I love to hear over and over how the multiples on the market are cheap and fundamentals are strong and so you have to keep buying this market. Thing about valuations on a micro level is that companies can and do take various actions to promote a façade of improving valuations such as share buybacks, which improve EPS by reducing the number of shares for which earnings must be distributed. I won’t go into all of the games but suffice it to say there are many and they are well known to most of us in that world. However, on a real macro scale it is much harder to create a façade of improvement albeit not impossible. Some of the games that have been played are changing the calculation of GDP, changing the inflation benchmark and shifting benchmarks as the existing ones don’t provide the desired message. When we take a step back and really ask what is a market valuation we recognize it is the price of the market versus some prediction of future economic production that translates into expected income and cash flows. If we agree on that then we agree that share buy backs do not change the true valuations. One can argue buy backs do provide the shareholder higher return for his investment in the short run. That is true but remember that micro action does not create sustainable future economics especially if the capital used to purchase share buybacks is replacing real future production expansion via capital reinvestment. And worse on a mass scale (which we have seen over the past year as many companies have felt pressured to increase dividends or buy back shares) allocating capital away from macro level expansion to provide higher short term returns to relatively few shareholders as opposed to long term sustainable returns to all economic stakeholders (which includes employees/consumers) actually hurts everyone including shareholders after their initial windfall. Nor does changing calculations or definitions of GDP or other leading indicators equate to a change in valuation. Again, value is price versus what you get for that price and market value is no different than any other value.
Notice in the first chart below that I borrowed from VectorGrader (Total Market Cap/GDP) the change in 1995 in the trend line from 40 years of a slow curving random walk to a harsh spiking random walk (steep runs with knee jerk reversals). Also notice the continuous reversion back toward the median level of .65 over time. Since 1995 we’ve seen three steep runs way above the .65 median. Two of the three resulted in equally steep declines back to the .65 median and each decline took place around the 6 year mark of the respective market run. We are currently in the 5th year of the third steep run above the .65 median since the 1995 new trend line. It certainly begs the question as we push through the 5th year of this market run whether we are on the precipice of the next steep reversion to the .65 level of market cap to GDP.
The simple fact is that there is a fundamental relationship between income (GDP) and market valuation. Those who deny this fundamental relationship will eventually learn a hard felt lesson. An additional interesting point (see S&P price chart – bottom chart below) is that the sell off of 2008 saw lower lows than the previous sell off of 2001, which ended a trend of higher lows since the early 1970’s. The trend line of S&P since 1997 is effectively flat, which we don’t see across any other 15 year period of S&P. The point is that we may be in a scenario that mathematicians would say is the second derivative of the market function now set to zero. That is, we’ve had a long term run of increasing markets and we seem to have hit a point where the long term slope is no longer positive but is zero (or flat). This signals an inflection point which may lead to a stall before further increase or could lead to a negative slope, only time will tell. But be certain in terms of binomial probabilities this zero slope trend is not insignificant.
To further point out that valuations are actually inflated despite the many market pundits trying to convince us otherwise, let me just throw out one additional note. The six year run from 1995 to 2001 saw the market increase 200%. The 6 year run from 2001 to 2007 saw the market increase close to 100% and we have now seen the market increase close to 150% in our latest 5 year run. One major difference is that in 2000 when the market had increased around 200% the U6 (unemployment and underemployment) was 6.8% (about where our current U3 sits today) and we lost almost 50% of market value during the decline of 2001. We also lost 50% of market value in the 2007 decline after seeing a U6 of 7.9%. Today we have a seen a 5 year and 150% market run while U6 hasn’t been below 12% and in fact is moving back up to just under 13% today. U6 is a much better indicator than U3 as it depicts those who are working but not in jobs that can support a family nor create disposable income. When the reversion kicks in it could be sharper and deeper due to this U6 fact. So please, I guess I can handle listening to the bullshit but I would advise those who want to jump on the bandwagon of market bull pundits to take a few minutes a day to find a dark quiet space and have a reality check for your own PA. I get that the Fed is still obeying the markets demand for undefined period of zero interest and money printing and that creates market asset inflation meaning intense upward market price pressure. That said, true fundamental valuations are what they are and the market is way beyond its median level given its current or expected economic production. Remember, the definition of crazy is repeating the exact same action yet expecting a different result. Take another look at the first chart below and ask yourself if you were a betting man where do you think the chart goes over the next year?