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3 Looks At Current Market Multiples

Summary The S&P 500 has come of its all-time high, down 9% from its May peak. This article puts the current level in historical context by examining three different earnings multiples. Trailing 1-year earnings, estimated forward 1-year earnings, and a measure of cyclically-adjusted price/earnings are used to frame the current market level. I leave readers with three takeaways on my views of this data. When the S&P 500 (NYSEARCA: SPY ) was hitting new all-time highs in early 2015, I authored an article entitled ” A View From the Top: 3 Looks at Market Multiples “. Given the recent market pullback, this article reprises these different views to put the market drawdown in context. This article looks at the current price level of the index via three different measures: 1) a historical examination of the index relative to trailing one-year earnings; 2) a historical examination of the index relative to forward one-year earnings; and, 3) a historical examination of the cyclically adjusted price earnings multiple. (Source: Standard and Poor’s; Bloomberg) The graph above shows the most commonly cited earnings multiple, the Price/Earnings (P/E) ratio, which shows the index level relative to trailing one-year earnings. When I wrote a version of this article in February, the market was valued at roughly eleven percent more than its average since the broad market gauge went to its current five-hundred constituent form in 1957. With the recent pullback, we are trading at just a 1.6% premium to the market’s historical multiple. (Source: Standard and Poor’s; Bloomberg) The second graph shows the current index level relative to a best estimate of forward earnings from Bloomberg. Based on the current expectation of continued strong growth in earnings, the index is valued at 16.2x forward earnings. In February, this valuation was 6.5% greater than the trailing 25-year average, which is the extent of the ratio history available on Bloomberg. Today, the market is actually trading at a small discount of 2.7% relative to this historical valuation multiple. (click to enlarge) (Source: Robert Shiller ) While we often talk about valuation relative to trailing or forward one-year earnings, as we did in the previous two sections, examining the index level relative to earnings over a length of time more consistent with an entire business cycle can be viewed as more appropriate. Above is a version of Yale economics professor and Nobel laureate Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE or Shiller P/E), a valuation measure applied to the equity market that divides the price level of the index by the average of ten years of earnings, adjusted for inflation. With the index multiple now roughly equivalent to the post-crisis market peak in 2007, and trailing only the historic bubbles in 1929 and 2000, the CAPE is the most oft-cited reason for lowered forward return expectations in the domestic equity market. The current multiple is 46% above its trailing 144-year average. Three takeaways: When I wrote a version of this article in early 2015, the valuations looked stretched by all three measures. In my article, ” 10 Themes Shaping Markets in 2015 “, I wrote: “Stretched equity multiples domestically will necessitate that valuations be driven by changes in earnings, tempering further price gains”. Well, we have not received price gains, with the S&P 500 producing a -6.7% return in 2015. This reduction in the index level has outpaced lower earnings from the commodity-sensitive sectors of the market, making the current market valuation appear more fair. Low interest rates have contributed to higher market multiples. In the CAPE graph above, notice that the market multiple moves inversely to the long-term interest rate level. With interest rates in the U.S. again rallying with increased macro volatility, market multiples have expanded. I covered this relationship in the 2012 article, ” Equity Multiples and Interest Rates: Is the Current Risk Premium Sufficient? ” Common stock valuation techniques include discounting future earnings back to the present, which demonstrates why lower (higher) interest rates would be consistent with a higher (lower) equity multiples. Low interest rates and near-zero short-term interest rates have pushed investors from cash and fixed income into more risky asset classes, which has also driven equity multiples higher. As rates began selling off in the taper tantrum in mid-2013, it felt like rate-driven equity gains could be peaking. With long Treasuries again rallying, and the Fed signaling to the market that they are likely to move slowly even if they move the Fed Funds rate higher, perhaps this upward pressure on valuations could stick around. 16.5 still looks to be a magic number. In all three of these valuation measures, which feature different perspectives and time horizons, the average market multiple has been around 16.5x (16.19x forward earnings multiple; 16.63x CAPE; 16.96x trailing earnings multiple). Over extended time horizons, elevated earnings multiples above 16.5x are going to be consistent with below-average forward returns. Conclusion In February, these three multiples signaled that the market was rich. After our first correction in several years, the valuations now appear more fair, although the CAPE multiple is still historically elevated. Shortening the lookback period in the CAPE multiple from ten years to five years strips out the 2008-2009 downturn, and the multiple is just 28% above its historical average. Readers must ascertain whether they believe that a proper risk premium is being reflected in this market valuation, and where they believe earnings growth is headed in the context of their own risk tolerance and portfolio construction. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

After The Fall: The Dividend Aristocrats Detailed

Summary Loss averse investors with long-run horizons should not be heading to the sidelines, but rather looking to buy quality businesses on weakness. An index tracking the Dividend Aristocrats has outperformed the S&P 500, producing higher average returns with lower variability of returns over the trailing quarter-century. This article details the components of this index, with current valuation and year-to-date performance, to highlight companies that may outpeform through the next bout of volatility. In yesterday’s article entitled ” Stocks Will Go Higher “, I showed readers that over ten year periods, stocks almost invariably produce positive returns, and suggested the readers plan to buy high quality businesses on weakness and be prepared to hold these investments for long time periods. If history is a guide, such a strategy is very likely to come out a winner. (click to enlarge) Sources: Standard and Poor’s; Robert Shiller (Blue Line is price returns and pink line includes dividends) That article was spurred by a recent quote by famed investor and CEO of Berkshire Hathaway ( BRK.A , BRK.B ), Warren Buffett, who stated in an August 10th interview on CNBC that ” Stocks are going to be higher, and perhaps a lot higher 10 years from now, 20 years for now .” In this same interview, Buffett went further stating that “my game is to own decent businesses and decent prices and you are going to make a lot of money over time.” A strategy populated by good businesses that have generated market beating returns over times is the Dividend Aristocrats. The Dividend Aristocrats are S&P 500 (NYSEARCA: SPY ) constituents that have followed a policy of increasing dividends every year for at least 25 consecutive years. To be included in this index, these companies, at a minimum, have paid increasing dividends through the Eurozone Sovereign Crisis, the Global Financial Crisis, the Tech Bubble, and the early 1990s recession. These are the types of businesses that would be likely to produce market-beating risk-adjusted returns through the next downturn as well. Heeding Buffett’s advice, perhaps buying these businesses on weakness will spur market beating returns prospectively. Demonstrating this success, below is the cumulative total return of the S&P 500 Dividend Aristocrats Index, which is replicated by the ProShares S&P 500 Dividend Aristocrats ETF (NYSEARCA: NOBL ). (click to enlarge) Source: Standard and Poor’s; Bloomberg The Dividend Aristocrats have produced higher average annual returns, outperforming the S&P 500 by 2.5% per year. This approach has also produced returns with roughly three-quarters of the risk of the market, as measured by the standard deviation of annual returns. This long-run outperformance saw this strategy included in my “5 Ways to Beat the Market .” Given the weak domestic equity market performance in August, I wanted to detail the Dividend Aristocrat components for Seeking Alpha readers with current P/E ratio and year-to-date performance. (click to enlarge) For the broad “Investing for Income” community on Seeking Alpha, I have also sorted the list of Dividend Aristocrat constituents descending by dividend yield. (click to enlarge) If you are a long-term investor, looking to buy solid businesses on weakness, perhaps this list of companies who can weather another bout of market-related volatility. If readers find this helpful, I will also put together a list of the constituents of the Low Volatility Index, another factor tilt towards high quality businesses that has generated long-run alpha. Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long NOBL, SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Low Volatility & Momentum: Doubling The Market Return

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. While low volatility strategies are often an appropriate long-term buy-and-hold strategy, this article offers a strategy that uses a momentum signal to tilt towards higher beta securities selectively. The alpha-generative strategy combines two market anomalies – Low Volatility and Momentum – to produce outsized returns. In recent articles, I have been authoring a fairly extensive examination of the Low Volatility Anomaly, the tendency for low volatility assets to outpeform high beta assets over long-time intervals. A Low Volatility strategy was one of five buy-and-hold factor tilts that I described in a previous series of articles. I believe that these buy-and-hold strategies to capture structural alpha are appropriate for many in the Seeking Alpha audience, but understand that some readers are looking for strategies that can generate even higher absolute returns. This article depicts one such strategy. Long-time readers know that two of favorite topics on which to author have been Low Volatility and Momentum strategies. This article combines these two strategies to produce a return profile that as the title of the article suggests has more than doubled the return of the S&P 500 over the past quarter-century. Before we delve into this strategy, we should first discuss the two components that drive this tremendous performance. Low Volatility Anomaly Regular readers know that I am currently authoring a multi-part series on the Low Volatility Anomaly. These articles include an introduction to the concept, a theoretical underpinning for the anomaly , cognitive and market structure factors that contribute to its long-run performance, and empirical evidence that demonstrates the outperformance of low volatility strategies across markets, geographies and long-time intervals. In past articles, I have depicted the relative outperformance of Low Volatility strategies using the graph below which shows the cumulative total return profile (including reinvested dividends) of the S&P 500 (NYSEARCA: SPY ), the S&P 500 Low Volatility Index (NYSEARCA: SPLV ), and the S&P 500 High Beta Index (NYSEARCA: SPHB ) over the past twenty-five years. The volatility-tilted indices are comprised of the one-hundred lowest (highest) volatility constituents of the S&P 500 based on daily price variability over the trailing one year, rebalanced quarterly, and weighted by inverse (direct) volatility. Source: Standard and Poor’s; Bloomberg The Low Volatility strategy contributes an important base component to this strategy that would have doubled the return of the market over the past twenty-five years, but we also need an element that pushes the strategy into riskier parts of the market when we can get paid for this tilt in the form of higher returns. Momentum Like the low volatility strategy, momentum strategies have been alpha-generative over long-time intervals and across markets. Consistent with Jegadeesh and Titman (1993), which documented momentum in stock prices that have outperformed in the recent past over short forward intervals, the efficacy of momentum strategies have been widely documented. Academic literature has described excess returns generated by momentum strategies in foreign stocks ( Fama and French 2011 ), multiple asset classes ( Schleifer and Summers 1990 ), commodities ( Gorton, Hayashi and Rouwenhorst 2008 ), and my own studies on momentum in fixed income strategies and more recently the oil market . Academic literature offers competing theories on why momentum has generated alpha over long-time intervals across markets and geographies. Proponents of market efficiency suggest that momentum is a unique risk premium, and the long-run profitability of these strategies is compensation for this unique systematic risk factor ( Carhart 1997 ). Behaviorists offer multiple competing explanations. In my previous series, I referenced both Lottery Preferences and Overconfidence as potential justifications. Studies contend that markets under-react to new information ( Hong and Stein 1999 ), which allows for the autocorrelations found in return series. Other behavioral economists contend that the disposition effect, or the tendency for investors to pocket gains and avoid losses, makes investors prone to sell winners early and hold onto losers too long ( Frazzini 2006 ), which could be further amplified by a “bandwagon effect” that leads investors to favor stocks with recent outperformance. Blitz, Falkenstein and Van Vliet (2013) offer an expansive summary of these explanations. The Strategy I am of the opinion that low volatility stocks should be a part of investors’ longer-term strategic asset allocation given that class of stocks’ historical higher average returns and lower variability of returns. In ” Making Buffett’s Alpha Your Own ,” I described academic research ( Frazzini, Kabiller, Pederson 2013 ) that broke down the Oracle of Omaha’s tremendous track record at Berkshire Hathaway ( BRK.A , BRK.B ) into two components – capturing the Low Volatility Anomaly and the application of leverage. If an allocation to low volatility stocks should be part of your long-term strategic asset allocation, then an allocation to high beta stocks must be done tactically with a short-term focus given that class of stocks’ lower long run average returns and higher variability of returns. This view is borne out of the data underpinning the chart above. However, a temporary allocation to the High Beta Index in sharply rising markets can further boost performance. The High Beta stock index has typically outperformed in post-recession recoveries. How do we combine Low Volatility and Momentum? A quarterly switching strategy between the Low Volatility Index and the High Beta Index, which buys the leg that has outperformed over the trailing quarter and holds that leg forward for the subsequent quarter, would have produced the return profile seen below since 1990, easily besting the S&P 500 with lower return volatility. For a pictorial demonstration of the leg that would be chosen by the Momentum strategy, please see the exhibit at the end of the article. It is a very simple heuristic. The Momentum strategy buys either Low Vol or High Beta stocks based on the index that outperformed in the trailing quarter and holds that index for the subsequent quarter before re-examining the allocation once again. The results are striking. (click to enlarge) From the cumulative return graph above, one can see that $1 invested in the S&P 500 would have produced $9.04 at the end of the period (including reinvested dividends) whereas $1 invested in the Momentum portfolio would have produced $19.90. These are gross index returns and do not consider taxes. Readers envisioning employing momentum strategies should utilize tax-deferred accounts. Summary statistics of the trade are captured below: (click to enlarge) The simple quarterly switching momentum strategy would have produced a 13% return per annum over the long sample period. This 3.6% outperformance relative to the S&P 500 led to the cumulative doubling of the market returns over time. Note that while the Momentum strategy is riskier than the broad market as measured by the variability of quarterly returns, practitioners of this strategy would have been rewarded with correspondingly higher returns for this incremental risk. While I contend that a long-run, buy-and-hold tilt towards lower volatility equity is probably appropriate for many Seeking Alpha readers, this article demonstrates a momentum-based switching strategy that can help inform investors when to pivot towards higher beta stocks when they offer returns commensurate with their higher risk. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Exhibit: Returns of Low Vol, High Beta, Momentum, & Market (click to enlarge) Disclosure: I am/we are long SPLV, SPHB. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.