Monthly Market Muhsings - May 2021

Markus Muhs - Jun 07, 2021
May was a continuation of the year so far, with technology/growth lagging and the broader indices and various other sectors forging new highs. What worked really well last year isn't working so well this year and vice versa. Surprised?
I think, just like last month, the story in the table below is more around currency than anything else. We again see the Canadian dollar and Euro (both "risk-on" currencies) getting stronger, while the Greenback and Yen (both "risk-off" currencies) get relatively weaker. Commodities continue to soar—even gold taking part again—which largely plays in Canada's favor. With rising commodity prices and a weaker USD, it's surprising that emerging markets continue to be flat, but perhaps that's an opportunity for those of us investors seeking value and not the shiniest thing out there.
I didn't list crypto currencies on my table on the way up, and I won't now on the way down. This update is about investing, not gambling, anyway.
Today I want to touch on a subject that I've mentioned before in my market updates, and that is price/earnings ratios; PE ratios for short. They're coming up in conversation again, mainly from market perma-bears, or other people who want to sound smart prognosticating about the markets. As Morgan Housel once wrote, pessimism is more intellectually seductive than optimism. Just as smart sounding people get all the attention on nightly news shows these days, scaring us about the newest Coronavirus variants, those telling us how and why the markets will crash again also get more attention than us simpletons telling you the markets will go up forever (yet, on average, they have!).
Let's review what a PE ratio is first of all. Typically there are three different ratios that people refer to. All of them have the same numerator (P): a current share price or index level. It's the denominator (E, for earnings) that changes. Generally PE ratios are like two sides of a coin: on the one hand they may tell us that a stock or market is overvalued or undervalued, but on the other hand, markets are very efficient and a PE ratio tells us the market's expectations for future earnings. Growth stocks have higher PEs, because the markets expect higher earnings growth. Likewise, market indices generally have higher PEs during economic expansion than during recessions.
By default (if not otherwise specified), people are usually referring to a trailing twelve month (TTM) PE ratio, where share price is divided by earnings per share over the past 12 months. You can find a current PE ratio for the S&P 500 here. As I write this, on June 1st, it's registering a sky-high 44.67. What this means is that when buying the S&P 500 index you're paying almost $45 for every $1 of profit its stocks collectively earned over the past year. The long-term averages were around 15-16, so you can see why people are raising the alarm bells now, but we'll get back to that.
Another frequently used PE measure is the forward PE (FPE), which divides current share/index price by forward expected earnings (as calculated by analysts and company forward guidance). As an investment in stocks is generally seen as a long-term investment in the future cash flows of businesses, FPE might be a bit more relevant. The Wall Street Journal has a forward PE for the S&P 500 here, down the page under "estimate". As I write this, it's at 22.55.
Why the huge discrepancy between price over earnings of the past 12 months vs price over earnings expected over the next 12 months? We're in an especially unusual time now, due to the pandemic, where earnings of the past 12 months were severely hampered (in some industries, anyway) and are generally expected to be quite strong going forward. Just goes to show that either number on its own doesn't tell you that much about stock valuations; one says valuations are sky-high, the other only slightly overvalued.
There's another type of PE that intends to give us an average that is less affected by market cycles, called the Shiller PE Ratio, or "CAPE Ratio" (Cylically Adjusted PE). This one, at least until 2018/2019, tended to be significantly higher than the TTM PE ratio, as it divides price by the past 10 years of earnings (thus including record-low 2008/2009 earnings as part of the calculation). Today it's actually a bit lower, as the impact of 2020's earnings implosion isn't felt as much and those really low earnings years have dropped off.
By the graph below you can see that it too is historically quite high (over 37); almost as high as before the dot-com bubble burst in 2000, and significantly higher than prior to the Great Financial Crisis (2008), Black Monday (1987), or Black Tuesday (1929).
Here's where the negative Nancies are raising the alarm bells: PE ratios being this high in the past represented market bubbles, which burst in spectacular fashion.
Maybe they're right? The risk though is that someone could have made the same prediction in January 2018, when the CAPE was an also-high 33.31. At that time the S&P 500 was at around 2800. It's a whole 50% higher today! "Well, today's markets are more over-valued than ever and I won't invest in them!"
When we look at the long term compound annual growth rate of the markets—that wonderful number (8%? 10%? 5% real return? Whatever it is) that has contributed to the happy and dignified retirements of generations before us—we must keep in mind that the number is a blend of down markets, up markets, market crashes, and market surges. If we miss some of the up markets and surges, it can severely hamper our overall long-term returns.
In 1991 the Shiller CAPE was at a historically average 15. By May of 1997 it was double that. If 30 was your magic trigger to declare the markets "overvalued" and as a result, you pulled your money out of the markets, you missed the end of that bull market and another doubling of your investment (assuming it was an S&P 500 index fund you were invested in). That doubling, over a period of 3 years, was part of the long-term return. Missing it could have had serious consequences on your long-term average.
It would be impossible to time the markets based on any type of PE ratios. Let's just assume you did get out in 1997, at a Shiller CAPE of 30—when the S&P 500 was in the 800s—and then determined you would only get in once the CAPE was back below the average of 15. Yes, you would have actually gotten in perfectly in February 2009, which was the first time post tech-bubble that the CAPE actually went below 15 again (it stayed in the 20s throughout the early-2000s). At that time, the S&P 500 briefly dipped below the 800s. Would you, or could you, have actually waited that long? Or, might you have gotten tired of waiting after 10 years, seeing a reasonable CAPE in the mid to high 20s in 2007, on the back of strong earnings growth, and decided to get back in then (at an S&P500 level approaching 1500)? Despite the low CAPE, would you have gotten back in during the darkest days of 2009? The CAPE quickly broke higher than 20 again by the end of that year and has climbed higher ever since.
The bottom line is you should never try to time the market, least of all based on valuation ratios.
Where the ratio does help inform financial decisions is in setting the right expectations for longer-term growth. A high PE ratio signifies absolutely nothing as to where the market is headed over the next few years. A high PE might represent an overvalued market, or it might represent a very confident market that marches higher still; that part's a complete crapshoot. Over longer periods of time—decades or more—it has informed us pretty well on growth expectations though. There is a strong likelihood that today's higher than average CAPE predicates lower than average returns over the next few decades, so adjust your retirement plans accordingly.
I wouldn't count on the long-term historical ~8% average growth rate for U.S. stocks over the next few decades; a 4-5% return expectation might be more realistic. Let's put it to the test: a few months back I updated an old blog post listing A Lifetime of Reasons to Avoid Investing in Stocks, and in it included a table that showed the annualized growth rates of the S&P500 from that year to the end of 2020. Throughout the 1980s and early 1990s, the CAPE was relatively low and the rates of return ended up being 10%-11% from those dates onward. In 2000 though you can see what happened, if someone invested all their money a few months before the tech bubble burst, when the CAPE was 43.77 (Jan 2020): Not a 10-11% return, but a 6.6% return. In 2009 the CAPE was below 15 again, and an investment from that point forward yielded 15% annually. The Shiller CAPE is an excellent predictor of multi-decade returns.
Anyway, to close off my Muhsings for the month, before this post gets too long, what exactly can we do about it as investors today? Let's recap what we know: PE ratios of U.S. stocks are quite high. Can they go higher? Sure. The denominator in the equation seems almost certain to go higher—barring another black swan event—which means a slightly declining PE ratio can still mean a rise in market values.
The first and most important thing we should do with the information at hand is to ensure our financial plans are updated with the right growth expectations for stocks. If you last updated your retirement plan a decade ago, using 8% as your equity return expectation and 6% as your bond return expectation, it's time to update that thing! Presently the return expectation I use for U.S. equities in my financial plans is 4.38%; a default in my financial planning software that comes via Morningstar. 
Secondly, look beyond the U.S. Yeah, it's the hottest market and you did really well if you avoided international diversification over the past decade, concentrating mostly on U.S. equities. As it stands today though, almost anywhere else in the world the CAPE ratio is more reasonable. According to this site, at the end of 2020, Canada's CAPE was only 23. Japan's was 22. Western European countries are mostly in the teens. Globally the markets aren't that overvalued. At the same time, globally the markets aren't on the type of bull run the U.S. has experienced: Europe is mostly flat for the past 20 years, Japan's still in the negative for the past more than 30 years, even Canada has only just recently broken through its highs from earlier in the last decade.
Some of the emerging markets are incredibly cheap, and this gets back to my first paragraph on the markets, above. I think stocks in those parts of the world (the actual demographically growing parts of the world) are being largely overlooked. Sure isn't the euphoria around them we saw back in the mid-2000s. That's perhaps a topic for a future Market Muhsing, especially if they remain flat.
I think I've said my bit about PE ratios, and I'll leave it at that. As always, feel free to contact me if you have any questions, and subscribe to my eNewsletter to get updates on new posts as well as links to the other great stuff I read throughout the month.
Markus Muhs / CFP, CIM
Investment Advisor & Portfolio Manager