Episode #289: Stocks Are Allowed To Be Expensive Since Bonds Yields Are Low…Right?
Guest: Episode #289 has no guest, it’s a Mebisode.
Date Recorded: 02/04/2020
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Summary: Episode 289 is a Mebisode. In this episode, you’ll hear Meb put today’s stock valuations into historical perspective. He addresses the claim that stock valuations should be high because bond yields are low and then looks at what conditions were present at the start of the best ten-year stock returns in history. Finally, he provides some thoughts on what investors could do to handle the current market environment.
All of this and more in episode 289.
Links from the Episode:
- 0:39 – Welcome
- 0:54 – Stocks Are Allowed to be Expensive (Faber)
- 1:35 – Twitter poll
- 4:06 – Shiller Excel Databases
- 4:16 – Meb’s Top 5 Global Stock Valuation resources
- 4:17 – Downloadable CAPE ratios
- 9:35 – Schillers New Article on Excel
- 14:25 – Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns (Bogle)
- 16:02 – The Meb Faber Show Podcast: Episode #202: Joe Davis, Vanguard, “The Idea Multiplier…We Believe It’s One Of The First Leading Indicators Of Commercial Innovation”
- 16:05 – The Get Rich Portfolio (Faber)
- 16:15 – QSBS rule
- 18:01 – Four-part series: The Get Rich Portfolio (Faber), The Stay Rich Portfolio (Faber), How I Invest My Money (Faber), Investing in the Time of Corona (Faber)
- 19:43 – The Meb Faber Show Podcast: Episode #18: Rob Arnott, Research Affiliates, “People Need To Ratchet Down Their Return Expectations”
- 19:44 – The Meb Faber Show Podcast: Episode #124: Howard Marks, Oaktree Capital, “It’s Not What You Buy, It’s What You Pay for It That Determines Whether Something Is a Good Investment”
- 21:29 – Office Hours Summary…You Are Not Alone (Faber)
Transcript of Episode 289:
Welcome Message: Welcome to The Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up y’all? Today we have another Mebisode. It’s been a while. But with all the craziness going on, I thought it’d be good time to pause and reflect. There’s an article we published at the beginning of the year, which already feels it’s like two years ago, called stocks are allowed to be expensive since bond yields are low, right? And to refrain we hear from a lot of people. So I’m going to read this. You can find it on the blog. We’ll add the notes in the show links with the charts as well as graphs, etc. Let’s get started. There are a lot of investment sayings that get repeated by individual and professional investors alike. One I hear parroted over and over and over again, is a variation of high stock valuations are fine since interest rates are low. How many times have you heard that? How many times have you said that? But did you ever stop and ask, is that true? This podcast was inspired by a tweet poll I did a few years ago in which I asked, would you still own stocks if they reached 10-year price earnings ratio valuation multiples, we call those the CAPE ratio multiples, of 50 or 100 times earnings? And I was shocked. But most people said they would still own stocks at 50 times earnings. And many, about a third said they would own them at essentially any price, 100 times earnings. That had me scratching my head, as it sounds totally insane. Most investors use the value approach when it comes to buying things like cars or houses or TVs. Now you just buy them on Wirecutter. Okay. How long would you spend before buying that new 80 inch TV? Hours online searching Amazon, searching other sites, Best Buy, just to save 100 bucks? But time spent to think about investing your life savings, many are just willing to click auto-invest into stocks at any valuation level. And historically, investing in stocks at sky-high multiples is a horrible, terrible no good idea. Again, most are willing to continue to hold stocks at a higher valuation than the Internet bubble in 1999 that hit a P-ratio of almost 45. Many, a third would still hold stocks at a higher valuation than ever recorded in any stock market in history, which was Japan in 1989. It hit a valuation of almost 100 I think is around 95. And a third of people say that’s okay. And we all know how that didn’t work out.
Japan’s had 30 years of zero returns, although it’s starting to perk up now. But again, that’s three decades entire generation of investors with nothing to show for it. Now, the reasoning today when we look at valuations in the U.S., which are around 36, the second-highest they’ve ever been in history next the Internet bubble, 45, people say that’s different because the high valuations today are fine since interest rates are low. Now to which I normally respond, “Well, why are valuations so low in the rest of the world with lower or even negative rates for us, the U.S.?” Well, we’ll come back to that later. Let me preface this podcast by saying that many other researchers have already done a fine job of debunking this claim. Their work tends to lean a little bit academic though, so I thought I’d try to frame it in a slightly different way. So you can check out all sorts of work. And we’ll post in the show notes links from Cliff Asness, Robert Knott, Ben Anchor, Bernstein, Bogle, Hussmann, Schiller, many others, again, link to these mebfaber.com/podcast. You can also download and play around with Professor Schiller’s excellent Excel databases, they’re free online, and I would love to see people expand upon or critique anything here. There’s also a link, we’ll post to my top five global stock valuation resources, which includes downloadable CAPE ratios. We were the first to create and publish these but lots of people do it now. And you can see again, we’ve mentioned the U.S. is around 36 versus a historical average around 17, and an historical average the last 40 years around 22, which is where the rest of the world is today. Foreign developed is around 22 in foreign emerging at 15 and the cheapest countries down around 12. But for whatever reason, when you talk about this 10-year price-earnings ratio, people’s brains start to short circuit. And let me be clear, you could replicate this entire study with dividend yield in lieu of CAPE ratio and it’ll give you the same exact results. Seriously, go try it. Valuation metrics are not meant to be a very specific, two decimal points to the right analysis, they’re meant to get you in the right ballpark. And to me, the question is always is the CAPE ratio 36 or 34 or 38? People love debating that. It’s not the right question. The right question is, is it 36 or is it 14? You cannot find a valuation indicator that says stocks are cheap right now. They all say they’re expensive. Anyway, let’s get started on the point of this whole analysis.
Question one. When stock valuations were at their highest, where bond yields low? And these valuations, historically, going back to 1900, have ranged from a low of 5, 1920, 100 years ago to a high of 45, again, at the Internet bubble with an average around 17. We’re at 36 now, which again, has only been exceeded once in history, Internet bubble, my favorite bubble. I was in university at that point. The top 10% of stock valuations is basically any cape over 25. The average bond yield during this period is 5.1%. A long way from where we are today. So that feels high relative to now but it’s about average over time. What about over 30 CAPE ratio? Even higher bond yields 5.5%? So question one, when stock valuations were at their highest, were bond yields low? No. Historically, high stock valuations have occurred in tandem with average or higher than average bond yields. Let’s ask a different question and flip the criteria. When bond yields are low, are stock valuation’s higher? And if you examine the bottom quintile of bond yields, the average CAPE ratio valuation is actually below average around 13. This applies to short and longer-term 10-year yields alike. Weird, that’s backwards from what most people say. Okay. Maybe we’re missing something. As we know, it’s hard to compare yields across time since inflation at 2% isn’t the same as inflation at 10%. Question three. What’s the relationship between stock valuations and inflation? Well, inflation and bond yields tend to be tied at the hip. Valuations do a rollover, as inflation picks up to over say, 4%, where investors are willing to only pay a CAPE ratio valuation of around 10%, below 4%, double that to around 20%. So investors seem to like that safe zone of 1% to 4% inflation, it’s warm and cozy, and will pay more for that certainty. And some would argue that, “No, Meb, it’s not the level of interest rates, it’s direction,” which is of course true, but this requires you to accurately forecast future interest rates, which to my knowledge, no one can. Also, the change in interest rates doesn’t affect the valuation that much in both bottom and top quintiles of historical bond yield moves, it results in a few total CAPE ratio points over 10 years. So not a big influence. Again, if you got the interest rate prediction correct because the opposite is also true, there seems to be a universal assumption that bond yields in the U.S. can only go higher and of course not negative, which is odd, given most of, the rest of the world is already there.
Barron’s when they did a poll didn’t even include negative rates in an option. It just said, “What will the 10-year Treasury note be one year from now?” And zero was the bottom bound?” Almost everyone said higher. Okay. All we know so far is historically investors have rewarded low, nominal and real bond yields with lower valuations on stocks, largely due to lower trailing earnings growth, which we’ll get to, which makes sense. Think about it. Investors are also willing to pay a bit more for stocks when inflation is tame. But none of this is what people are really asking. When they say, high stock valuations are fine, since interest rates are low, what they really mean is, high stock valuations are fine since interest rates are low, therefore, future stock returns will be okay. Honestly, no one really cares if current multiples are justified. What they really care about is if those valuation multiples and low bond yields produce higher or lower stock returns in the future. So let’s ask the question differently. Q4, when bond yields are low, are future stock return’s higher? And it turns out the answer is yes. In fact, the lowest quintile of bond yields results in high real stock returns, so after inflation, of 10% over the next 10 years, and that’s above the 6.5% average. So, Meb, you’re an idiot. Stick that discounted cash flow, or the sun don’t shine. Well, hold on a second. We all know nominal doesn’t really mean anything. So let’s examine real rates. In fact, the lowest quintile of real bond yields results in high real stock returns about 11%, also above the 6.5% average, even better. Ditto for future stock versus bond returns, though this is dominated by the stock side. And by the way, everyone in the media has misinterpreted Schiller’s new article in Excel. I suggest you take it for a spin and come to your own conclusions. But the conclusion so far seems, “Ha, I knew you’re an idiot Meb,” but that’s just scratching the surface. Tim Griffin, one of my favorite followers on Twitter is going to murder me for this, but I think he may agree that using just one variable is too simplistic perhaps. As mentioned previously, there are numerous factors at play and isolating anyone doesn’t reveal the full picture. It reminds me of my one of my first books, talking about the blind men and the elephant parable where each blind man was touching a different part of the elephant. One touching the trunk, said it was the snake, one touching the legs said it was a tree, on and on.
So, when there are numerous factors at play and isolating any one doesn’t reveal the full picture, so in sorting by bond yields, and future stock returns, where were valuations? So that analysis we just did was bond yields and how future stock returns return, we ignore valuations. But when you look at the lowest quintile bond yields that resulted in high future stock returns, they had on average a starting valuation of 13 CAPE ratio, and a dividend yield of 5.4%. More importantly, they ended the decade, if you walk for 10 years, on average with a CAPE ratio of 18. Aka, the whole period, you had valuation multiple expansion from 13 to 18. Similarly, the lowest quintile of real bond yields that resulted in higher future stock returns had a start valuation of 11 CAPE ratio and a dividend yield of 5.7%. And more importantly, the end of the decade on average with a CAPE ratio of 18. Again, valuations went up. So the valuation multiple expansion over 10 years can easily have a 5% to 7% tailwind per year from these low starting valuations. So the simplistic analysis was, hey, low bond yields great future stock returns. But, was it really the low starting bond yields or rather that they occurred along with low valuations and high dividends that drove the returns? Strip out the valuation move, and low or real-bond yield regimes are nothing special. Historically, you had a higher future real earnings growth from low yields, a percentage or point to higher, largely due to lower trailing real earnings growth. Also, trailing stock returns were lower than average. Notice, we have low bond yields today. But valuations are triple the average starting valuation, or example, in dividends less than half historical averages. Let’s walk through one last exercise for fun. Let’s reverse back the starting conditions for the best and worst-performing quintiles of stock returns in history. What conditions are present when we observed the best stock returns ever? Almost 20% returns for a decade, ah, to be alive in 1920. Champagne, flapper dresses, perhaps we’ll have the roaring 2020s. I sure hope so. Man, I miss live music, going to pubs with Guinness on tap, on and on. Now, of course, you had to be solid on your timing if you’re an investor in 1920 because if you started in 1930, you had no returns for a decade. So amazing how, by the way, the best of times often lead to the worst and vice versa.
So, on average, the best returns and the top quintile gives you 14% real returns after inflation for a decade. On average the worst returns in the bottom quintile give you minus 1% real returns after inflation for decade. Pretty big difference in outcome for the buy and hold holders, hurdlers we’ll call them today. The conditions at the start of these big return periods on average have been high dividends, low valuations, average bond yields, lower trailing real stock returns, lower trailing real earnings growth, and higher trailing inflation. The conditions at the start of these bad return periods on average has been lower dividends, higher valuations, average bond yields, higher trailing stock returns higher trailing real earnings growth, and lower trailing inflation. And most importantly, if you strip out this 7% per year tailwind or headwind evaluation, expansion, or contraction, the average real returns of the best or worse bucket are in line with average returns over time. Valuation seems to have a pretty massive influence on the best and worst decades. Let me restate that. Most of the excess returns from the best performing stock periods have come from valuations going from really low back to average or above, and vice versa. Bogle himself published a similar article about this in the 1990s and later updated it, it’s called, “Occam’s Razor Redux.” Future stock returns, he distilled to just three things starting dividend yield, future earnings growth, and change in valuation. And you can also decompose earnings growth into real earnings growth and inflation and buybacks have increased the dividend growth but inflation has been lower than historical, this sort of washed out. You know two of the starting variables, dividend yield, and starting valuation. What you don’t know are the other three future inflation, future real earnings growth, and ending valuation. But historically you can come up with a matrix to give you a good idea of where we might be going, and in most cases, it’s not pretty. I think the base case for U.S. stocks is about 0% to 2% real returns from the next 10 years. Recall that most investors expect 10% returns on their portfolio, and like many recent surveys, 15%. For 10%, what you need is valuation multiples go up to the peak of 1999. For 15% you need them to go up to Japan levels in the 1980s. Is that likely? No. These scenarios assume historical growth rates, which depending on who you ask could be massively over understated, ditto for margins. As we mentioned prior low bond yield environments tend to be associated with lower past real earnings growth and higher future earnings growth.
Now, as any experienced older market investor will tell you or show you with their scars, markets have a way of making you eat humble pie. So it’s always interesting to think of how you could be wrong. One positive case I can fathom is an actual explosion in innovation and entrepreneurship. My podcast chat with Vanguard’s Joe Davis points a little bit in that direction. And those that read my piece the, “Get Rich” portfolio know that I invest a significant amount of my net worth into start-ups, we’re over 230 counting for this reason. And also the QSBS rules, which could be the most significant part of this thread or podcast that no one understands. So go Google it. And usually, taxes have more of an impact than any of these other stuff that we’re talking about, taxes and fees. So spend a little time there. Who knows? Maybe we’ll all live to 200 years old, we’ll be teleporting to Mars. But you have to recall that our historical results included plenty of innovation too. Railroads, cars, telephones, Internet antibiotics, Taylor Swift. S o this low bond environment could add one or two percentage points to real earnings growth. That would take real returns from zero to two to maybe one to four, which still isn’t great. My friend, John Hussmann would interject here, again, with discussion on profit margins, but you also don’t have to invest in the market-cap-weighted passive index. There are pockets within the U.S. stock market that offer opportunity, such as low valuation, high cash flow companies distributing cash to shareholders via dividends and buybacks, we call that shareholder yield. You can go online and type in any fun symbol into Morningstar or other sites and they’ll tell you the valuation of that fund. Go try it. You’ll be surprised what some of the output is. And if an innovation Renaissance were the case, I would much rather own stocks in foreign stock markets where the starting conditions are flipped. They have low valuations and higher dividend yields. Again, foreign developed is around 22, emerging at 15 and the cheapest at 12. Dividend yields, way higher too. But it’s also helpful to fathom the bear case. What if U.S. stocks don’t just go back to average valuations, but sail right through them? What if inflation ramps up and growth stalls out? And as last year and this year already reminded us anything can happen to markets. Back in March of last year, you guys may have heard my podcast and article we wrote, four-part series “Get Rich Portfolio,” “Stay Rich Portfolio,” “How I Invest My Money,” and “Investing In A Time Of Corona.” We published it in March. And at the time we actually outline the bull and bear case for stocks. And believe me, judging by my inbox and Twitter DMs, at the time no one thought we’d be hitting all-time highs by year-end, but here we are.
All right, it’s time to wind down. So many times on social or TV, you hear people rant and rave, and then there’s no conclusion. They get plenty of diagnosis, everyone loves to give you their opinion, but really no prescription. So after all this theoretical discussion, here’s both my diagnosis and prescription. First, diagnosis. The good times often follow the bad times in markets and economies and vice versa. Super technical I know but it tends to be true. Starting conditions right now for U.S. stocks are not great. Low dividend yields with high valuations mean future stock returns could be lower. Bond yields don’t really offer an attractive alternative. You could reasonably forecast no real return on either investment for the next 10 years. Real earnings growth may be higher than average going forward. And starting conditions for foreign stocks, however, are much better. Higher dividend yields with lower valuations mean future stock returns could be much higher. Value tilts within these markets are even more extreme in the positive. Also, realize that markets will continually surprise us and all the above could turn out to be wrong for long and painful periods of time. End of diagnosis. What’s the prescription? What do we do about this? If you have a basic buy and hold portfolio, continue to rebalance. Or if you’re more aggressive, if you listened to our old podcast with Robert Knott and Howard Marks, we mentioned an opportunity for an over-rebalance, or perhaps a tilt or calibration. You can take your medicine. Ratchet down those expectations of lower stock and bond returns in the U.S. Be prepared for the possibility of a normal 50% decline in U.S. stocks, at least consider it. Consider diversifying to the global market average stock allocation, which is roughly half U.S. and half foreign. Most Americans listening to this have about 80% of their stock allocation in the U.S., which is a massive overweight bet to one of the most expensive markets in the world. And if you’re a little bit bolder, consider breaking the market cap link to a larger allocation in line with global GDP. U.S. is only 25% of global GDP. A lot of people that surprises. In particular value stocks in places like emerging markets, where most Americans only have a 3% allocation look even better.
I’ve mentioned on Twitter many times I invest my son’s entire 529 and my entire 401k in foreign and particularly emerging market stocks. And given the reactions I get, it actually makes me think it’s a brilliant decision. You can also consider alternative strategies like trend-following, tail risk hedging. You guys know I love real assets like farmland. And then there’s other sort of alt strategies like market-neutral or arbitrage style investments that are less dependent on the market continuing to go up. You can also consider ignoring all of the above, everything I just said, and just by the global market portfolio with low-cost ETFs and getting on with your life. After all, I love saying most investors trying to be Nostradamus when they should aspire to be Rip Van Winkle. Importantly, you should write down your plan and share it with someone to help keep you honest. We’ll post a show note link to an idea and how to go about that. And look, that’s all folks. Stay safe, stay sanitary. And have a great start to ’21 and look forward to seeing you all in person. Good investing.
Meb: Podcast listeners. We’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We’d love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.