The Seven Questions Goldman"s Clients Have About "Rational Exuberance"

In mid-November, just days after Barclays released its 2018 equity outlook with the title "Rational Exuberance"...

... Goldman"s David Kostin decided that imitation was the sincerest form of unveiling a non-contrarian year-end forecast, and in presenting his revised S&P price target for 2018 of 2,850 - which accounts for GOP tax reform - "borrowed" the Barclays title for his own year ahead preview...

... despite admitting that valuations have never been higher, thus suggesting that contrary to the title, the exuberance is anything but rational.

To be sure, despite their hyperbolic titles, both Barclays and Goldman simply went with the sellside flow: in fact, in addition to Barclays and Goldman, Wall Street strategists polled by Barron"s said they expect about a 7% S&P gain for 2018 same as basically every single year, according to Sentiment Trader who points out that "they"re not stupid, they go with the base rate." Indeed, there is power in numbers, because if everyone is wrong about the year ahead, it is the same as nobody being wrong, something Wall Street discovered in 2007.

And yet, with not one but two banks mangling Alan Greenspan"s infamous words to justify their late cycle bullish outlook which both admit is not deserved on a fundamental basis, Goldman"s clients remain confused, and in his Weekly Kickstart, Goldman"s chief equity strategjst David Kostin writes that he has spent the last two weeks meeting with investors to discuss his outlook for US equities in 2018, including the impact of tax reform.

"Our Nov. 21 report, entitled Rational Exuberance, describes our expectation that 14% EPS growth, driven by healthy economic growth and a 5% boost from tax reform, will lift the S&P 500 index to 2850 by year-end 2018 (+8%)."

While it will hardly come as a surprise, Kostin confirms that as we reported last week most investors remain exceptionally bullish despite the all time high in the S&P and despite record valuations, instead betting that the Fed will always step in to keep the upward mometum in risk assets; still while "most clients agree with our bullish sentiment but they questioned several of our specific views."

Below Kostin addresses seven of the most common investor questions prompted by his forecast, or specifically the things Goldman"s clients think is irrational about "rational exuberance.":

1. How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high? Although the median S&P 500 stock trades in the 99th historical valuation percentile, valuations are typically poor indicators of short-term returns. Moreover, in contrast to the “irrationally exuberant” market of the late 1990s, today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy. Nonetheless, earnings growth, rather than higher valuation, drives our 2018 forecast. 

 

 

2. If the out-of-consensus US Economics forecast for the Treasury yield curve is wrong and rates stay low in 2018, could equity valuations rise further? The “melt-up” scenario of a forward P/E that rises to 19x or 20x is possible, but unlikely. Our forecast for a stable 18x forward P/E multiple at year-end 2018 assumes the economic expansion continues, ROE rises, and the equity risk premium (ERP) narrows. However, in contrast with market pricing (2 hikes) and almost every client we have met (2 or 3 hikes), our economists expect the Fed will raise rates four times next year as the labor market tightens and inflation firms. A rising term premium should lift the 10-year Treasury yield to 3.0% and restrain further P/E multiple expansion.

 

3. Why did you downgrade the Information Technology sector when it has twice the sales growth and twice the margins of the rest of the S&P 500? The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade. However, we recommend a Neutral weight (24%) in the sector due to strong fundamentals. Investors with sufficiently long investment horizons may find policy-driven weakness an opportunity to add to positions in the sector’s strongest secular growth constituents, which we believe remain attractive. We recommend overweight positions in Financials and Industrials. Both sectors pay above-average effective tax rates and are likely beneficiaries of tax reform. In addition, each sector has fundamental tailwinds such as deregulation and rising capex spending that should boost earnings in 2018.

 

4. Following value stock outperformance during recent weeks, do you still recommend growth as a style in 2018? Concentrated positioning and correlation with the Technology sector are clearly short-term headwinds to growth stocks. In fact, the  acceleration in already-strong US economic activity should have led value stocks to perform even better than they have during the past several months (Exhibit 2). However, our economists’ forecast of 2.5% US GDP growth in 2018 portrays an economic environment typically conducive to growth stock outperformance and suggests that our sector-neutral growth factor should fare well during the course of the year.

 

 

5. Is the equity market already pricing the full impact of tax reform? The prediction market shows roughly 80% odds of passage. Equity market indicators such as Altaba (AABA) and our High Tax Rate basket (GSTHHTAX) send broadly similar signals. However, lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store.

 

 

6. What does the Senate proposal to delay the tax rate cut until 2019 mean for S&P 500 earnings and performance? The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut. However, we expect the net 5% boost to future earnings will be unaffected, as would our 2019 EPS estimate of $158. The likelihood that companies pull forward capex and other expenses into the higher-tax year of 2018 may even boost economic activity and provide a net 2019 earnings benefit to S&P 500 companies beyond our current f orecast. In total, particularly against a backdrop of low discount rates, we expect little impact on stock performance from a potential delay in tax cut.

 

7. How big a risk to EPS is the Senate’s proposal to limit interest deductibility at 30% of EBIT? The proposal would have a minor impact on S&P 500 firms but pose a greater risk to more highly-levered small-caps. Consensus 2018 estimates show 5% of S&P 500 constituents but 15% of the Russell 2000 paying interest expense above 30% of EBIT. However, the proposal suggests incremental downside risk to buybacks and credit issuance as companies adjust corporate structures in response. In addition, the pro-cyclical proposal would have a much greater potential effect on US firms in environments of higher rates or weaker earnings; the current ratio of S&P 500 interest expense to EBIT is nearly the lowest in at least 35 years.

 

Finally, for those who have missed the barrage of year-ahead outlooks from Goldman in the past two weeks, here is a summary of what the world"s most influential bank believes will happen in the next 12 months: "We forecast the S&P 500 index will rise by 8% to 2850 by year-end 2018. EPS will benefit from tax reform and climb by 14% to $150 while the forward P/E multiple remains stable near 18x. Growth style will prevail over value and Industrials and Financials will outperform while Consumer stocks lag. Thematically, we prefer firms that prioritize investing for growth via capex and R&D. Most clients agree with our bullish sentiment but they questioned several of our specific views. Investors have a less hawkish view than Goldman Sachs economics on the bear flattening of the yield curve and implications for equity valuation and continue to focus on the implications of tax reform."

Six Ways US Stocks Are The Most Overvalued In History

Submitted by Mish Shedlock

US large cap stocks are the most overvalued in history. Let"s investigate six ways.

Crescat Capital claims US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000.

Their 25-page presentation makes a compelling case, with numerous charts. It"s worth your time to download and investigate the report.

Six Ways Socks Most Overvalued in History

1. Price to Sales


2. Price to Book


3. Enterprise Value to Sales


4. Enterprise Value to EBITDA


5. Price to Earnings


6. Enterprise Value to Free Cash Flow

Here are a few snips from the report.

Bear Market Catalysts

There are many catalysts that are likely to send stocks into bear market in the near term. A likely bursting of the China credit bubble is first and foremost among them. Our data and analysis show that China today is the biggest credit bubble of any country in history. We believe its bursting will be globally contagious for equities, real estate, and credit markets. The US and China bubbles are part of a larger, global debt-to-GDP bubble, which is also historic in scale, and the product of excessive, lingering central bank easy monetary policies in the wake of the now long-passed 2008 Global Financial Crisis. 

 

These policies failed to resolve the debt-to-GDP imbalances that preceded the last crisis. Now, easy money policies have created even bigger debt-to-GDP imbalances and asset bubbles that will precipitate the next one.We are in the very late stages of a global economic and business expansion cycle with investor sentiment reflecting record optimism typical at market peaks, a sign of capitulation at the end of a bull market. Crescat is positioned to profit from the coming broad, global cyclical market and economic downturn that we foresee. We strongly believe that our global equity net short positioning in our hedge funds will be validated soon.

Cyclical PE Smoothing

It is critical to use cyclical smoothing to accurately gauge market valuations in their current and historical context when using P/E.Yale economics professor, Robert Shiller, received a Nobel Prize in 2013 for proving this fact so we hope you will believe it. 

 

The problem with just looking at trailing 12-month P/E ratios to determine valuation is that it produces sometimes-false readings due to large cyclical swings in earnings at peaks and valleys of the business cycle. For example, in the middle of the recession in 2001, P/Es looked artificially high due to a broad earnings plunge. P/Es can also look artificially low at the peak of a short-term business cycle, which can produce what is known as a “value trap”, such as in 2007 during the US housing bubble and such as we believe is the case today in China, Australia, and Canada.

 

Shiller showed a method for cyclically-adjusting P/Es using a 10-year moving average of real earnings in the denominator of the P/E. Shiller’s Cyclically-Adjusted P/E, called CAPE multiples have been better predictors of future full-business-cycle stock market returns than raw 12-month trailing P/Es. Shiller showed that markets with historically high CAPEs lead to low long-term returns for long-only index investors. Shiller CAPEs are fantastic, but they can be improved by including an adjustment for corporate profit margins which makes them even better predictors of future stock price performance and therefore even better measures of cyclically-adjusted P/E for valuation purposes. 

 

.Shiller’s CAPEs simply need an adjustment for profit margins because margins are a key element of earnings cyclicality. We can understand this by looking at median S&P 500 profit margins in the chart below. For example, even though profit margins were cyclically and historically high during the tech bubble, they are even higher today. In the same spirit of Shiller’s attempt to cyclically adjust earnings to determine a useful P/E, CAPEs need to be adjusted for cyclical swings in profit margins.

When we multiply Shiller CAPEs by a cyclical adjustment factor for profit margins (10-year trailing profit margins divided by long term profit margin), we get a margin-adjusted CAPE that is not only theoretically valid but empirically valid as it proves to be an even better predictor of future returns than Shiller’s CAPE!

 

Credit goes to John P. Hussman, Ph.D. for the idea and method to adjust Shiller CAPEs for swings in profit margins.As we can see in the Hussman chart below, margin-adjusted CAPE, shows that today’s P/E ratio for comparative historical purposes is 43, the highest ever! The 1999 peak P/E was 41 and the 1929 P/E was 40. Once again, we can see that today we have the highest valuation multiples ever for US stocks, higher than 1929 and higher than 1999 and 2000!

Margin-Adjusted CAPE

It"s easy to discard such talk, just as it was in 2000 and 2006. People readily dispute CAPE, concocting all sorts or reasons why it"s different this time. The most common reason is interest rates are low. We also hear "stocks are cheap to bonds" which is like saying moon rocks are cheap compared to oranges. I do not know when this all matters. And no one else knows either. What I am sure if is that it will matter.

How?

I don"t know when, nor am I sure "how" it happens. It could play out as a crash or stocks can decline over a period of 6-10 years with nothing worse than a 15% decline in any given year, accompanied with several sucker rallies leading people to believe the bottom is in.

History Lesson

Some might ask: If you don"t know when or how, of what use is such analysis.The answer is that history shows this is a very poor time to invest in stocks. That does not mean, they cannot go higher(and they have).

History also suggests that people who invest in bubbles, start believing in them. People believe in bubbles because they have to, in order to rationalize their investments. Others know full well it"s a bubble but they think they can get out in time. Historically, few do because they are conditioned to "buy-the-dip" philosophy, and keep doing so even after it no longer works.

Yesterday, I noted Oppenheimer Predicts PE Expansion, Most Bullish S&P Forecast Yet.So if you are looking for a reason to stay heavily invested in this market, you have one. But don"t fool yourself, this is the most expensive market in history.

 

What If The "Exuberance" Is "Irrational"? Then Hold On To Your Hats...

As discussed earlier, Goldman"s entire S&P500 price forecast for 2018 and the next three years is based on two things: tax reform passing, but more broadly, something that David Kostin dubbed "Rational Exuberance", to wit:

“Rational exuberance” best describes our forecast for the trajectory of the S&P 500 during the next several years. Earnings drive stocks over time and should support the index rising to 2850 at year-end 2018, 3000 at the end of 2019, and 3100 by the close of 2020, representing a price gain during the next three years of 20%. Our price targets imply a modest expansion in forward P/E multiple to 18.2x at year-end 2018, a flat multiple in 2019, and a contraction to 18.1x in 2020.

As Kostin describes it, "rational exuberance" is defined by "above-trend US and global economic growth, low inflation, low albeit slowly rising interest rates, and underlying corporate profits boosted by pending corporate tax reform likely to be adopted by early next year."

So far so good, but as Kostin also explained, absent tax reform passing, the S&P will not only not hit 3,100 in 3 years, it may well be lower: "Assuming tax reform passes, we forecast S&P 500 adjusted EPS will jump by 14% to $150 in 2018. Equity investors will be rewarded as the index advances by 11% to 2850 at year-end 2018 and delivers a total return of 13% including the 2% dividend yield." Meanwhile, "If tax reform fails, S&P 500 will fall near-term by 5% to 2450."

It was not clear what would happen to Goldman"s 2020 S&P price target of 3,100 if tax reform does not pass.

What was clear is what would - according to Goldman - happen if the rational exuberance is, in fact, irrational. Here the bank notes that it is impossible to know ex post what flavor the current exuberance has: "Unfortunately, it is only in retrospect that one can definitively establish that assets have reached unsustainable levels. Greenspan was prescient, but three years early. Following Greenspan’s speech warning of the potential for excessive valuations, the S&P 500 subsequently more than doubled (+116%) during the next three years before the Tech bubble finally peaked in March 2000 at a forward P/E multiple of 24x."

So what would happen if the exuberance that awaits the S&P is, in fact, irrational? To that question, Goldman has a ready answer: "We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s."

In such a case, Goldman predicts that the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If slightly "less irrational" bubble over the next three years would mean stocks instead trade at a similar forward P/E to the Tech Bubble (24x), and would imply a year-end 2020 index level of 4050 (57% above today). During the three years post Greenspan’s speech, S&P 500 EPS rose by 26% ($40 to $50). Translated to today, Goldman calculates such a growth rate would imply 2020 EPS of $166 compared with our estimate of $163.

And for the visual traders, the light blue line in the chart below - i.e., the "irrational" one - would recreate the late 1990s exuberance in the context of today"s market.

7 Reasons Why Goldman's Clients Are Very Worried About An Imminent Crash

Over the years, the clients of Goldman Sachs have periodically found themselves on the verge of panic.

In March of 2015, we said that Goldman"s clients were most worried about the then-relentless crash in the EUR and how the resulting strong USD would hit US earnings (which, in retrospect, is ironic now that the tables have fully turned). Then In November 2015 we reported that "Goldman"s Clients Are Suddenly Very Worried About Collapsing Market Breadth" (and with good reason, the market was about to crash precisely for that reason). Several months later, Goldman"s clients were again confused - and worried - this time demanding that all their questions be answered before BTFD.

Then, in July 2016, Goldman"s clients again had a burning question: they were struggling to reconcile how extreme valuations of both equities and bonds can co-exist. As David Kostin explained one year ago, "client discussions reveal low portfolio risk coupled with concern that the rally lasts. Most investors have  been skeptical of the valuation expansion and have not participated in the 8% rebound from the post-Brexit low on June 27. Upside call buying has been a popular strategy to insure against upside risk." Additionally, Goldman clients were very worried that this remains a market without any earnings growth, and that much of the S&P upside has been due multiple expansion: "the S&P 500 forward P/E has already expanded by 70% during the past five years, exceeding all other expansion cycles except 1984-1987 (up 111%) and 1994-1999 (up 115%). Both prior extreme P/E multiple expansion cycles ended poorly for equity investors."

While it is unclear if said clients got over their concerns and got on with the BTFD program, what we do know is that since last July, already extreme valuations have only gotten more extreme, and as a result, Goldman clients are once again very worried, this time about an "imminent equity downturn" (banker euphemism for crash).

As Goldman"s chief equity strategist, David Kostin writes in his latest Weekly Kickstart, "the question every client asks: “Is an equity correction imminent?”

He then concedes that "Of course, at some point the S&P 500 will retreat"... but then gives two (painfully laughable) explanations why not just yet. First, however, he lays out the 7 reasons why Goldman"s clients are so fearful:

• 1. History. Many investors argue the bull market is “long in the tooth” and will soon come to an end. It has been 14 months since the S&P 500 index experienced a 5% sell-off and 19 months since the market had a correction of 10%. The last bear market defined as a fall in the index greater than 20% ended in 2009. The current bull market has lasted for 8.5 years and the S&P 500 has climbed by 260% compared with a 124% rise in earnings and a 64% P/E multiple expansion to 18x forward EPS.
   


• 2. Volatility (or lack thereof). Realized 3-month vol is nearly the lowest in 50 years. Implied vol as measured by the VIX stands at 12, a 6th percentile event since 1990. In his recent book, Tectonic Shifts in Financial Markets, the legendary Salomon Brothers economist Henry Kaufman (with the superb sobriquet “Dr. Doom”) references the lesson of Sherlock Holmes in “The curious incident of the dog in the night-time” that what doesn’t happen matters as much as what does. Low volatility across asset classes may be masking risks that are not evident today but will be obvious in retrospect.


• 3. Valuation. Equity valuations are stretched on almost every metric. The typical stock trades at the 98th percentile and the overall index at the 87th percentile relative to the past 40 years. Only on a Free Cash Flow (FCF) yield basis is the market valued at an average level (4.4%). But as we detailed in a recent report, the collapse in capex spending explains the FCF yield. On a cash flow from operations basis the market trades at the 87th percentile. Other asset classes are also highly valued vs. history: nominal Treasury yields (92nd), real yields (75th), and HY (75th) and IG (69th) spreads.
  


• 4. Economics. The current US economic expansion just celebrated its 8th birthday making it one of the longest stretches without a recession. Only the 10-year expansion during 1991-2000 and the 9-year expansion from 1961 to 1969 had longer durations. The median length of the 16 expansions since 1921 has been 42 months. Along with the question about an equity correction, another frequent inquiry is “when will the next recession occur?” Our economists assign an 18% probability of a recession within 12 months.


• 5. Fed policy. The FOMC has lifted the funds rate by 100 bp since it started tightening in December 2015. During prior hiking cycles, equity P/E multiples typically fell but multiples have actually expanded during the past two years. Futures imply one hike by year-end 2018 vs. our economists’ estimate of five. The uncertain pace of further tightening is a cause of much investor anxiety.
   


• 6. Interest rates. Two months ago, Treasury yields equaled 2.4%, ten-year implied inflation was 1.7%, and the S&P 500 stood at 2410. Our year-end forecasts of a 2.75% bond yield and a 2400 level in the S&P 500 looked rational. However, weaker-than-expected inflation data sparked a 35 bp drop in bond yields to 2.05% and a 2% stock market rally to 2465 (+10% YTD). Looking ahead, we maintain our year-end 2017 target (-3%).


• 7. Politics. President Trump’s fluid positions on domestic policy disputes in Washington, D.C. and geopolitical gamesmanship with Pyongyang and Beijing make political forecasting a precarious activity. One fund manager cited the “Law of Conservation of Volatility” under which there is a finite amount of uncertainty in the world. All the risk is now concentrated inside the Beltway and volatility outside of politics is close to zero. Of course, this could change at a moment’s notice.

As Kostin further adds, "investors cite the points above to justify their forecast of a looming correction. According to their narrative, high valuation leaves little room for error. A Fed tightening despite low inflation will spark concerns about the sustainability of economic expansion and lead to a jump in vol that may be compounded by a political event that in turn will spark a wave of selling. As factors reverse performance, quant funds will liquidate positions putting additional downward pressure on share prices and driving indices lower."

So what is Goldman"s response to these 7 very valid concerns? In a nutshell, "don"t worry and just BTD" or as Kostin puts it, "because investor euphoria is non-existent, an imminent start of a long decline seems
unlikely."

Skepticism abounds with normal 3% mutual fund cash positions. However, a sturdy consumer accounts for 69% of US GDP and buybacks remain persistent. Firms with high growth investment ratios have durable prospects even in the event of a market hurricane.

Sturdy consumer? Strong Buybacks? Has Kostin seen either of these two charts proving that neither of these statement is true, first the worst retail sales in nearly 4 years...

... or at least SocGen"s chart showing the biggest drop in buybacks since the financial crisis?

. 

Maybe Goldman clients should add an 8th concern: a grossly incompetent advisor. 

In any event, for those who enjoy having their hand held and buying stocks which trade at the 98th percentile in valuations, hoping for even higher prices, this is who Kostin "rationalizes" his grossly wrong assessment:

Although the preceding sequence of events could happen, we view it as a low probability event in the near-term for two key reasons:

First, investors are not complacent. In Sir John Templeton’s timeless observation, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Investors today are situated between skepticism and optimism. Few are euphoric as 27% of core managers are beating their benchmark. “Tormented bulls” best describes investor mentality. Alpha-seekers have normal cash positions (3.2% of mutual fund assets), active manager redemptions are offset by beta inflows (ETFs), and corporates continue to repurchase shares.

Second, US economic growth persists led by consumers that account for 69% of GDP. Monthly job growth has averaged 175K YTD, wages are rising (our leading indicator is a 2.7% rate), confidence is at the highest level since 2001, and household balance sheets are the strongest since 1980. For corporates, S&P 500 sales and EPS will rise by 5% and 7% in 2018. “Firms of tomorrow” with Growth Investment Ratios averaging 91% of CFO in past 3 years (vs. S&P 500 median of 17%) will grow 2018 sales and EPS by 7% and 12% and will outperform should a market hurricane occur (GSTHHGIR).

In short: yes, the market should crash, but because investors are not complacent (just don"t look at the VIX), and because the economy is so strong (just don"t look at the 10Y), everything will be fine.  Surely this optimistic bias would lead Goldman to at least expect some upside from here in the S&P? Well, no:

• "We expect the S&P 500 will end 2017 at 2400 (-2.6)%."

And scene.

Dear David: a) you are not even trying any more, and b) in your next weekly letter, can you please just let us know how much more Goldman"s prop desk has left to sell before it pulls the rug out of the market. Thanks.

The Stock Market Is Like Yellowstone: "It's Beautiful, But It Has A Volcano Underneath It"

Authored by Mac Slavo via SHTFplan.com,

Anyone putting money in the stock market at this point should have their head examined. The fact that the stock market had reached a record high for the ninth day in a row should be enough for any rational person to see that we’re in a bubble of massive proportions. But there’s also the fact that all of the big players in the investment community are backing out of stocks like there’s no tomorrow.

Sovereign wealth funds are pulling their money out of stock markets in developed countries, corporate insiders are selling stocks in their own companies, and infamous investment companies like Goldman Sachs are admitting that there’s a 99% chance that the stock market won’t keep rising like this in the near future. Berkshire Hathaway, the 7th largest company in the S&P 500, is sitting on a $100 billion dollar pile of cash that grows year after year, because as the stock market climbs to new heights, there aren’t many attractive investments left. You can’t buy low and sell high when there are no lows, and that should say a lot about current state of the economy.

The latest damning report on the stock market comes from Barry James, the president of James Advantage Fund. In a recent interview with CNBC he compared the global market to Yellowstone National Park.

“It’s beautiful, but it has a volcano underneath it.”

“Even though [the market] looks beautiful - setting new highs, good momentum, and earnings have been coming in strong, [there are] things to worry about,” explained the portfolio manager recently on CNBC’s “Futures Now.”

Aside from the rise of passive investing, which James says is creating a “herd mentality” among investors, he also believed that the earnings picture isn’t telling the whole story.

“In the 18 months ending in June, we saw companies that had no earnings, they were losing money, outperform those that were making money,” said James. He highlighted many stocks’ performances this year may not be reflective of their revenues.

And when you look at the data behind these stocks, you’ll find that we’ve been down this road before, and it’s not pretty. Much like Goldman Sachs’ prediction that the market simply cannot sustain itself at this rate, James sees evidence that we’re in for a crash sometime in the next year.

But the biggest threat to the market rally, according to James, is the current valuation levels of stocks.

“We went back to 1994 and researched team data that said [that if we look at cyclically adjusted P/E, one out of two times] the market was down in the next 12 months, and about one out of three times it was down more than 10 percent,” he said.

The stock market has defied all expectations for years. We’re in the one of the longest bull markets in history, which has also coincided with some of the worst economic growth numbers ever recorded, and that obviously isn’t sustainable. Every day that passes, the odds of our economy crashing go up a little more, and the investors who know this are getting out while they still can.

The Difference Between "Old" And "New" Retail? A Record 50x PE Turns

In the battle between "old" (bricks and mortar) and "new" (online) retail, few will survive although according to the market, the winner couldn"t be more clear.

As BofA"s Savita Subramanian writes in her latest relative value cheat sheet report, "retailers compete for share of the total consumer wallet, and it is old news that online retailers have continued to take share from traditional brick and mortar retailers." Nowhere is this more obvious than in the near-50x multiple point forward P/E spread between "New" (65x) and "Old" (17x) Retail, which is close to a record high (Chart 1). New Retail"s multiple expansion has pushed the P/E of the overall retail group to another near record high of 26x.

In the context of the broader market, this puts retailers at a 46% premium to the S&P - more than double the historical average premium of 17%.

Why the gaping disconnect?

There are two possible explanation: i) the market may be ascribing too much growth to the online group, or ii) is double-counting future profits by giving full credit to New Retail for market share gains without taking it away from Old Retail. However, in a surprising twist, BofA calculates that assuming a reversion to the historical 17% market premium for the total retail group, "one-fourth of the total group"s future earnings (or one-third of Old Retail"s future earnings) may be being double-counted."

Looking at it another way, if the market is fairly discounting the combined group"s future earnings potential, based on the overall retail group"s current P/E of 26x, then given that New Retail makes up nearly half of the combined market cap today, it should also make up half of the total group"s future earnings potential vs. just 18% of current earnings that it represents today. That implies that 35% of Old Retail"s current earnings would eventually need to shift to New Retail.

Taking this one step further, since "new" retail is mostly Amazon, what BofA is suggesting, is that just based on current valuation, the market is either flat out wrong, which would hurt "online" retailer earnings, or it is already pricing in one company (AMZN) generating half the earnings of the entire sector, which may not be the definition of a monopoly, but is getting perilously close, if only for Jeff Bezos.

Hedge Fund CIO: "We’ve Realized Roughly 3 Years Of Gains In The First 6 Months Of 2017"

As part of the local Sunday ritual, here is Eric Peters with his latest Weekend Notes, providing some context on recent, and not so recent market moves.

Weekend Notes

“US stocks rise roughly 7% per year,” he said. “Same holds true for Australia; basically, for all economies uninterrupted by catastrophic war at home.”

The 7% roughly equals 5% nominal GDP growth plus an extra 2% which is due to the S&P 500 index periodically kicking out bad companies and replacing them with better ones.

“Sometimes the market runs ahead of this 7% rate of return, which doesn’t mean it’s the wrong price, it simply means it’s premature.” In a world of fiat money, high prices are never wrong, they’re only early. 

“It took fourteen years for the stock market to return to its 1968 highs,” he continued. “And at that point in 1982, with overnight interest rates at 20% and the S&P 500 price-to-earnings multiple at roughly 8, the market still had miles to run.”

By the year 2000 with the S&P 500 P/E multiple at roughly 29, it was kind of the opposite. Then roughly 13 years later, it broke back above that Jan 2000 high, with a P/E ratio of roughly 17.

Today the trailing P/E is roughly 26, with overnight rates 19% below the 1982 levels, and 4.5% below the 2000 levels. 

“So we’re obviously not at a similar point to 1982,” he continued. “But where are we?”

Nerds forecast a 3% a year S&P 500 returns for a decade. Quants say we’re in the top few percentiles of historical valuation across every asset class (except volatility).

The S&P 500 is up roughly 10% this year. Which means we’ve realized roughly 3yrs of gains in the first 6mths of 2017.

“At some point, you rally so much that your 10yr return forecast turns flat. At which point you could go sideways for a decade.” But roughly speaking, stocks either go up, or down.

Household Wealth Has Never Been Higher Relative To Income

For 45 years - until roughly 1994 - the average wealth-to-income of American households had held steady around 4.9x. Then the stock bubbles started, first under Greenspan, then Bernanke, and now, Yellen and really every other central bank, and as a result as of Q1 2017 for the first time in US history, household wealth reached a point where it is over 6.6 times larger than inflation-adjusted household disposable income in America.

As we showed earlier in the day, the surge in wealth, driven almost entirely by new all time highs in the S&P, pushed this measure of relative exuberance (think of it as the country"s price-to-earnings ratio) above the housing boom peak of mid-2000s and well above the dot-com bubble driven highs of the last 1990s.

As Alliance Bernstein economist Joe Carson recently wrote in a note: "Economic and financial history do not always repeat, but sometimes they do."

The logical next question is how much higher can this disconnect go, before something snaps?

The Five Largest Stocks Account For 42% Of The Nasdaq, And Why Goldman Clients Are Concerned

With the Nasdaq 100 index making new record highs on practically every day of 2017, and returning 32% during the past 12 months vs. "only" 19% for the S&P 500, Goldman"s clients are starting to  get concerned. And, as Goldman"s David Kostin writes in his latest weekly letter, increasingly nervous investors are asking "whether NDX outperformance will continue."

Some facts: "100 of the largest stocks in the composite index, reached an all-time high [Friday] (5646), along with the S&P 500 (2399). Information Technology is the best performing sector YTD in both absolute and risk-adjusted terms and has led both indices. Technology accounts for 58% of NDX versus 23% of the S&P 500 and largely explains the 870 bp YTD outperformance (16% vs. 7%; see Exhibit 1)."

While Kostin provides some details about his outlook for the relative performance of the S&P and Nasdaq, what is most notable about the recent disconnect between the broader market and the tech heavy index, is just how concentrated the Nasdaq has become.

As Goldman shows in the chart below, the Nasdaq is so concentrated at the stock-level, the five largest stocks comprising 42% of the index compared with 13% of S&P 500.

Further demonstrating the skew, the top 25 stocks of the Nasdaq 100 account for 72% of the index weight.

Apple (AAPL) alone accounts for 12% of NDX versus 4% of the S&P 500. The index weight of AAPL and its stellar performance explains roughly 25% of the 79 pp excess return of NDX vs. S&P 500 since 2009 (229% vs. 150%). Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), and Facebook (FB) are the next four largest stocks in both indices (Exhibit 2). Each of the five stocks has beaten the S&P 500 YTD, by an average of 16 pp, and together have contributed 56% of NDX and 33% of S&P 500 returns YTD.

And yet despite what has been a clear outperformance for the Nasdaq, Goldman which has been increasingly bearish on the broader market, has a soft spot for the tech sector. This is how Kostin explains why the Nasdaq juggernaut may continue:

Current relative valuation may restrain upside, but superior sales and EPS growth prospects coupled with a larger weight in Technology suggests NDX total return of +2% vs. -1% for S&P 500 in the next 12 months. Excess return of 300 bp would rank in the 41st percentile since 2002."

The relative valuation of NDX vs. S&P 500 is in line with the 10-year average and will curb the magnitude of further outperformance. The valuation of NDX vs. S&P 500 using EV/Sales is most predictive of future relative returns. Current relative EV/Sales is 0.4 standard deviations below the 10-year average (Exhibit 3). A return to this average would suggest 3 pp of outperformance. In contrast, NDX vs. S&P 500 trades 0.8 standard deviations expensive on an EV/EBITDA basis and 0.1 standard deviations expensive using forward P/E. Taken together, the current relative valuation of NDX versus the S&P 500 appears consistent with the past 10 years.

The performance of NDX vs. S&P 500 is dependent on economic growth, but exhibits low sensitivity to other macro variables. NDX vs. S&P 500 returns show low correlation with changes in inflation, interest rates, USD, and oil. However, NDX is heavily concentrated in growth equities and NDX vs. S&P 500 relative returns are positively correlated with our growth factor (see Exhibit 4). Our US Economics team expects 2017 US GDP growth of 2.1%. Our US MAP score, a measure of economic data surprises, is in positive territory. Growth stocks typically outperform in this type of economic environment. Seven of the 25 largest NDX firms (GOOGL, AMZN, FB, ADBE, NFLX, PYPL, and CELG) meet our secular growth criteria (see Secular growth stocks for a secular stagnation economy, Jul 21, 2016). However, a reacceleration or collapse in economic growth would pose a risk to further NDX outperformance.

The micro landscape favors NDX versus S&P 500. Looking into 2018, consensus forecasts faster revenue and EPS growth for NDX versus S&P 500. Superior sales growth (8.4% vs. 5.3%) and earnings growth (13.5% vs. 9.7%) represent key drivers for further NDX outperformance. Since the start of the earnings season, revisions to consensus estimates have been more positive for NDX than for S&P 500. Long-term NDX earnings growth prospects are strong relative to S&P 500 (19% vs. 12%). However, while the 2018 estimates favor NDX, 2017 estimates are mixed. NDX sales in 2017 are forecast to grow by 8.3% vs. 7.5% for the overall S&P 500 (5.3% excluding Energy), the smallest gap since 2008. Similarly, NDX earnings are expected to rise by 9.0% in 2017, versus 10.7% for the S&P 500 (7.7% ex-Energy).

And, to be sure, Goldman"s prop trading desk is more than eager to sell (or short) to any client one or more of the Top 5 companies that comprise nearly half the Nasdaq and whose market cap has never been higher.

Our GS research analysts have strong fundamental forecasts for the five largest stocks in NDX. Despite a slowdown in China, our Hardware team remains optimistic about AAPL’s upcoming product cycle and growth in services revenues. Our Software analysts forecast strong advertising revenue growth and exposure to the best secular trends in technology (mobile search, enterprise cloud computing) will drive 19% sales growth for GOOGL in 2018. The team is also upbeat on MSFT on the back of expense discipline and potential upside to out-year EPS. Our Internet analysts view FB as well-positioned in one of the best secular growth markets and expects 2018 consensus top-line estimates will climb from the current 28% towards their 30% forecast. The team believes consensus underestimates the revenue benefit to AMZN from the ongoing shifts to cloud computing and online retailing. They forecast 22% sales growth in 2018. The average return of the five stocks to their GS equity analyst price targets equals 19% versus 9% to the consensus targets.

What goes unsaid is that if central banks, like the SNB, can continue to create money out of thin air and continue bidding up names like AAPL, and the rest of the Nasdaq top 5, this trade is always effectively without downside.

Bubble Alert: Stocks Are Trading Based on Accounting Gimmicks and Fraud, Not Growth

Time to bust yet another hole in the “stocks are cheap” argument.

As we’ve already noted earlier this week, based on the only valuation metric that can’t be massaged, stocks are more expensive than they were in 2007 and on their way to tying the all-time high established in 1999.

Source: The King Report

Of course, few people use P/S to value stocks. Most people use Price to Earnings or Earnings Per Share (EPS), since this is meant to represent how expensive stocks are relative to the money a stockowner gains by “owning them.”

On that note, according to the “official data” the S&P 500 is sporting a P/E ratio of 25. This is supposedly “cheap” since it’s below the P/E ratios established in the past.

Unfortunately, this too has been shown to be a load of nonsense. As Lance Roberts has revealed, only 13% of today’s earnings per share results stem from actual “growth” via revenues. The rest are based on accounting gimmicks like buybacks, write offs and the like.

Put another way, 87% of earnings growth since the GREAT CRISIS has been the result of accounting gimmicks.

This is a 1 in 100 year type event. The fact that stocks have rallied to new all-time-highs based on this is like someone winning a Olympic Gold medal while hopping themselves up on every steroid imaginable.

The fall-out will be just as intense.

The below chart isn"t a pretty one, but it"s worth keeping in mind as stocks move ever higher into nosebleed territory based on accounting trickery.

This bubble, like all bubbles, will burst. And when it does, the market will crash, just as it did in 2000 and 2008.

We offer a FREE investment report outlining when the bubble will burst as well as what investments will pay out massive returns to investors when this happens. It"s called The Biggest Bubble of All Time (and three investment strategies to profit from it).

We are offering just 1,000 copies to the general public. As I write this a mere 99 are left.

To pick up your FREE copy...

CLICK HERE NOW!

Best Regards

Graham Summers

Chief Market Strategist

Phoenix Capital Research

Why Robert Shiller Is Worried About The Market

The last time Robert Shiller heard stock-market investors talk like this in 2000, it didn’t end well for the bulls.

As Bloomberg reports, Shiller says when markets are as buoyant as they are now, resisting the urge to pile in is hard regardless of what else might be happening in society.

“I was tempted to do it, too,” he says. “Trump keeps talking about a new spirit for America and so you could (A) believe that or (B) you could believe that other investors believe that.”

What Shiller will say now is that he’s refrained from adding to his own U.S. stock positions, emphasizing overseas markets instead. One factor that makes him cautious on American shares is the S&P 500’s cyclically-adjusted price-earnings ratio: While the metric is still about 30 percent below its high in 2000, it shows stocks are almost as expensive now as they were on the eve of the 1929 crash.

Shiller is not alone.

“I don’t generally call the entire market wrong -- investors are very smart, highly motivated individuals -- but I find it hard to say why stock markets are so un-volatile right now," says Nicholas Bloom, a Stanford University economist who co-designed the uncertainty gauge with colleagues from the University of Chicago and Northwestern University.

For Hersh Shefrin, a finance professor at Santa Clara University and author of a 2007 book on the role of psychology in markets, the rally is just another example of investors’ remarkable penchant for tunnel vision. Shefrin has a favorite analogy to illustrate his point: the great tulip-mania of 17th century Holland. Even the most casual students of financial history are familiar with the frenzy, during which a rare tulip bulb was worth enough money to buy a mansion. What often gets overlooked, though, is that the mania happened during an outbreak of bubonic plague.

“People were dying left and right,” Shefrin says. “So here you have financial markets sending signals completely at odds with the social mood of the time, with the degree of fear at the time.”

But while the academics can look back and study and reflect on the nature of bubbles, the Wall Street types will always find excuses:

“It’s been a period of repeated shocks, and I think people get toughened against that,” Ethan Harris, Bank of America Merrill Lynch’s global economist in New York, says. “It seems like uncertainty is the new norm, so you just learn to live with it.”

We leave it to Mr. Shiller to sum it all up...

“The market is way over-priced," he says. "It’s not as intellectual as people would think, or as economists would have you believe."

Trade accordingly.

Goldman: Investors Will Soon Capitulate

After the inflation in P/E multiples has sent the S&P500 to to a level above the 90% percentile of all historical valuations, Goldman has called a time out, and says that there will be no more multiple expansion. As a result only one thing will push stock prices higher "as equity valuations compress as interest rates rise" - higher profits.

In his latest note, Goldman"s equity strategist David Kostin says that his tactical view remains that S&P 500 has peaked at 2400 and (unlike BofA"s recent flipflop which now expects the S&P to keep rising to 2,450 after earlier predicting a 2,300 year end target) will fade to 2300 by year-end. In fact, looking dead ahead, Goldman comes about as close as it has in recent months warning of an imminent market drop: "investors will soon capitulate on their expectation of upside to 2017 EPS forecasts as they face the reality that the accretive impact from tax reform will not occur until 2018. In fact, revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018."

But don"t worry: like other recent sellside notes, any imminent corrections (or crashes) will be a "buy the dip" opportunity, and thus Goldman keeps its year-end 2019 S&P 500 target at 2500, a 6% rise from the current index level and implies a forward P/E multiple contraction of 5% to 18x.

Below are some further observations on the current state of the market from Kostin.

Thursday marked the 8th anniversary of the current bull market, making it the second-longest on record. On March 9, 2009, the S&P 500 index traded at 677 and it now stands at 2365, reflecting a price gain of 250% or 17% annualized (19% annualized with dividends). Happy Birthday indeed!

But the current bull market is really a tale of two sub-cycles (Exhibit 1).

During the first phase (March 2009 to April 2011), the market rallied on the back of a rebound in earnings from the depths of the Global Financial Crisis. Higher profits accounted for 66% of the index’s 102% gain while P/E multiple expansion explained just 17% of the rally (faster expected EPS growth contributed the remainder; see Exhibit 2).

In 2011, the US only narrowly averted defaulting on the national debt. As Congress dithered over the debt ceiling, the S&P 500 plunged by 19%, just missing the 20% threshold typically used to define a bear market. Hence, some investors debate over whether the current bull market started from the low in 2009 or after the debt ceiling debacle in 2011. Since the market low of 1099 in 2011, the S&P 500 has climbed by 115%.

This second phase of the bull market has lasted more than five years and has been driven mostly by an increase in valuation rather than the level of profits. The adjusted P/E multiple climbed to 18x from 10x, explaining 71% of the rise in the index. Higher earnings accounted for just 28% of the rise.

After the inflation in P/E multiple, the S&P 500 now trades at the 90th percentile of historical valuation relative to the past 40 years. Current consensus forward P/E of 18.1x is the highest level since 1976 outside of the Tech bubble. The median stock trades at the 99th percentile vs. history.

The drivers of a bull market matter for investors. Some rallies are powered by earnings while others rely on valuation. Since 2011, real GDP expanded at an average annual pace of 2%, Fed funds hovered at extraordinarily low levels, and the valuation of stocks surged. However, looking forward, growth in an economy with limited slack will lead to rising inflation, higher interest rates, and a lower P/E multiple.

We are on the cusp of the Fed accelerating its pace of tightening. The Current Activity Indicator (CAI) from our US Economics team stands at 4.4% following the strongest ADP report in three years, above-consensus payroll gains of 235K, and an unemployment rate of 4.7%. Our wage tracker has accelerated to 2.8%. Next week we expect the FOMC will tighten the funds rate by 25 bp (to 0.75%-1.0%) and futures imply an additional two hikes during the remaining nine months of 2017 to roughly 1.4%. The 10-year US Treasury yield equals 2.6% and is marching towards our 3% year-end target.

 Continued US economic expansion will lift operating EPS by 13% to $127 by 2019 (adjusted EPS of $134). Our 2500 year-end 2019 target for the S&P 500 represents a 6% rise from the current index level and implies an adjusted forward P/E contraction of 5% to 18x from 19x, consistent with our forecast of higher interest rates. Simply put, only higher profits will support higher stock prices because equity valuations will almost certainly be lower.

Our tactical view remains that S&P 500 has peaked at 2400 and will fade to 2300 by year-end. S&P 500 has rallied by 11% since the election amidst optimism that corporate tax reform will increase S&P 500 earnings. However, investors will soon capitulate on their expectation of upside to 2017 EPS forecasts as they face the reality that the accretive impact from tax reform will not occur until 2018. In fact, revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018. There are only two drivers of stock performance when multiples stop expanding: (1) Earnings growth, and/or (2) expected earnings revisions.

Valuations Matter – Even For Millennial Investors

Submitted by Lance Roberts via RealInvestmentAdvice.com,

A friend reached out to me today and asked me a simple question:

“If the average person gets a $3000 tax refund every year and then invests the refund into the S&P 500, what would their end result look like?” 

No problem. All we need to do is make a few quick assumptions.

1. Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends. (This is important and we will return to this later.)


2. Given the lack of ability, and or desire, to save in younger years most people begin to get serious about saving money around 35 years of age on average.


3. We will assume a retirement age of 65 which puts our saving and investing time frame at 30-years.

As I stated, this is a relatively easy calculation which you can find regularly espoused throughout the majority of the financial media, blogosphere, and Wall Street as the promise of “passive indexing” persists.

Not bad. The $3000 per year savings plan grows to a nice lump sum of $500,000.

This clearly supports the long-held belief that if you have 30-years to retirement, just dollar-cost average into some index funds and you will be fine. 

You can stop reading now.

---

But What If The Entire Premise Is Flawed? 

If, as a millennial investor, you really want to save and invest for retirement you need to understand how markets really work.

Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:

• Lack of capital to invest.


• Psychological and behavioral factors. (i.e. buy high/sell low)


• Variable rates of return.


• Time horizons, and;


• Beginning valuation levels 

I have addressed the first two at length in Dalbar 2016, Why You Still Suck At Investing but the important points are these:

Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.

Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”


• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.


• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.


• Mental Accounting – Separating performance of investments mentally to justify success and failure.


• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.


• Herding– Following what everyone else is doing. Leads to “buy high/sell low.”


• Regret – Not performing a necessary action due to the regret of a previous failure.


• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.


• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity.  As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling.

This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.

However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.

Over any 30-year period the beginning valuation levels, the price your pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.

As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.

For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation adjusted, basis.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market than ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

“Price is what you pay. Value is what you get.” 

This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

So, with this understanding let me return once again to the young, Millennial saver, who is going to endeavor at saving their annual tax refund of $3000. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.

The red line is 10% compounded annually. You won’t get that but it is there so you can compare it to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The short fall between the promised 10% annual rates of return and actual returns are shown by in two shaded areas. In other words, if our young saver was banking on some advisors promise of 10% annual returns for retirement, he isn’t going to make it.

I want you to take note of the point made that when investing your money when markets are above 20x earnings, it was 22-years before it grew more than money stuffed in a mattress. Why 22 years? 

Take a look at the chart below.

Historically, it has generally taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.

The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future. 

Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.

But isn’t that what Baron Rothschild meant when quipped:

“The time to buy is when there’s blood in the streets.”

7-Steps To Long-Term Investment Success

With the market currently trading at the third-highest valuation level in history, only surpassed currently by the peaks in 1929 and 1999, you can only surmise what the outcome for our young saver will likely be.

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

• Expectations for future returns should be downwardly adjusted.


• The potential for front-loaded returns going forward is unlikely.


• Control investment behaviors and emotions that detract from portfolio returns is critical.


• Future inflation expectations must be carefully considered.


• Understand risk and control drawdowns in portfolios during market declines.


• Save money regularly, invest when reward outweighs the risk. 


• Expectations for compounded annual rates of returns should be dismissed 

Robo-advisors, passive indexing, etc. do not address these issues and will impair the ability of young investors to achieve their long-term goals.

Investing is not a competition. There are no awards for beating the market, but there are severe and lasting consequences for chasing markets where others fear to tread.

You are fine as long as there is a “greater fool” to eventually sell to. Just make sure that “fool” is not you.

How A Major Bank "Calculated" That 20x P/E Is Now "Fair Value"

Carbon-based traders of a certain vintage - which excludes today"s 20-year-old hedge fund managers - may recall a time when a 15x P/E was considered "fair." Not any more. In fact, according to a new analysis by Barclays" equity strategist Keith Parker, which tries to factor in so-called "animal spirits" as a driver of valuation has found that 20x P/E is perfectly normal and fair for the current market, further demonstrating just how deep into the goalseeking rabbit hole US capital markets have fallen.

First, to prove we are not joking, here is Barclays explaining why it is important to quantify animal spirits as a input factor of "permanently high plateaued" P/E multiples:

Core drivers of the P/E multiple and animal spirit indicators

In order to estimate the effects of “animal spirits”, or the potential effects of some of President Trump’s agenda, we first model the S&P 500 P/E using the core fundamental drivers of equity valuations. We then compare the residual from the model (actual minus fitted P/E) to various indicators of “animal spirits” or potential policy changes, including: tax policy, credit spreads, inflation, macro volatility, long-term growth expectations and corporate/consumer sentiment data.

Rates, growth and payouts are the core drivers of the P/E. Using a dividend discount framework, an equity price is the present value of future dividends. Dividing both sides of the equation by earnings, the P/E multiple is equal to the dividend payout ratio divided by the cost of capital minus the growth rate. Accordingly, the US 10y yield, US real GDP yoy and the dividend payout ratio explain 57% of the movement in the S&P 500 trailing P/E multiple from 1955 to 1997. We use the 1955-97 sample period because confiscatory tax policies prior to 1955 distorted returns to equity holders (excess profit taxes, etc), and thus affected valuations, while the 1998-2001 tech bubble would also distort results.

Other “animal spirits” indicators also affect the P/E, even controlling for the core drivers. Including the US 10y, real GDP and dividend payout ratio variables in each regression, we assess the statistical significance of other variables as it relates to the S&P 500 P/E.

The punchline: "Based on our findings we incrementally add other variables to build a more comprehensive P/E model, to better evaluate the potential effects of “animal spirits” on equity valuations"

At this point Barclays provides numerous pages of tortured, goalseek "empirical evidence" to extract the result it is after. What it "finds" is that what was once a "fair" 15x P/E is now really 20x P/E thanks to, drumroll, animal spirits.

Post-election rally closed the valuation gap with the P/E now near “fair”. The current fitted S&P 500 trailing P/E of 19.6x reflects the historical average of 15.2x adjusted for lower rates (+3x), lower dividend taxes (+2x), slightly higher analyst long-term EPS growth (1.4x), lower macro vol (+0.5x), lower dividend payout ratios (-2.6x) and the net of credit spreads and growth (+0.3x). Accordingly, the current P/E of 19.4x, although high by historical standards, is far from pricing excessive optimism, based on our model.

Here is Barclays" rationalization:

It is difficult to discern how the fundamental drivers are impacting equity valuations using current values, let alone trying to assess the potential ramifications of policy changes. As a starting point, we lay out how the variables in our model are affecting the fitted P/E relative to the historical average (Figure 14).

By separating out the drivers of the multiple, we are then better able to assess how policy changes may impact each variable and thus the P/E. The historical average trailing P/E is 15x.

• The US 10y yield at ~2.5% is much lower than the in sample average of 7%, which leads to a fitted P/E of 18x, all else equal.


• Lower dividend taxes than the historical average adds another 2x.


• Long-term EPS growth expectations using IBES data are now ~40bp above the historical average, which adds another 1.4x.


• Earnings flat-lined since 2014 and EPS moved slightly below trend, which adds 0.5x to the trailing P/E.


• Finally, inflation and IP volatility have been below historical averages, which adds another 0.5x.

On the negative side, dividend payout ratios are much lower than the historical average, which in turn reduces the fitted P/E by 2.6x. Real GDP growth is below average and is a 0.2x offset to the fitted P/E  value. Lastly, credit spreads are near the historical average.

Overall, the current fitted P/E is 19.6x based on the macro drivers of the multiple, compared to 19.4x for the actual P/E using broker adjusted earnings.

And here is Barclays" goalseeking exercise distilled to its undisputed visual glory:

And that, ladies and gentlemen is how sellside analysts use "animal spirits" to explain that a market which is valued 33% higher than historical average, is really "fairly valued."

What's Wrong With This Picture?

Turn on any mainstream business channel (or President Trump"s tweet stream) and you will be told how "awesome" everything is going to be... look at stocks, look at sentiment surveys, look at consumer confidence, look at small business optimism.

There is two small problems with all of this...

1) The "hard" data is not confirming the "soft" data at all...

Philly Fed beating by 10 standard deviations, NFIB small business optimism at record highs, but Industrial Production is dropping, real wages are shrinking, and the housing market is imploding.

And 2) Earnings Expectations are declining...

Do the analysts not pay attention to how awesome everything will be? Are the CEOs not adjusting expectations higher because of how great America is going to be again?

It appears not.

As Factset notes, the S&P 500 forward P/E is at its highest since 2004...

During the past week (on February 15), the value of the S&P 500 closed at yet another all-time high at 2349.25. As of today, the forward 12-month P/E ratio for the S&P 500 stands at 17.6, based on yesterday’s closing price (2347.22) and forward 12-month EPS estimate ($133.49). Given the high values driving the “P” in the P/E ratio, how does this 17.6 P/E ratio compare to historical averages? What is driving the increase in the P/E ratio?

The current forward 12-month P/E ratio of 17.6 is now above the four most recent historical averages: 5-year (15.2), 10-year (14.4), 15-year (15.2), and 20-year (17.2).

In fact, this week marked the first time the forward 12-month P/E has been equal to (or above) 17.6 since June 23, 2004. On that date, the closing price of the S&P 500 was 1144.06 and the forward 12-month EPS estimate was $65.14.

Back on December 31, the forward 12-month P/E ratio was 16.9. Since this date, the price of the S&P 500 has increased by 4.8% (to 2349.45 from 2238.83), while the forward 12-month EPS estimate has increased by only 0.5% (to $133.49 from $132.84).

Thus, the increase in the “P” has been the main driver of the increase in the P/E ratio to 17.6 today from 16.9 at the start of the first quarter.

It is interesting to note that analysts are projecting record-level EPS for the S&P 500 for Q2 2017 through Q4 2017. If not, the forward 12-month P/E ratio would be even higher than 17.6.

Even Factset sounds skeptical.