Return of Irrational Exuberance
market, valuation

A host of industry articles have recently raised an alarm about a possible return of irrational exuberance in the stock market, much like the one at the end of the 1990s. Bloomberg reports that investors have poured the most money into stock funds in 13 years:

Stock funds won $172 billion in the year’s first 10 months, the largest amount since they got $272 billion in all of 2000, according to Morningstar Inc. (MORN) estimates. Even with most of the cash going to international funds, domestic equity deposits are the highest since 2004.

In addition, investors currently have a high proportion of stocks in their portfolios:

The market run-up has left investors as a group with an unusually high allocation to equities, at 57 percent. Equity allocations were higher only twice in the past 20 years: in the late 1990s leading up to the technology stock crash of 2000, and prior to the 2007-2009 global financial crisis.

The most often quoted signal of overvaluation is Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE).

The numerator of the ratio is the real value of the S&P 500® index, i.e. a nominal value adjusted for inflation by the consumer price index (CPI). The purpose of this adjustment is to bring the value of the index to an equivalent present level. Assuming a rising CPI, i.e. inflation as opposed to deflation, historical values of the index are adjusted upwards. The intuition for this adjustment is that the nominal return of the index can be modeled as a sum of the real return and inflation. In the presence of inflation, the real return is smaller than the nominal one, hence a higher adjusted historical value of the index.

Similarly, the denominator of the ratio is a 10-year average of real trailing earnings of the index. A longer-term average removes the effects of market cycles. Nominal historical earnings are adjusted for inflation the same way as the index value.

The result is that, as reported by a Wall Street Journal article, the current CAPE of 25.2 is well above its historical average of 16.5:

Tracking Exuberance

Most industry articles therefore conclude that the market is in a bubble (although perhaps not as bad as in early 2000 when the CAPE was approximately twice as high). However, as the chart shows, the CAPE is currently still well inside the “yellow zone” and not in the “red zone” of 28.8 or higher.

Moreover, the current CAPE value in the chart is just an estimate. As of this writing, the actual data used to calculate the metric are incomplete. The most recent trailing four months of earnings (July through October) are missing and thus their adjusted counterparts are not included in the historical average. The November CPI is estimated from the values of just two previous months that indicated deflation.

When the missing earnings are estimated from the previous 12-month trend, the CAPE comes out closer to 24.8. The current 10-year earnings average starts in November 2003 when real profits were just rebounding from the nadir in March 2002. Therefore, in the next few years the denominator of CAPE should get larger. It is also worth noting that even with the current incomplete data, the CAPE was as high as 23.5 in February 2011, which at that time did not seem to raise many concerns.

In an interview with BusinessInsider in January 2013, Shiller stated the following:

John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent. Wait until it goes all the way down to a P/E of 7, or something.

…the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.

I think predicting something like 4 percent real for the stock market, as opposed to 7 or 8 percent historically.

So, the CAPE should not be used as a timing mechanism but rather as an estimator of the future 10-year real returns. Even with the market reaching new highs, perhaps some rational exuberance is due after all.

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High Stakes in Small Caps
market, valuation

A trio of articles covers high year-to-date returns, valuations and, consequently, increased risk of small-cap equities, especially those with growth characteristics and in the technology sector.

An article in Bloomberg indicates that the rise of small-cap stocks has historically signaled an economic improvement:

Shares of companies … in the Russell 2000 Index (RTY) have advanced 32 percent in 2013, compared with 19 percent for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.

While small-cap earnings are growing fast, valuation of these stocks has also increased:

Russell 2000 companies are beating analyst earnings estimates by 11 percent, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg.

The Russell 2000’s price-earnings ratio increased 52 percent this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.

The first article of the two from The Wall Street Journal brings up an issue of high stakes in the technology sector in many small-cap growth mutual funds:

Fund Ticker Technology
Conestoga Small Cap CCASX 41.5%
Brown Capital Management Small Company BCSIX 66.8%
Wasatch Small Cap Growth WAAEX 27.4%
Artisan Small Cap ARTSX 41.2%
Buffalo Small Cap BUFSX 34.1%
Loomis Sayles Small Cap Growth LCGRX 29.0%
Category Average 23.6%

The second article in The Wall Street Journal worries about small-cap returns:

Small-capitalization growth funds are up an average of 33.1% in 2013 through October, according to Morningstar Inc. That compares with average gains of 28.7% for small-cap value funds and 26.3% for large-cap growth funds. Within the small-cap growth category, many funds have gains approaching, or even topping, 40%.

However, the article states several factors propelling small-cap stocks:

  • A more direct exposure to the U.S. economy compared to large-cap stocks (per the Bloomberg article, 84% of an average Russell 2000 company sales vs. only 55% of an average DJIA company are domestic)
  • A higher rate of organic earnings growth thanks to profit reinvestment
  • A continuing low interest rate policy of the Federal Reserve that encourages investors to seek higher returns in riskier assets.

So, have investors been compensated for the increased risk of small-cap stocks? One way to determine that is to compare historical Sharpe Ratios of small-cap ETFs to those of the S&P 500® ETF (all figures to October 31, 2013 from Morningstar):

ETF Ticker 3-Year SR 5-Year SR 10-Year SR
iShares S&P Small-Cap 600 Growth IJT 1.31 0.97 0.56
iShares Core S&P Small-Cap IJR 1.24 0.89 0.54
iShares S&P Small-Cap 600 Value IJS 1.16 0.81 0.50
iShares Core S&P 500 IVV 1.29 0.94 0.45

The above data show that small-cap growth stocks have indeed provided higher risk-adjusted returns than large-cap equities did. However, the same cannot be said about the broader small-cap sector or its value component in the last three- and five-year periods.

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Cash Cushion in Equity Funds
mutual fund, valuation

An article in The New York Times describes a recent build-up of cash positions in equity mutual funds:

Many fund managers have quietly been raising their cash positions. In their latest reporting periods, according to Morningstar, the average equity mutual fund held 9.7 percent in cash, up from 8.8 percent in the previous three-month period.

The article discusses the following funds with high cash positions:

Name Ticker % of Cash
Pinnacle Value PVFIX 44
Fairholme Allocation FAAFX 14.8
Tweedy, Browne Global Value TBGVX 17
FirstEagle Overseas SGOVX 23.1

Managers of these funds cite several reasons for keeping substantial cash cushions:

  • Inability to find sufficiently undervalued stocks
  • Paramount need for capital preservation in market downturns
  • Ability to get in on best buying opportunities during market sell-offs
  • Global markets currently being fully valued.

The argument of a full- or over-valuation of stocks backfires when applied to the existing equity holdings of a fund: If at present the manager does not want to use the surplus cash to add to these positions, this implies that they have a limited appreciation potential, are fully valued or even over-valued. With that diminished reward-to-risk ratio, the fund should sell these equity holdings and increase its cash position even further.

The other arguments hinge on an assumption that a major market downturn is imminent and will have a significant magnitude, which justifies a high cash position. This leads to market timing, at which, statistically, most managers fail. Meanwhile, such funds do not realize their full potential in a rising market. Investors end up paying the price both ways.

As Alpholio™ stated in previous posts, the decision about the percentage of cash should really be left to the investor at the portfolio level rather than to a manager of each mutual fund. Otherwise, the investor is forced to constantly monitor cash positions in funds and make offsetting portfolio adjustments to stay on the overall asset allocation track. Alpholio™ helps with that by providing a visibility into the equivalent exchange-traded product (ETP) positions of a fund in between its periodic regulatory filings.

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Are Stocks Overvalued?
market, valuation

According to an article in The Wall Street Journal, stocks are currently overvalued. First, the author compares the price-to-earnings (P/E) ratio of the S&P 500® index based on reported (i.e. net income) trailing twelve month (TTM) earnings to a 140-year median value. Then, the author admits that forward-looking, i.e. next twelve month (NTM), earnings estimates predict operating income that is higher than the net income, which suppresses the P/E ratio. To overcome this discrepancy, the author extends the average relation of the NTM P/E being lower than the TTM P/E by 24%, as observed from 1976 to 2003, to the entire 140-year historical period. (The 24% discount encompasses three factors: the predicted growth of earnings from TTM to NTM, difference between operating and reported earnings, and over-optimism in earnings forecasts.) This sleight of hand enables the author to conclude that in either case, stocks are currently overvalued by about 25% compared to a historical P/E median.

This mixing of reported and operating earnings, coupled with an arbitrary extension of a medium-term observation to a very-long-term historical period, leads to dubious conclusions.

Here is an alternative point of view from the July 22, 2013 edition of the S&P The Outlook:

From a fundamental perspective, S&P 500 valuations continue to look attractive. As of July 12, the S&P 500 is trading at 15.9 times trailing 12-month operating results, including the June 2013 EPS results projected by Capital IQ consensus estimates. This multiple represents an 11% discount to the median P/E of 17.8 times since Wall Street started looking at operating results in 1988. What’s more, the market is trading at a multiple of 15.2 times and 13.7 times trailing 12-month operating EPS for year-end 2013 and 2014 results, respectively.

Why does S&P look at operating results instead of reported earnings? Because of distortions caused by large, non-recurring, non-cash expenditures, and also by time misalignment of reported tax expenses with actual tax payments. Indeed, as the article’s title suggests, P/E ratios aren’t always what they seem.

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