Now what?
BY CARTER E. ANTHONY, CFA
Last month, I wrote there is an undercurrent in the economy and in the financial markets that has not yet been recognized by writers and investors.
I suggested buying short-term Treasury issues yielding 4%+ because the stock market cannot continue to appreciate in this environment and because the Fed’s next move is going to be a decrease in interest rates.
Taking my own advice, I waded into the bond market investing in 2-year, 3-year, 5-year and 7-year Treasury issues with an allocation up to 30% of selected portfolios.
Shortly thereafter, as the stock market will do, it made me second-guess my bond purchases with a strong rally back to the previous highs.
James Mackintosh of the Wall Street Journal wrote on Aug. 16 that based on three popular measures of market strength, it is a “fool’s rally” and he proceeded to lay out a few indicators of the over-valuation of the market.
Yale Professor Robert Shiller developed “CAPE” or the cyclically adjusted price-earnings ratio which uses the average of the past decade’s earnings, adjusted for inflation, and results in today’s market PE of 35.
Today, the S & P 500 is the third most expensive since the 19th century and it is pricier than the 1929 high. According to this measure, stock values are very high.
Another measure, the “FPE” or the forward price-to-earnings ratio dates only back to 1985, still an almost 40-year history, but it arrives at the same conclusion, stocks are expensive.
According to the FPE, today’s stock values are not as pricey as they were in 2000 and 2020, just before those crashes, but they are expensive.
The “Fed Model”, founded by strategist Ed Yardeni in the 1990s, attempts to compare bond yields and earnings yields.
Yardeni’s earnings yield was developed by dividing earnings per share by the stock price.
He then compared it to the 10-year Treasury yield. This comparison today indicates investors should sell stocks and buy bonds.
As with all statistical measures, there are pros and cons. The CAPE reached its highest valuation in July 1997 when those of us in the market for almost 30 years remember Fed Chairman Alan Greenspan uttering his “Irrational Exuberance” words, an unacceptable comment from an independent, apolitical chairman, but warning of a downturn.
In contrast, those who ignored Greenspan and stayed the course earned a 7% return after inflation since his comments.
The FPE relies on analysts who mostly work in big banks. They form a consensus and any consensus coming from Wall Street banks should be treated with extreme skepticism.
The Fed Model once again relies on analysts’ predictions of earnings. It predicted that stocks were their cheapest in November, 2007, since its inception in 1985.
We all know what happened from there through March, 2009.
You will note that these valuation models do not include any of the current economic and geopolitical conditions in their mathematical calculations.
As Mark Twain said, “Lies, damned lies and statistics can be made to prove anything”. According to the Warren Buffett indicator which is the long-term ratio of the total market value over the GDP, the stock market is significantly over-valued.
Buffett has been a fairly successful investor. Given the current market valuation and the many unsettled, uncertain conditions in the world, I can’t help but believe the market’s hitting new records every day may well be in Mackintosh’s “fool’s rally” and it is time to allocate some funds to bonds.
