Repeat After Me: Valuation Is Not a Catalyst!
[Darius Dale is a director and partner at Hedgeye Risk Management, a leading independent financial research firm based in Stamford, Conn., and a featured columnist for Investopedia. The views expressed by columnists are those of the author and do not necessarily reflect the views of Investopedia.]
“To be clear, ‘valuation’ is an opinion.”
– Hedgeye CEO Keith McCullough
While quoting my firm’s CEO can come off a tad obsequious, that phrase from his Early Look market note really resonated with me. I think about valuation all the time – most specifically ways in which I can succinctly and effectively explain why it has such a diminutive role in our tactical asset allocation process.
I’ve gotten better at it over the years, but not without learning from a number of very thoughtful investors in the process:
- “Valuation is not a catalyst.” – Keith McCullough
- “Valuation is not a catalyst; but when a catalyst occurs, valuation really matters.” – long-time Hedgeye client
- “Never express yourself more clearly than you think.” – Niels Bohr
The last quote comes from one of the greatest physicists the world has ever seen and was Bloomberg’s “Quote of the Day” yesterday. While it doesn’t explicitly pertain to valuation, I do find that it adds value to this discussion.
How Investors Get Valuation Wrong
Specifically, when Wall Street strategists cite their valuation opinions on a particular market, they use words and phrases like “cheap,” “expensive,” “fair value,” “rich,” “bombed out,” etc. It’s a really clear and succinct way to express one’s views on the underlying fundamentals.
But that’s just it – valuation is a powerful reasoning tool only if you’ve done the associated fundamental analysis and have a differentiated view from other investors based on your research.
Take our energy analyst Kevin Kaiser, for example. His seminal work on Kinder Morgan (KMI) or Linn Energy (LINEQ) started and ended with his belief that the companies didn’t generate enough cash to cover their respective distributions. The likelihood of meaningful distribution cuts rendered these stocks grossly overvalued on relevant industry metrics.
These stocks didn’t get hammered (LinnCo. actually went bankrupt) because they were suddenly “expensive”; they got hammered because said distribution cuts were catalysts to perpetuate material downside – catalysts that were only foreseeable by someone who did the work.
Is the U.S. equity market “cheap” or “expensive?” What is your process for obtaining an accurate answer to that question? Have you done “the work” on the 30 stocks in the DOW? What about all 500 stocks in the S&P? Doing the work on all 2,000 constituents in the Russell is a beast; may I suggest copious amounts of Red Bull.
I’m obviously being a bit facetious here to prove a point – which is that the way in which investors “value” the $26 trillion U.S. [public] equity market contains substantially less analytical rigor than what would be expected of them for any of the securities underpinning said market. At best, such characterizations are intellectually lazy; at worst, they are intellectually dishonest.
Take, for example, the Old Wall dog-and-pony show of generating a cockamamie EPS forecast for the S&P 500 and suggesting the market is “cheap” or “expensive” (usually “cheap,” of course) on said number.
How is it even plausible for an analyst or team of analysts to come up with accurate EPS forecasts for that many stocks? Perhaps these firms have fantastic people and the best models; who knows? All I know is that we can’t for the life of us replicate such magic here at Hedgeye.
The Right – and Wrong – Way to Use the CAPE Ratio
Another example that’s increasingly found its way into our in-boxes is Yale Professor Robert Shiller’s Cyclically Adjusted Price-to-Earnings Ratio – commonly referred to as the CAPE Ratio. From my vantage point as a macro strategist, Professor Shiller’s methodology for determining the valuation of the U.S. equity market is ripe with analytical rigor. That being said, however, its application by investors and financial journalists is typically far less thoughtful. Their mistake is using CAPE Ratio as a measure of valuation – not as a brilliant way of pinpointing where we are in the market cycle and what sort of expectations we should have as a result.
When an investor says to us something like “the market is expensive on CAPE” or “no bull market has ever commenced at a CAPE this high,” we always concede their point with little-to-no pushback. Instead, we typically reply with questions. What are the associated investment implications? Is the market going to crash tomorrow?
That’s where the conversation generally morphs into what said investor is doing with his or her own capital, rather than what the investor's previous statement implies for the U.S. equity market as a whole. That’s totally fine and we get it, but anyone striving for greatness (and the alpha associated with it) needs to be able to quantify statements like that.
We at Hedgeye have. The right way to use the CAPE Ratio is to look at it in detail over time. For example, currently the S&P 500 Index has a CAPE Ratio of 28.26. That’s in the 96th percentile of all readings (dating back to January 1881). If you concentrate on the trailing 30-year time period – which is arguably far more relevant than readings 100+ years ago – its 83rd percentile reading is still elevated, though not by as much.
Indeed, the CAPE Ratio itself has been on a “permanently high plateau” since the mid-'80s – probably as a result of a combination of factors (e.g. falling interest rates and business cycle volatility, increased information, globalization, foreign “savings glut,” increased retirement savings due to demographic tailwinds, etc. etc.).
Empirically speaking, percentile readings between the ninth and tenth decile have not necessarily been catastrophic for market performance. Specifically, the average returns on a one-year, three-year and five-year forward basis are +2.3%, +1.9% and -2.7%, respectively, and said returns are positive 55%, 40% and 25% of the time.
As l like to say in meetings, “Mean reverting data sets rarely spend a ton of time at their average; rather, the mean is typically a function of the data oscillating from one extreme to the other.” At this current extreme CAPE Ratio, the expected value, or probability-weighted average, of buying the S&P 500 today is +1.2%, -3.8% and -5.3% on a one-year, three-year and five-year forward basis, respectively.
As the Chart of the Day (below) shows, these outcomes aren’t good, given that they pale in comparison to how well the market does/can do when it's at lower-decile CAPE Ratios.
That said, however, they don’t necessarily imply one needs to sell everything today. Specifically, the top 10 one-year–forward returns of CAPE Ratio readings between the ninth and tenth decile carry a whopping average of +34.8%! That figure drops to +30.2% for the top 20 and +21.3% for the top 50. Over the last 30 years, the average of the top 10 one-year–forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%. Can you afford to miss a +31% move to the upside in your benchmark?
What Investors Should Be Doing
All told, these statistics would seem to suggest that pinpointing where we are in the economic cycle and identifying catalysts that will perpetuate a continuation or a reversal of the existing trend(s) are far more important tasks than trying to identify what valuation the stock market has. Being too early is the same thing as being flat-out wrong in P&L terms.
Potential negative catalysts to watch for at this stage of the market cycle are: a rising risk of recession, aggressive monetary tightening or material fiscal policy disappointments.
Keep your head on a swivel out there.
Darius Dale is a senior analyst on the Global Macro team and a core contributor to the firm’s economic outlook and associated investment strategy views.Hedgeye is an independent, conflict-free investment research and online financial media company. Its research team of over 40 analysts across myriad sectors – from macro, energy and industrials, to retail, financials and healthcare – is committed to delivering thoughtful investment ideas of the highest caliber through rigorous quantitative, bottom-up and macro analysis with an emphasis on timing. Click here to learn more.