Current Perspectives on the Risks of Losses
There are two kinds of losses. Obviously, one kind of loss is an actual loss from selling something for less than it was purchased. Keys to avoiding an actual loss are to not buy too high, when the outlook is too rosy or there is a fear of missing out, and not sell too low, when the outlook is too glum or people are panicking. The second kind of loss is less obvious and occurs when investments are sold or not made. In this case, better days lay ahead and the opportunity to experience would be gains is lost. Managing portfolios is an exercise in balancing the risks of these two types of losses.
There is a way of evaluating the overall valuation and mood of the market which has quietly been used for a long, long time. The market capitalization of all US stocks can be compared to US GDP to form a ratio. The basic idea is that the value of stocks is limited by the size of economy in which they operate. It is not a hidden secret; even the Federal Reserve monitors the ratio- see the chart below. There have been times when the mood was euphoric and the market capitalization of US stocks exceeded the underlying US economy by more than forty percent. Currently this ratio is at levels seen just before the Great Depression of 19291, the market top in 2000, and just before the Great Recession of 2008, as well as a couple other periods. This might seem like a pretty ominous sign that purchases made today could result in an actual loss.
Source: https://fred.stlouisfed.org/series/DDDM01USA156NWDB Updated 8/30/2017. Shaded areas indicate US recessions.
The market cap to GDP ratio signaled danger back in 2014. Thankfully, so far, we did not take drastic action. Valuation has always been a very blunt investment timing tool as investments can stay under or overvalued for years on end. Overwhelmingly, the largest source of losses in our careers has been the lost opportunity kind, when we did not buy something or sold something because it seemed overvalued, though it was not. So it was largely a sense of humility and comfort in our holdings that allowed us to hold the course from 2014-2017, while keeping a sharper lookout for risks of actual loss.
US companies have a much greater portion of revenue and earnings outside the US than before. So, if the ratio of reaches 1.5 today, how would that compare to a reading of 1.5 before the Great Depression1? With international revenues comprising over 45% of total revenues of S&P 500 companies2, perhaps the market capitalization should be reduced by 45% before calculating the ratio, to be comparable to the 1920s, in which case the current ratio indicates the market may go significantly higher. As it pertains to the market declines from 2000 to 2002, the ratio signaled euphoria in advance of the three year bear market. However, it should be noted that there was a safe harbor during those three years as an abundance of high quality medium and small sized companies were trading at remarkably low valuations in 2000. Having been ignored for several years by the euphoria surrounding large cap stocks, a very large number of medium and small stocks actually produced positive returns from 2000 to 2002. Unfortunately, unlike 2000, we do not see an area of the market that has been ignored to a similar extent, and we do not currently see a safe harbor should a bear market storm arrive. The market actions in and around the 2008 Great Recession were overwhelmingly due to major parts of the financial system nearly grinding to a halt, in our opinion, so we do not see the market capitalization to GDP ratio as an indicative factor for that period. The optimistic view to justify an expansion from the present ratio, would involve an economic boom driven by hyper levels of productivity from the internet of things, artificial intelligence, predictive analytics, etc. In which case, stock market valuations are simply an accurate leading indicator of great things to come. This sounds more like sowing the seeds of euphoria than anything else.
Presently the PE ratios for small, mid, and large cap stocks are quite high and consistent with high optimism or budding euphoria, in our opinion. Optimists argue the economy is picking up, effects of the new tax rates are potentially quite positive, and interest rates are still low. The National Federation of Independent Businesses (NFIB)3, as an advocate for small businesses, collects, analyses, and presents a great deal of information about the small businesses it serves. In November, the NFIB Small Business Optimism Index stayed at glum levels from June 2007 through November 20163, which coincided with underwhelming levels of economic growth. Since then, Small Business Optimism has shot up like a rocket from rather glum levels to the most optimistic level in the last 34 years3. Surveys show 26% of small businesses have plans to make capital outlays vs 0% this time last year, and 29% have current job openings vs 1% this time last year3. Our sense is that many of these basic small businesses only have US operations and are paying higher tax rates than several large and mega sized companies. For example, the effective tax rates in 2016 of Alphabet (formerly known as Google), GE, Facebook, Boeing, Merck, and Johnson & Johnson were respectively 18%, -5%, 25%, 12%, 22%, and 16%. Furthermore, we suspect that the typical employee of a small business will benefit from the increase in standard deductions, though not all will. So it is easy to see how there could be some serious economic momentum and optimism created by the new tax bill for small businesses and their employees across America.
This situation extends to public US companies and their employees as well. If a company that was taxed at 40% now pays 21%, the earnings will increase 32% from the new tax rate alone. And if the stock’s PE was a lofty 25 under the old tax rates, the tax adjusted PE is actually 19. In an improving economy, if the company’s earnings before tax grow 12%, the earnings per share would grow 47% in 2018! And now the stock that had an old tax rate high PE has a fairly common forward PE of 17. Furthermore, there is no shortage of corporate announcements about how the increased cash flow from the tax bill has resulted in increased hiring and/or employee compensation in 2018. Businesses and employees have good reason for elevated levels of optimism.
Clearly this specific example will not precisely apply to many companies, and stock market indexes are comprised of companies in widely varying tax situations. The PEs and forward PEs of the stock market indexes are more of a hodgepodge than ever before and, as such, are much less indicative of stock market valuations.
Our plan for 2018 is to start the year with reduced chances of opportunity losses and remain alert. Small business optimism and the new tax bill just might awaken “the animal spirits,” as described by JM Keynes in 19364, and the bull market could become euphoric. For a lot of reasons, 2018 could be a good year. But even with adjusting for international operations of US companies, the market capitalization to GDP ratio will not expand indefinitely. If markets become euphoric or growth falters, our thoughts will be shaded toward reducing the chances and amounts of actual losses.
January 2018
1 https://www.minneapolisfed.org/research/sr/sr294.pdf
2 https://www.marketwatch.com/story/sp-500-companies-generate-barely-over-half-their-revenue-at-home-2015-08-19
3 http://www.nfib-sbet.org/
4 https://www.investopedia.com/terms/a/animal-spirits.asp
