Valuation Investing

This year has been the year of broken records for the S&P 500, and the string of wins continued last week. The S&P 500 finished October with a positive total return, which means it has gained ground in all ten months of the year for the first time in the 90 years of S&P data. October also marks the twelfth consecutive positive month for the index, which equals a record set only twice before, in 1935 and 1949.

With a long list of historic records being smashed, there is no shortage of “gurus,” bloggers, and media types calling for anything from a pullback to an outright crash in U.S. equities. The primary rationale attached to these claims is “over-valuation.” This type of thinking is a great reminder of why it’s critical to always remain data-dependent in financial markets.

To be clear from the outset, I’m not one of the many perma-bull U.S. equity cheerleaders who believes it’s always a good time to invest in the S&P. Rather, I’m perma-agnostic, letting the data and my Gravitational Framework tell me whether to be bullish, bearish, or completely out of a given market.

From August 2015 to September 2016—57 weeks—I carried a bearish bias on the S&P 500. This bearish bias came after carrying a long or neutral bias in 138 of the prior 141 weeks.

Since last September I’ve been back on the long side, and right now economic and financial market data, along with my Framework, are saying there is only one way to continue to trade the S&P.

 

Shiller Says What?

A lot of valuation practitioners like to quote the Shiller P/E Ratio when they talk about markets being “overvalued.”

Over the past 40 years, the average Shiller P/E ratio has been 21.6. For the sake of our evaluation, let’s assume that a Shiller Ratio reading that is 1 standard deviation above the 40-year average is “overvalued” and any reading 1 standard deviation below the average is “undervalued.”

Here’s how the data stacks up for an “overvalued” market: Average monthly return = +0.83%; Percentage of positive months = 58%; Worst monthly return = -14.6%; Average losing month = -3.9%.

For an “undervalued” market the stats are as follows: Average monthly return +0.82%; Percentage of positive months = 56%; Worst monthly return = -22.0%; Average losing month = -3.6%.

You can see that the statistics for the two different valuation regimes are very similar, which highlights the problem with considering valuation to be a stock market catalyst. Even if valuation has some impact on the direction of the S&P 500, it’s minimal to say the least. Not to mention that historical returns indicate that investors should prefer an overvalued market to one that is undervalued.

This leaves us with the $64,000 question: if valuation isn’t a downside catalyst, then what is?

There are three critical forces, or gravities, that impact asset prices: Fundamental, Quantitative, and Behavioral. However, the most important factors influencing the return and risks of asset classes are the trajectory of economic growth and inflation, and how central banks respond to those conditions. This is what I call an economy’s “Fundamental Gravity.”

The Fundamental Gravity for the S&P 500 has been bullish since U.S. economic growth began accelerating in July 2016. Growth has continued to accelerate throughout 2017, but it will start to slow in 2018. This economic eventuality, my friends, is the real downside catalyst for U.S. equities.

 

It’s FUN-damental

How do I know the U.S. economy will slow next year? No, I’m not a descendant of Nostradamus; I’m data-dependent.

The first data-dependent fact that implies a high likelihood of a slowdown is duration.

Since 2009, we have experienced three phases of U.S. growth accelerating and three phases of growth slowing. The previous three growth-accelerating phases averaged 14 months, and the three growth-slowing phases had exactly the same average duration. Symmetry, anyone?

This current period of accelerating growth is the fourth since the Crisis and has lasted for 16 months. From a very recent historical perspective, the current regime has overstayed its welcome. By the time we enter 2018, the duration will be approximately 25% beyond previous similar economic regimes.

The second data-dependent fact is that various data sets are beginning to signal that the economic top may already be in, based on their own economic histories.

One example is the most recent ISM Manufacturing PMI, which hit 60.8 in September. This was an important development, because it marks just the seventh time this indicator has crossed the “60” threshold since 1990. I’d say something that has only happened 2% of the time in 30 years is worth monitoring.

In fact, those previous six occurrences came in succession from December 2003 to June 2004. This stretch of “60” readings coincided with a peak in U.S. GDP annual growth, at +4.4%, in Q4 2003.

But back to 2017. September’s record reading was followed by a 58.7 in October. Only time will tell if ISM picks back up in November, or if the manufacturing slowdown has already started.

 

The Consequence

In the previous three growth-accelerating periods, the S&P 500 averaged a 29.7% return with just an 8% maximum drawdown. During the current growth-accelerating regime, the S&P 500 has gained 26.2%, with just a 4.3% drawdown. When U.S. growth accelerates, the S&P has four times as much upside potential as downside risk.

However, this risk-reward dynamic gets turned on its head during periods when U.S. growth is slowing.

During the previous three growth-slowing periods, the S&P returned just 7%, with an average drawdown of 14%. Although it still posts a positive return, the S&P 500 exhibits twice as much downside risk as upside potential.

The bottom line is that slowing U.S. growth matters big time for anyone invested in the S&P, or U.S. equities in general.

This is where valuation comes into play because while it is not a catalyst for downside risks, “over-valuation” can absolutely be a downside accelerant once economic risks present themselves.

Lofty valuations skew those risk-reward characteristics even more to the downside when equity markets enter growth-slowing economic regimes.

The Bottom Line

Trading based on “valuation” or the latest story being woven by the media is the quickest way to find yourself ordering from the $1 menu at a fast food joint while feverishly attacking your lotto scratchers in the hope that your “investment” hits pay dirt.

I encourage you to trade based on economic and financial market data, and that alone. If you’ll remain data-dependent, you’ll be way ahead of the “valuation” crowd when the economic shift from accelerating to slowing occurs.