The latest from James Montier of GMO is a rundown on the current U.S. market valuation. Feel free to read that part, if you want (links are below).
I want to focus on his explanation of the factors that drive market returns and valuation. Because when you understand the factors, you can reach your own conclusions on where the market stands on valuation.
There are a lot of factors you can consider when doing this, but most are secondary. Besides, this isn’t rocket science, so let’s over complicate it. It’s best to keep it simple, which Montier’s does:
For any equity market, the return achieved can be broken down into four component parts. In the long term, the return is almost exclusively driven by dividends (growth and yield). Equity owners need to be compensated for providing capital to companies to help fund their long term investments. That compensation comes from the cash flows the companies generate from their risky investments via earnings and dividends.
The two other ways to make money from owning an equity asset class are from multiple (P/E) or margin expansion (collectively we call these elements the valuation components). Together these four components make an identity – we can (ex post) always decompose returns into these factors. In Exhibit 1, we show a return decomposition for the S&P 500 since 1970 based on these four factors (earnings, dividends, margins, and P/Es). Margins and P/Es are basically flat over this very long time period. As we stated above, over the long term, the returns achieved have been delivered largely by dividends.
But over the last seven years, P/E multiple expansion – investors paying more for a dollar of earnings than they did in the past – had the biggest impact on returns, with higher profit margins running a close second.
If earnings and dividends are remarkably stable (and they are), to believe that the S&P will continue delivering the wonderful returns we have experienced over the last seven years is to believe that P/Es and margins will continue to expand just as they have over the last seven years. The historical record for this assumption is quite thin, to put it kindly. It is remarkably easy to assume that the recent past should continue indefinitely but it is an extremely dangerous assumption when it comes to asset markets. Particularly expensive ones, as the S&P 500 appears to be.
The question then becomes, what would it take for the market to earn a good return, similar to the last seven years, going forward? P/Es and margins would have to continue to expand.
So what drove margin expansion? Off the top of my head, company cost cutting since ’08, stagnant wage growth, lower borrowing costs (i.e. falling interest rates), and productivity improvements helped earnings and profit margins in a good way. A turn in one or more of those might work against it.
So what’s the chance any of those continue to help margin growth as it has in the past? I’d bet on productivity improvements, but not the other three (cost-cutting has limits, rates are rising, wage growth is still a question mark). And there are probably factors I missed.
But it doesn’t matter what I believe. You have to decide this for yourself before considering the risks and deciding on the best course of action, if any, to take.
Now, P/E expansion is easier to explain. The market doesn’t always trade on facts. In the near term, it trades on investor attitudes. If investors feel good about the future, they’ll continue to invest at higher prices. All else equal, higher prices = higher P/Es.
In other words, the market can continue to move higher despite the facts.
If you don’t believe that’s possible, consider the latest trend. It’s become acceptable to look at the obvious and call it “fake news”.
People believe what they want to believe, select facts that fit their beliefs and ignore facts that contradict their beliefs. Which pretty much explains the cycle of booms and busts.
Anyways, this is a fun little exercise that helps you consider the potential risks in the market. Unfortunately, it won’t tell you when P/E multiples stop expanding and start to contract.
The S&P 500: Just Say No – GMO
- Seven Strategies for Investing at Market Peaks – B. Carlson
- The Rise of Market Power and the Decline of Labor’s Share – ProMarket
- Always Invert – Above the Market
- The Constants – C. Bilello
- Can You Short the Apocalypse? – Marginal Revolution
- The Butterfly Effect: Everything You Need to Know About this Powerful Mental Model – Farnam Street
- Business vs. Investing, with Jason Zweig and Morgan Housel (podcast) – Invest Like the Best
- The Worlds Most Successful People Do This Every Day – Quartz
- Eliminating the Human – MIT Tech Review
- The Awesome But Mostly Unknown Story of Carlsberg Beer in China – Part 1 and Part 2