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A Thin Line

by Victor K. Lai

2013 in review

It was an eventful year for the markets - records were set and turning points were made. After much anticipation, US equities reached new all-time highs. Home prices and interest rates seem to have finally turned the corner, leaving their lows behind them. Meanwhile, gold experienced an abrupt reversal and posted its worst price decline in decades. Figure 1 below shows the price performance for major asset classes in 2013.

Figure 1

Source: Yahoo Finance, BCM

With the S&P 500 up by more than 32% for the year, it seemed like investors just could not lose. Yet, the reality is that outside of developed market stocks, returns were not that great. In fact, four out of the six asset classes shown above had negative price performance for the year.

Good, bad, and ugly

As usual some of our opinions were good and some were bad, but we managed to come out ahead overall. Our cautions outlook on US stocks was just plain wrong. Not only were US stocks one of the best performing asset classes for the year, but real GDP growth was revised to a surprisingly strong 4.1% annualized rate for the third quarter.

On the flipside, our positive outlook on foreign developed market stocks worked out well. Like US stocks, they were one of the strongest performing asset classes in 2013, as measured by the MSCI EAFE index. Our negative outlook on emerging market stocks and gold were also spot-on. The MSCI EM index was down for the year, and gold prices experienced the ugliest performance since 1981.

Regardless of how strong our opinions are, we always recognize that we could be wrong -- that keeps us cautious and humble. That is also why we maintain balanced and diversified exposure across a broad range of global asset classes (albeit to varying extents). In 2013, that meant still having exposure to both equities and fixed income, despite our concerns about valuations and interest rates.

Moving forward, whether conditions are good, bad, or ugly, you can expect much of the same from us. We continue to maintain the same prudent and disciplined approach -- one that is focused on risk management and maintaining a long-term term perspective.

With that in mind, this letter focuses on one of the biggest risks we see ahead -- stock market valuation. It is nothing new, and you have read it from us before. Heading into 2013, we were concerned about valuations in US equity markets. Following an additional 30%+ climb, it should be no surprise that this concern has heightened further alarming now.

For the sake of not sounding crazy, or too much like a broken record, we want to provide a closer look at some of the measures and models we use. This will help shed some light how we form our opinions.

In practice, we do not rely on a single measure for stock market valuation. Instead, we use several different measures and average out the results. This prevents us from overreacting to insignificant abnormalities from any one measure. On the other hand, if all the measures we track simultaneously indicate abnormal conditions, then we have good reasons to be alarmed. Our criteria for which measures to use are very simple.

First, the measure must be logical. In other words, it needs to make rational sense. Just because it was raining the last time the S&P 500 had a big day does not mean the two have a causal relationship.

Second, the measure must be transparent. In other words, the underlying components of the measure must be observable, understandable, and available for analysis. We think mysterious “black-box” algorithms that require teams of rocket scientists to decipher tend to obscure more than clarify.

Third and last, the measure must have a track record of relevance. Of course, accurately and consistently predicting the future is impossible - and no measure, model, or indicator is perfect. We just mean to say that the measure, on average and over time, should show a relationship with subsequent market performance that is at least better than totally random.

With that in mind, let us look at a few different measures that meet our simple criteria, and that we follow here at BCM.

Fair value and common sense

To start, let us be clear that valuation is a terrible tool for market-timing, or for precise predictions about market tops and bottoms. Just because something looks expensive does not mean its price cannot rise even higher. In fact, stock market prices often reach levels that are well beyond underlying fair value. Our objective is not to predict when price moves will happen (we recognize that we simply do not know), rather our purpose is to determine is market prices are generally cheap or expensive relative to underlying fair value.

Fair value is a moving target, but intuitively the current intrinsic value of any asset should be the present value of its expected cash flows. For example, an investment that pays $1 in dividends per year and will be redeemed for $100 after 5 years should be worth $105 today. Of course we would need to discount that figure for things like inflation and risk to reach present value - but the basic concept should make sense.

In the same way, we can estimate a fair value for the stock market, which is simply the present value of expected earnings, dividends, cash flows, or whatever measure is preferred. Over time market prices seem to move with fair value reasonably well. However, as noted before, they can also deviate significantly above or below fair value at any given moment. Jeremy Grantham, CIO at GMO, shows this well with a chart, reproduced in Figure 2.

Figure 2

Source: GMO

The black line represents fair value for the S&P 500 over time based on dividends and a real discount rate between 6% and 7%. The red line shows historical real prices for the S&P 500. The blue GDP line shows historical real GDP. Notice that fair value has grown with GDP fairly consistently over time. On the other hand, stock market prices (the red line) have experienced wide swings around fair value. In fact, roughly one-third of the time, stock market prices were more than 19% away from fair value.

The point to understand here is that while stock prices can deviate from fair value, they have always reverted back to fair value. Though the timing of reversion is utterly impossible to predict, it is also utterly certain to happen.

As of now, stock market prices are clearly well above the fair value implied by historical trend. What if market prices move higher? Well, they certainly could and the “what-ifs” are always possible. I think what is more important, however, is to recognize that market prices will revert to fair value – that is not an “if,” but a “when.”

There is only one of two ways for that to happen. First, the stock market’s fair value and economic growth could suddenly step up to levels that have been historically abnormal and unsustainable. Or second, stock market prices could fall back towards the fair value implied by growth rates that have been historically consistent.

If history is any guide, and if for no other reason than simple common sense, I think we know what to expect. In that sense this measure of valuation is flashing red.

A Nobel Laureate’s perspective

One of the most common and popular relative valuation measures for the stock market is the Price to Earnings ratio (or P/E ratio). In previous letters, we have reviewed different versions of the P/E ratio as well specific issues with each. To keep things concise, suffice to say that it makes sense to use a version that “normalizes” earnings volatility caused by booms and busts in the business cycle.

One of the most widely-used of such measures is the Cyclically Adjusted Price to Earnings ratio (or CAPE ratio), developed by Dr. Robert Shiller (who won the Nobel Prize in Economics for work related to irrational stock market prices).

The CAPE basically compares the current market price of the S&P 500 to its average earnings over the past ten years, all adjusted for inflation. Figure 3 below shows the CAPE (in blue) over time along with long-term interest rates (in red). Currently the CAPE is over 25. This is not as high as the all-time record reached in 2000. However, it is clearly above the long-term average level of 15 to 16.

Does that mean prices cannot go any higher? Of course not – the CAPE could set a new all-time high for all we know. Yet even if it did, that may not be good for the equity markets since extreme overvaluation is typically followed by extreme crashes -- like those that followed the technology bubble and financial crisis. Looking back in time, history’s worst bear markets have occurred after the CAPE reached valuation levels beyond 20.

Figure 3

Source: Robert Shiller

There is criticism about Shiller’s method. One of the most resounding is that the CAPE’s 10 year look-back results in an inherently conservative earnings figure (as earnings generally grow over time).

While that may be true, it is not an issue if your process for looking back and being conservative is consistent over time. In that case one conservative measure would be compared to another equally conservative one. In relative terms it is the same as comparing two aggressive measures.

Problems arise when people try to compare two disparate measures that are not appropriate for comparison to begin with – for example, comparing a forward P/E measure to the CAPE. Criticism based on that kind of “apples to oranges” thinking simply does not compute.

Dr. Shiller’s CAPE, on the other hand, is not only rationally sound, but has also been a historically reliable measure of whether markets are over or under-valued. As of now, this measure is flashing red. If history is any guide, we think prudent investors would be wise to heed the CAPE’s warning.

The Oracle’s favorite measure

Legendary investor Warren Buffett, the great “Oracle of Omaha,” stated during an interview in 1999 that he considered one stock market indicator as the “single best measure of where valuations stand at any given moment.” That measure is the ratio of total stock market value to gross national product, or Market Cap to GNP. Since then it has been commonly referred to as Buffett’s favorite measure.

In many ways this measure is similar to the Price to Earnings Ratio. In this case “Price” is represented by the total value of all US stocks (instead of just a group like the S&P 500) and “Earnings” is represented by the total value of goods and services produced by Americans (instead of just earnings produced by S&P 500 companies). In other words, we can think of the Market Cap to GNP ratio as an aggregate P/E for the entire economy at large. Since the measure is not “normalized,” it reflects a current snapshot of market valuation (versus a historical perspective like the CAPE).

Intuitively, the ratio makes sense as being a fair gauge of current valuations at the most aggregate level. Its popularity has led to many different versions and interpretations of the measure. For example, one version that is often used is the ratio of S&P 500 Price to GDP. While similar – this really is not the same thing.

First, the S&P 500 represents roughly only about 85% of total US stock market capitalization. Also, it is heavily weighted towards large and mega cap stocks. Second, GDP is not the same as GNP. GNP captures the value of goods and service produced by Americans regardless of where they are domiciled (whereas GDP only captures domestically produced goods and services).

The correct measure, in our opinion, should be expressed as the ratio of the Wilshire 5000 Index (which is the broadest measure of the entire US stock market) to Gross National Product. A historical look of this measure is shown in Figure 4. Buffet has noted that the measure should be less than 1, under normal conditions. Historically, the ratio has averaged 0.70.

Currently, the ratio is at 1.13. While that is not as high as it was in 2000, the current ratio has earned the distinction of being at the second highest level on record (since data has been available). Though the Oracle has not sounded any alarms about this, we know that the ratio is more than 50% above its long-term norm and what would be considered fair value. To that end, this measure corresponds with the others to indicate that stocks are significantly overvalued.

Figure 4

Source: FRED, BCM

No coincidence

This last bit of information is not something that we track normally or something that we rely on to make decisions. It is however, interesting and seems too timely to be a coincidence, so we wanted to share it. Figure 5 is a chart from BlackRock that shows the opinions that the world’s big banks have about stocks versus bonds for 2014 Green represents an overweight (or bullish) opinion and red represents an underweight (or bearish) opinion.

Figure 5

Source: BlackRock

The opinion is unanimous. Literally every big bank on “the street” has a positive outlook on stocks (green) and a negative one for bonds (red). Historically, this type of wide spread, consensus-thinking is a hallmark for unexpected and contrarian outcomes. And of course, coincidentally, all this “green” on the sell-side comes right as all of our indicators are flashing bright red. Does that mean a stock market crash is eminent? No, of course not, the consensus may very well even be correct. However we think there is a good chance that at least one of these unanimous calls will be wrong.

A thin bottom line

Overall, our opinion on stock market valuation remains cautious, but even more so than last year. It is worth repeating that valuation is a blunt tool that is not effective for market-timing or for making precise predictions. On the other hand, valuation is very useful for understanding whether prices are generally high or low -- something that should be fundamental to any investment decision. Based on historically reliable measures of market valuation, we continue to think that US stock prices are high.

Of course valuation alone isn’t enough to rule out stocks. Both economic conditions and investor sentiment could push prices higher still. And regardless of what anyone’s models or indicators say, the market moves how and when it wants. Investors are mostly just along for the ride, swinging back and forth over the thin line that separates right from wrong, fear from greed, and brilliance from insanity.

Though we cannot predict when, we are confident that valuations will revert – ultimately driven by price declines rather than improving fundamentals. Until that happens, we may look crazy, scared, and on the wrong side. However, when all is said and done we will be early and careful more than anything -- and we are fine with that.

From a prudent, long-term perspective, the implication is to be cautious with your equity exposure. We are not advocating that you eliminate it, but be careful to keep it in check, especially if it is overweight relative to strategic targets. In that case, use this as an opportunity to rebalance and “take some money off the table.” More generally speaking, our best recommendation for prudent, long-term investors is to maintain balanced and broadly diversified portfolios regardless of what markets may or may not do. Those portfolios should be designed according to your goals, needs, and circumstances as part of a coordinated and comprehensive financial plan. To that end BCM is here to help. Thank you for reading, and please feel free to contact BCM with any questions.

Be Great,

Victor K. Lai, CFA

Bellwether Capital Management LLC (BCM) is a registered investment adviser (RIA). It provides investment management and consulting services for people and organizations. Please visit to learn more.


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