November 25, 2020 glacierinvest

With the election in the rearview mirror and legitimate vaccine options on the horizon, the stock maret continues to grind higher. The stars appear to be aligning for another leg up in stock prices as the market discounts a continued recovery and eventual triumph over COVID. However, there continue to be plenty of bears out there highlighting record valuation levels and expectations of double dip recessions. There’s no way to predict what’s going to happen but with the increase in COVID cases and what appears to be an increasingly more restrictive approach to the virus in certain parts, the economy could experience a hiccup. The stock market doesn’t seem to care much about that right now because of the promising outlook for a vaccine in the not too distant future.

Regarding valuation, several metrics are near or at all time highs. While valuation can be quantified, it’s interpretation can be highly subjective depending on the perspective, metrics, components and timeframe. For example, Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio is more than two standard deviations above its historical average dating back to 1871. That’s a long time frame and may not be the best lens through which to view the CAPE for valuation context today.

(Note: Whlle above chart only goes back to 1977, the averages and standard deviations are based on the entire historical data set going back to 1871).

Chart Source: Robert Shiller, GIM

Perhaps a more appropriate lens would be to look at the CAPE over a time period that is more representative of the world we live in today. Drawing on the work of Michael Mauboussin, a significant change in company income statements and balance sheets began to occur in the 1970s. Specifically, the rate of intangible investment began to march steadily higher while the rate of tangible investments began to move lower. For clarification purposes, intangible investments include items like research and development and patents while tangible investments include items such as factories and equipment. It makes sense that as we’ve moved into the technological age that intangible investment would meaningfully increase. As a result, important changes to components of widely used valuation metrics occurred. Specifically, book value and earnings became less comparable between companies, making them less useful. Mr. Mauboussin has written about this extensively. Readers that want to learn more about his research can refer to his papers and books on the topic.

For purposes of today’s post, I want to adjust the CAPE lens. Looking at the CAPE ratio back to 1977, when the rate of intangible investments began to climb higher and the rate of tangible investments began to decline, results in the following:

The average multiple over that time period is 4.4x higher (>25%) than the average multiple over the full data set going back to 1871. Looking at today, the multiple is 1.3 standard deviations above the 43 year average. That’s a much more reasonable level than the 2.3 standard deviation difference between today’s CAPE level and the average of the149 year data set. I’m not saying one is more correct than the other, but there’s quite a disparity and depending on which lens you use you can draw vastly different conclusions. Data can be manipulated to support most narratives. Adjusting the timeframe to account for the diverging paths of tangible and intangible investment rates makes a lot of sense to me.

Chart Source: Robert Shiller, GIM

The current reality is unless a vaccine doesn’t materialize or the recovery hits a snag somewhere else, there’s no reason to think elevated valuations, perceived or otherwise, or recession fears will lead to a meaningful drop in asset prices. Of course, something else we’re not thinking of right now or not seriously considering could occur and lead to a sizeable correction. That’s always a possibility though. The main takeaway from today’s analysis is stocks aren’t cheap but they aren’t necessarily expensive either depending on the metrics and lenses you use. Sentiment is positive and volatility has been trending down for nearly all of November. In the near-term, at least, stocks are likely moving higher. As always, having risk controls in place is critical even if you’re not capturing every last point of return on the stock market. Balancing capital preservation with sustainable long-term growth should be the objective of every investor.

Photo by Rishabh Pammi on Unsplash