Valuations are Relative

business hand pushing Valuation on Flipboard Display

Past performance is no guarantee of future results.  Trend signals are proprietary research of Fortunatus Investments, LLC, a Registered Investment Advisor with the Securities and Exchange Commission (SEC). Reference to registration does not imply any particular level of qualification or skill.  Prior to June 2014, Fortunatus Investments was a wholly owned subsidiary of Executive Wealth Management, LLC and they continue to share common ownership and control. Data source for returns is FactSet Research Systems Inc. This chart is not intended to provide investment advice and should not be considered as a recommendation.  One cannot invest directly in an index. Executive Wealth Management does not guarantee the accuracy of this data.

Quote of the Week

Admittedly P/Es are high but that’s maybe not as relevant in a world where we think the 10-year Treasury is going to be lower than it’s been historically from a return perspective. 

Federal Reserve chairman Jay Powell talking about stock valuations during a press conference last Wednesday.

Market News

Bear with us, we are going to get technical and tell you why the stock market is undervalued and overvalued all at the same time, and why such things are really just constructs that we use to explain movements to ourselves.
The most frequently used and easiest to understand valuation metric is the Price-to-Earnings (PE) ratio. This is simply the price per share of a stock dividend by the earnings per share (EPS). Earnings are what is left over after the cost of materials, wages, taxes, and interest are paid and depreciation is deducted. The theory goes that this is what the shareholders are entitled to in the long run. PE ratios vacillate with time and are the most volatile portion of return of a stock. Looking right now at PE ratios (the blue line in the graph below), most stocks look like they are at all-time high valuations.

PE ratios rely on analysts best estimates on the earnings potential for the next twelve months (NTM). These are only estimates and during periods of massive economic upheaval (checking around to see if we are in the middle of such a time) forward looking estimates are inaccurate at best. So relying on forward looking estimates can be a bit dodgy, but it is all we have from a valuation standpoint. Nobody really cares what a company did in the past, we are looking to divine the future. So looking at this metric says that the market is near all time highs in terms of valuations and definitely stretched compared to recent norms. What if the analysts have estimated forward growth too low?

You can take the PE ratio and flip it to get a yield metric similar to what is normally done with fixed income. This means that you are calculating an Earnings Yield (EPS/P). Again if the earnings are what you as a shareholder technically have a future claim on, then you can say the earnings yield is what could be paid out. You can see in the chart below that the earnings yield  (the gray line) reached a high in 2008 and has been trending down slowly ever since.

Of course we never look at any metric in isolation. So we must also look at what we can get paid for holding something else. In this case, we can look at the US 10-Year Yield, or “risk free rate”. The US 10-Year has been trending down since 2006 and is currently yielding less than 1%. That means that if you bought a US 10-year note you would realize 1% per year if you held it to maturity. So now let’s look at the interaction of the two.

The chart above says that for all of the volatility of the last year, the Earnings Yield minus the US 10-Year has stayed relatively flat. This is what Jay Powell was getting at when he took questions during his press conference on Wednesday. He was saying that stocks are not expensive when compared to historical levels of earnings versus the risk free rate.
Valuations change and “normal” valuations move over time. There are periods when the market is willing to pay a little more for something and periods when the market is willing to pay less for something. While valuations matter, and high valuations can be concerning, there also must be a catalyst for valuations to change. We said often in 2019 that bull markets don’t die of old age, they end because of some exogenous event. We saw that with a fury in 2020. So can the market continue to go up? Yes it can. Does it have to continue to go up? No it does not. 75% of the last 30 years the S&P 500 was positive, so chances are better than even that the market will be up next year.


Model Update

There were no trades in the Fortunatus models for the week ending on December 19, 2020. All major market sectors remain in a long-term uptrend. The Asset Allocation models maintain equity exposures near their maximum levels with overweight positions in domestic stocks in relation to international shares. 

EWM News

This will be the last newsletter of 2020. While this year certainly has had some complications, we sincerely hope all of our clients finish the season with a merry Christmas and a happy New Year.  Executive Wealth Management offices will be closed on Christmas Day and New Year’s Day.  The domestic financial markets are also closed on those days. EWM offices will be open until noon on Christmas Eve and New Year’s Eve.

We hope to see all of you again in 2021.

Executive Wealth Management (EWM) is a Registered Investment Advisor with the Securities and Exchange Commission. Reference to registration does not imply any particular level of qualification or skill. Investment Advisor Representatives of Executive Wealth Management, LLC offer Investment Advice and Financial Planning Services to customers located within the United States. Brokerage products and services offered through Private Client Services Member FINRA/SIPC. Private Client Services and Executive Wealth Management are unaffiliated entities.  EWM does not offer tax or legal advice. Please do not transmit orders or instructions regarding your accounts by email.  For your protection, EWM does not accept nor act on such instructions. Please speak directly with your representative if you need to give instructions related to your account. If there have been any changes to your personal or financial situation, please contact your Private Wealth Advisor.

Returns are calculated as indicated below with reinvested dividends not considered except for the Barclays U.S. Aggregate Bond Index. Data source for returns is FactSet Research Systems Inc. The London Gold PM Fix Price is used to calculate returns for gold

1 Week = closing price on December 11, 2020 to closing price on December 18, 2020

 1 Month = closing price on November 18, 2020 to closing price on December 18, 2020

 3 Month = closing price on September 18, 2020 to closing price on December 18, 2020

 YTD = closing price on December 31, 2019 to closing price on December 18, 2020

All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Material provided is for information purposes only and should not be used or construed as an offer to sell, or solicitation of an offer to buy nor recommend any security. Any commentaries, articles of other opinions herein are intended to be general in nature and for current interest. Some of the material may be supplied by companies not affiliated with EWM and is not guaranteed for accuracy, timeliness, completeness or usefulness and EWM is not liable or responsible for any content advertising products or services.

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