition of “end” is.
It was a certainty that things wouldn’t end well in the late 1990’s and 2000. And many geared up for it. Of those folks who actually caught the crash back then or got out in time, how many got back in? What is their total return through all the cycles since then?
For reference, BRK grew BPS 9.4%/year from 2000 through 2015. BRK stock price rose 7.1%/year since then. If you were smart enough to own MKL, they grew BPS +12%/year and the stock price rose +11%/year in that time period. The S&P 500 index total return was 5%/year.
The same was a certainty back in the late 1980’s; it was a certainty that things wouldn’t end well. The above figures would be even more dramatic than the 2000-2015 figures. This is not to say that we will have high returns like that going forward!
Back to the Trees
OK, so getting back to the issue. As I said, one thing I do when I see scary charts is to go back and look at my holdings to make sure none of them are bubbled up. To see what’s in store for the market overall, I will look at some major components as a sanity check to see how bubbled up the market is.
One of the first places I look is Berkshire Hathaway’s (BRK) holdings. Buffett is the greatest stockpicker ever with a live portfolio we get to see in real time. If the market is bubbled up, there might be risk built into BRK too, which we may want to be aware of.
I like to look at current P/E because ttm P/E often has a lot of noise, write-offs etc. Of course we can’t ignore those ‘one-offs’ as they often are not, but I like to look at companies based on a normalized earnings basis, and for that, current P/E often reflects a little bit more of a normalized picture (as analysts estimates often exclude charges).
Forward P/E is for the year 2017, so may be too far ahead for some. Anyway, we are more than half way through 2016, so the numbers should be decent estimates.
Here is the BRK portfolio; I only include companies listed in the annual report. CHTR and KHC are not here as there are no earnings estimates available. I added AAPL. The list includes non-Buffett names, but since it’s in the annual report top-holdings list, might as well leave them in.
So, looking at this, I think to myself, “where is the bubble?”. OK, the FANG stocks and many others are really expensive, but who cares, really, if you don’t own them. Right? OK, if those guys collapse and cause a correction or bear market, many stocks will go down. But from a valuation perspective, I don’t see a big problem here.
Let’s take a look at something more representative. The S&P 500 index is too unwieldy to look at individual names, so let’s just look at the Dow. It has a high historical correlation with the S&P 500 index so it can tell us something about the market.
Here is the same table as the above with the Dow 30 stocks:
The Dow is trading at around 20.7x P/E, and 16.6x 2017 estimates. Well, actually, that’s the simple average P/E of the Dow stocks. Yes, on the high side historically. But again, I don’t really see anything bubblish. The high P/Es of XOM, CAT, CVX are due to depressed earnings, not speculative frenzy. Some of the other high P/E names seem to be trading at where they have traded in the past. Maybe some a little higher, but for the most part, they seem consistent with what I would expect them to be trading at in ‘normal’ times. Nothing really screaming out at me that it has to crash.