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Valuations, do they mean anything?

| June 22, 2020
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We have talked about valuations in the past. What you pay for something matters, especially when you rely on that something to provide future growth. Given all that we’ve been through over the past few months, I thought it would be a good time to take a look at various valuation metrics to get a feel for where we are at currently. Like we’ve said before, valuations are never a reliable short-term timing signal, but are useful for assessing longer-term return potential. The first metric today is from Jeremy Grantham and his firm, GMO.  They work on the theory of ‘reversion to the mean’. Simply put, this means that if a market gets too far above its long-term average, it is likely to underperform when it heads back to it’s averages. Makes sense.

Our next view is from our friends at Riverfront. They look at a long-term regression line for any given asset class. For large-cap US equities, that is 6.4% (dating back to 1925). From there they look at whether the market is above or below that long-term trend.  As you can see below, the market is about 9% above the long-term average. If you want to see why we say valuation metrics are less useful for predicting short-term moves, just look at how far and how long valuations have stayed above or below this trend line historically.

 

Moving on, below we look at a composite of four different valuation metrics. You can see that they are all very overvalued at this moment. If I take you back to February (which seems like a lifetime ago!), we were saying that the market was somewhat overvalued, but at the same time we thought there was some room for the market to move higher (‘cautiously optimistic’ was a recurring phrase). Then we got COVID-19 and shut down a large part of the global economy, much of which is just starting to come back online. We are still below year 2000 market (dot-com bubble) levels but are high relative to broader historical levels.

Finally we look at the US household equity allocation charted versus the subsequent 10-year S&P 500 inflation-adjusted total return.  If you want to read the whole article you can click here.  You can see that when equity allocations are high, forward 10-year returns tend to be low.

 

Again, using valuation for short-term trading is virtually worthless, but it does give us an idea of what the appreciation potential is over the intermediate to longer-term time frame. As you can see from the above valuation measures (of which there are umpteen more), forward expectations are less than otherwise hoped for.

That said, from a relative perspective (relative to Treasuries), the stock market looks to be a better place to invest. The problem that we have discussed many times in the past is that portfolio risk goes up substantially the more money is put into stocks versus bonds. When bonds are yielding close to zero, it is easy to find better relative options. We just need to be aware of the extra risks associated with higher stock allocations.

As always, we welcome your comments and questions. In the meantime, we’ll continue to test our assumptions, dig into our research, and lean into our model as we seek to be ever mindful of risk while pursuing long-term returns for your portfolio. Lastly, welcome to summer! May it be filled with great adventures, connections, fun, and continued health.

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