The initial series of year-end updates to the Crestmont Research website is now available at www.CrestmontResearch.com. The updates are listed below in this newsletter. Your comments and suggestions are welcomed ([email protected]) and often influence future updates and additions.
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The next set of updates should be available on January 17th, and a final set of updates is expected on or before February 4th. If you received this notification directly from Crestmont Research, you will be promptly notified of future new additions and updates. If this notification was forwarded to you, please visit the upper-right corner of the home page to sign-up for this complimentary service.
Today's updates are listed below. The most significant points are:
(1) 2019: Despite relatively elevated valuations, the stock market ended the year at record highs. Momentum is a more powerful force than valuation in the short-run. Graham's weighing machine remains in the back seat to his voting machine.
The year 2019 and the decade ending 2019 delivered another pair of records for the history books: (1) as of July 2019, the current economic expansion became history's longest and, (2) 2010-2019 is the first calendar decade without a recession (Recessions by Decade).
As long as good economic conditions prevail, significant downside risk in the stock market is likely to be deferred, and the market will likely benefit from its current momentum.
Nonetheless, stock market valuation remains high (Secular Stock Market P/E), and volatility has returned to the moderate zone (Stock Market Volatility: An Erratic Cycle). For more on volatility, see Volatility in Perspective.
Lastly, consistent with recent years, 2019's initially hopeful surge in reported earnings tapered throughout the year (Earnings Trends: History & Future). It's unclear whether the final reports of 4Q19 EPS will reflect the sixth "big dip" in a row. Each of the past five years had significant declines in reported EPS as the year was finalized after year-end. Update pending...
(2) Outlook: Crestmont's objective is to provide an outlook for investing over the next decade or two. Crestmont does not attempt to predict cyclical cycles--the shorter-term periods of surge and fall within longer-term secular periods. The value of Crestmont's research and analysis is its forecast of the secular market environment.
This year's most compelling chart regarding the level of P/E and its implications for future returns is Gazing at the Future.
Gazing overlays (1) S&P500 Index P/E and (2) annualized returns over rolling ten-year periods. Ten-year returns are offset in the chart to align subsequent returns with starting P/E.
For example, 1909 on the chart is the leftmost green bar; it reflects the compounded average annual return for the decade 1900-1909 (i.e., ~9%). 1909 also has a point on the orange line corresponding to P/E at the start of that decade (i.e., 1899, since 1900 is the first year of the ten-year period).
The last bar in the chart is the decade 2010-2019 (which includes a point on the orange line for P/E at the start of that ten-year period). Since P/E is time-shifted by ten years, the orange line continues forward to reflect ten-year periods ending 2020 to 2029, each of which has P/E starting in the years 2010 to 2019. Each of the 10-year periods ending over the next ten years has already started, and starting P/E for each of those periods is already known.
Gazing demonstrates the impact of the starting level of P/E across more than a century of history. The starting level of P/E generally has limited effect on short-term returns, yet starting P/E is the most significant driver of subsequent long-term returns. The chart's insights include:
First, the chart highlights the reason that the most recent 10-year return was so strong. P/E valuation was relatively low at the start of the 2010-2019 period.
Second, Gazing offers a sobering insight about the trend for trailing 10-year returns over the next ten years. The starting year P/E for each of those periods (i.e., 2010, 2011, 2012, etc.) progressively increases. As a result, it is highly likely that trailing 10-year returns will reflect a declining trend. This has significant implications for financial advisors and institutional investors that use trailing returns for perspective or benchmarks.
Third, the chart helps investors to understand the expected level of return for the next ten years. Investors should avoid the temptation to extrapolate the past year or decade into the longer-term horizon. It will never be more true that past performance is not an indicator of future results.
Ten-year annualized returns decline significantly as the starting level of P/E rises. The ten-year period ending 2029 will likely add a very short bar to the chart. With awareness of the environment, investors and advisors can take appropriate action to achieve investment success despite market conditions.
There are a number of new charts and articles being planned for this year to deliver insights that bolster investors' understanding of the market environment and promote conviction about the appropriate investment strategy.
(3) All measures of P/E are well-above their respective average (e.g., when using P/E based upon forward operating EPS, be sure to use its historical average near 12; for CAPE P/E10 and Crestmont's P/E, the averages are near 16). Even though P/E is appropriately above average due to low inflation and interest rates, the current normalized P/E above 30 has ascended beyond fair value and reflects a stock market that is "significantly overvalued." Nonetheless, as previously mentioned, momentum is a more powerful force than valuation in the short-run.
(4) The article Half and Half emphasizes the need to adjust investment approach depending upon secular market type, and it explains why it works to "row" with a more actively-managed and diversified portfolio.
The article has been updated through 2019...and, spoiler alert, the tortoise lost ground in 2019, but remains slightly ahead during the most recent cyclical bull and nicely ahead since 2000.
SELECTED ITEMS FROM BELOW:
P/E: Secular Stock Market P/E, The P/E Report, and Secular Cycles Explained
Volatility: Stock Market Volatility: An Erratic Cycle and Volatility in Perspective
Earnings: Earnings Trends: History & Future
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Secular Cycles Explained
The long-term view of the stock market reflects extended periods of surge and stall. These periods, known as secular bull markets and secular bear markets are not optical illusions; rather they are extended periods when market valuation (i.e. price/earnings ratio: P/E) is either multiplying the effect of rising earnings or mitigating them.
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This Secular Bear...So Far
This secular bear began in 2000 and has lasted well more than a decade. The surges and falls are relatively consistent in both magnitude and duration to past secular bear market cycles. With valuation levels still relatively high, as measured by normalized P/E, this secular bear has quite a way to go.
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Gazing at the Future
The starting valuation matters! When P/E starts at relatively lower levels, higher returns follow–paying less yields more. When the market P/E starts at higher levels, subsequent returns are lower. This graphical analysis presets the compounded returns that follow over the subsequent ten years based upon the starting P/E ratio.
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Components of Return
There are only three components (excluding transaction costs and expenses) to the total return from the stock market: dividend yield, earnings growth, and the change in the level of valuation (P/E ratio). To assess the potential returns from stocks for the next decade, this analysis presents the total return and its components for every ten-year period since 1900.
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Distorted Averages
Investors only can spend compounded returns, not average returns. This chart presents the difference between average returns and compounded returns for investors. The two issues assessed are the impact of negative numbers and the impact of volatility, as measured by the variability within a sequence of returns. Both issues can devastate the actual returns realized by investors compared to the average.
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Generation Returns
Even an extended period of 20 years does not ensure positive cumulative returns in the stock market. Returns appear to be dependent upon the starting level of P/E. When P/E is relatively high and above the average, investors’ returns over the subsequent 20 years have been below average or negative. When P/E is relatively low and below the average, investors’ returns have been above average and rewarding.
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Stock Market Yo-Yo
Up today and down tomorrow. The stock market seems to be constantly reacting to good news and bad news….sometimes “because of” the news and other times “despite” the news. In this research, we explore the portion of days that the market is up compared to the number of days it is down.
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Secular Stock Market P/E
The preceding secular bull ended with the market valuation (P/E) at levels twice as high as all previous secular bulls. That meant that this secular bear had twice as much ground to cover. The current secular bear market started to deflate the bubble, but the market still remains at or above levels consistent with secular bear starts.
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The P/E Report
There are numerous versions of the price/earnings ratio (“P/E”), yet there are very few of them that can be appropriately compared to the recognized long-term average of 15. The objectives of this report are to detail the current level of the P/E ratio, to answer frequent questions about it, and to address the status of the current stock market cycle.
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P/E Ratio vs. Dividend Yield
The dividend yield of the stock market is relatively low by historical standards. Why? Valuation directly affects dividend yields. As the price-to-earnings ratio (P/E) rises, the price-to-dividends ratio rises as well {thus lowering the dividend yield}. This presents another view of the market’s relatively high valuation.
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Significant Swings
Although the compounded average annual change in the stock market is near 5% over the past century, the range of dispersion in annual returns is dramatic. More than 50% of the years ended with changes in the index exceeding +/-16%, either less than -16% or greater than +16%!
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Stock Market Volatility: An Erratic Cycle
This graph reflects a measure of stock market volatility--the statistical standard deviation of monthly changes for the S&P 500 Index. The line on the graph reflects volatility for each trailing twelve-month period starting in January 1951 and continuing with each month to present. There are several insights from the graph. First, volatility is volatile; it cycles erratically over time. Second, periods of extremely high or low volatility often follow the other. Third, volatility tends to spend most of its time around the average (i.e., within 25% above or below the average).
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Volatility in Perspective
Is the current level of volatility “normal”? If so, it’s a new normal! The purpose of this presentation is to graphically put volatility into historical perspective. This report will be updated periodically as volatility itself is just too volatile to be ignored.
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Stock Market Returns & Volatility
This analysis presents an uncanny relationship between stock market performance and the volatility of the market. In the context of secular bull and bear markets, this relationship further emphasizes the need to consider risk as well as reward in an investor’s investment decisions.
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Earnings Trends: History & Future
This graph presents both (1) the historical trend for actual reported earnings per share (EPS), including a forecast by Standard & Poor's, and (2) an inset graph presenting the historical record for S&P's forecast over the past five years. To put the historical trend and future forecast into perspective, the graph includes Crestmont's assessment of the long-term baseline trend for EPS. Crestmont's baseline also puts into perspective whether current and forecast EPS are above or below the long-term trend for EPS.Note: the inset graph reflects S&P's EPS forecasts for recent years; forecasts begin about two years in advance and proceed until the year is finalized.
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