With inflation risk high, valuations still obscene (that’s a technical term), and stock market momentum now negative, our outlook for US stocks could not be poorer. Our valuation model estimates the 10-year annualized forward return for the S&P 500 will be about zero. By itself, we don’t put much faith in valuation analysis. If being expensive meant an imminent bear market, then stocks would never stay expensive in the first place. But taking into account high inflation—as bad for stocks as it is for bonds historically—and falling prices—meaning investor sentiment is negative, we couldn’t be more concerned for the equity investor.
Our Tactical Framework for Equities
In accordance with our “Winning By Not Losing” investing philosophy we’ve outlined here, our goal with any tactical portfolio decision is not to shoot for higher returns directly. Instead, we’re trying to use a historically informed rules-based process to sidestep at least part of major drawdowns. This could add to return indirectly by reducing the time spent simply recovering from big portfolio value drops but hopefully in a way that doesn’t require taking on more risk. At the very least we hope to smooth returns for planning purposes and thereby lower the stress on investors caused by market volatility.
Anyone can increase returns over time by simply taking on more risk. But we look at the default portfolio risk level we’d help you select during our planning work as our max constraint. Then we do what we think we can while attempting to stay near or below the level of volatility you’ve said you’re comfortable with (and your overall financial plan assumes). There are no guarantees, of course. Investing is inherently uncertain. But over the long term, we think following cycles and focusing on when to take risk as well as what to take a risk on is the best way to invest. It’s how we manage our own money as well. Let’s jump in.
We assess equities along three dimensions:
- The macroeconomic environment: Is recession risk or inflation risk high?
- Valuation: What are we paying for the corporate profits that stock market companies generate for us shareholders?
- And stock market price momentum as a measure of investor sentiment
We’ve developed a key indicator or composite of indicators to help us evaluate each one. Now, you’ll find instances where any one of them would have swayed you wrong in the past. But that’s why we require that at least two of these to some degree independent variables are flashing red for us to act—what we call “corroborating evidence.” Combined, we believe this framework can act as a powerful guide to portfolio management.
The Macro Today
We’ve mentioned before that investors face two big risks: recession risk and inflation risk.
Recession Risk
The deepest and longest bear markets have been associated with recessions. In our blog last month, we mentioned recession risk. Among the eight major variables we look at, though, only three are flashing red. So while recession risk is not low, it’s not worrying us yet.
Inflation Risk
Inflation risk on the other hand is high. We think 5% and rising is the threshold for concern. And we’ve been there since October 2021. Stocks are down from then.
Inflation risk is most associated with fixed-income investments. But in fact, inflation might be an even greater concern to equity investors. Since 1965, the annualized return for US stocks in months when inflation was high and rising has only been 1.74%.1
Market Valuation
Around the time of the dot-com stock bubble in 2000, Nobel Prize-winning economist Robert Shiller introduced what became known as the Shiller Price-to-Earnings ratio or Cyclically Adjusted Price to Earnings (CAPE) ratio. He struck upon the idea that the overall earnings (AKA profits) of stock market companies in any given year was not reflective of their earnings power into the future. There was too much annual variability. He proposed comparing what you must pay for stocks to a 10-year inflation-adjusted average of earnings versus just the latest year’s figure. While a single-year P/E ratio had little predictive power, the Shiller P/E did. It’s been over 70% correlated with future 10-year returns. Shiller nicely publishes historical data for us to study back to the 1800s and updates it each month.
We use a version of the Shiller P/E—the details of which we keep in the footnotes2—that has a higher correlation for a well-understood reason. But the idea and general results are qualitatively similar. Valuations today are obscene as we mentioned. In the following chart, the green line is our valuation model’s real-time prediction and the black line is what actually occurred over the next 10 years from that point:
You can see how tightly the model fits since 1965 and also where it deviated temporarily: during the dot-com bubble and recently up until this year. So in stretched bubblicious markets, valuation discipline doesn’t work and causes a lot of grief.
Because of that, expensive valuations from some statistical model, no matter how accurate over the long term, are not enough for us. Valuations make one big assumption—investors will demand the same level of compensation for equity risk as they have throughout history—and that may not be valid. Regardless, valuations have been shown to be an “aggravating variable”—they tend to make a subsequent drawdown due to some other reason like a recession or inflationary spiral that much worse. The drawdowns in 2000/02, 2008/09, and 2020 were either deeper or faster than bear markets when valuations weren’t as high.
Price Trends
Lastly, let’s turn to price trends, which for us do not have mystical significance. We view them simply as reliable measures of investor sentiment that are worth paying close attention to. Investor surveys exist, but market prices are determined by millions of investors betting large sums in aggregate on particular outcomes. Money speaks louder than words in our opinion. There can be madness in crowds. There can wisdom in crowds. But when investors develop some “thesis” and ignore a market continually moving against them, they’ve entered into folly.
Therefore, we take price trends seriously as a confirming variable to what economic or earnings-related variables might be saying. The most convincing theory to us as to why trend following seems to have worked so well through history relates to investor psychology. People tend to be influenced by past performance and exacerbate market movements by jumping on fads on the way up and being scared into irrational selling on the way down. As students of these momentum swings, we can try to exploit them. You give something away at the top and bottom of cycles for sure because you’re waiting a bit for trends to develop. But by doing so, you get to piggyback on the insightful research (or dumb luck) of early movers’ trading—for free—just by watching how prices change over different time periods.
There are many ways to measure price trends in equity markets, including whether 12-month excess returns (over cash) have been positive or negative or whether a market index is above or below some moving average. We show those examples below:
Stocks Are Below Their 200-Day Simple Moving Average
Our own preferred proprietary measure of market momentum, which is based on a volatility filter concept that has exhibited fewer false signals, finally turned negative yesterday, May 11, 2022. Now all the major momentum signals we look at are negative.
Putting It All Together
With inflation risk high and expected returns based on valuations looking extremely low, equity investors’ prospects were already poor. Add in negative price trends and almost everything is lining up against equity investors. This doesn’t mean the market volatility will continue. Anything can happen. Much of our framework is based on the past. There’s always the chance something different develops. Any one of the indicators we look at could improve quickly: Inflation could start falling as supply issues resolve and the Federal Reserve raises rates to cut off demand. Stock market performance can turn on a dime. And earnings can rise, relieving valuations that have already improved with the declines we’ve already suffered year to date. But in that case, we will move as quickly as our indicators. Yet, with so much working against stocks, we are wary. We remain focused on our number one job as stewards of other people’s money: playing defense.
Even if we are right and we have entered into a new market downturn, beware that repeating rallies are a typical feature of equity bear markets, each one tricking a new batch of optimistic investors into jumping in too early. Most of the best days in the stock market have occurred within bear markets.3
What a first year for our firm! Founded just as inflation reached its highest point since the 1980s and now this. Still, we think we’re prepared for what the future has in store. Our confidence stems from having put in the work already building a systematic process we believe in, so that during a crash or highly volatile time in the markets when the stakes are high, we don’t have to worry about making decisions on the fly, something that’s prone to error. With the right rules in place, you almost don’t have to think—which is good, because the right investing move often feels stupid or scary in the moment (selling stocks after they’ve done well or buying stocks after a crash when everyone is just sure an eternal depression has begun or even doing nothing). Our framework is our insurance that emotion doesn’t cloud our judgment.
Note, we’ve crafted this piece to pull the curtain back a bit on how we think about investing and how we’re assessing the current market environment in real-time. No investment decisions should be based on any individual chart, data point, or indicator. There are inherent limitations to any economic, market, or investment analysis or forecast because the future is uncertain. You shouldn’t act on any piece of research you read without talking it over with your financial advisor or conducting your own thorough due diligence.
Eric R. Figueroa, CFP®
I am a Folsom, CA, fee-only wealth manager serving the Greater Sacramento area, California Gold Country, and the nation virtually. I offer financial planning and investment management, specializing in impact investing and personalized values-based investing.
All content presented in this article is for informational purposes only. Materials presented should not be interpreted as a solicitation or offer to buy or sell a security or the rendering of personalized investment advice, which can only be provided through one-on-one communication with a financial advisor. The content reflects the opinions of Hesperian Wealth LLC (HW), which are subject to change at any time without notice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All information or ideas provided should be discussed in detail with a financial, tax, or legal advisor prior to implementation.
This article includes mentions of HW’s primary methods of investment analysis: Fundamental, Technical, Cyclical, and Charting analysis.
Fundamental Analysis involves analyzing individual companies and their industry groups, such as a company’s financial statements, details regarding the company’s product line, the experience, and expertise of the company’s management, and the outlook for the company’s industry. The resulting data is used to measure the true value of the company’s stock compared to the current market value. The risk of fundamental analysis is that the information obtained may be incorrect and the analysis may not provide an accurate estimate of earnings, which may be the basis for a stock’s value. If securities prices adjust rapidly to new information, utilizing fundamental analysis may not result in favorable performance.
Technical Analysis involves using chart patterns, momentum, volume, and relative strength in an effort to pick sectors that may outperform market indices. However, there is no assurance of accurate forecasts or that trends will develop in the markets we follow. In the past, there have been periods without discernible trends and similar periods will presumably occur in the future. Even where major trends develop, outside factors like government intervention could potentially shorten them.
Furthermore, one limitation of technical analysis is that it requires price movement data, which can translate into price trends sufficient to dictate a market entry or exit decision. In a trendless or erratic market, a technical method may fail to identify trends requiring action. In addition, technical methods may overreact to minor price movements, establishing positions contrary to overall price trends, which may result in losses. Finally, a technical trading method may underperform other trading methods when fundamental factors dominate price moves within a given market.
Cyclical Analysis is a type of technical analysis that involves evaluating leading indicators, recurring price patterns, and trends based upon business cycles. Economic/business cycles may not be predictable and may have many fluctuations between long-term expansions and contractions. The lengths of economic cycles may be difficult to predict with accuracy and therefore the risk of cyclical analysis is the difficulty in predicting economic trends and consequently the changing value of securities that would be affected by these changing trends.
Charting Analysis involves the gathering and processing of price and volume information for a particular security. This price and volume information is analyzed using mathematical equations. The resulting data is then applied to graphing charts, which is used to predict future price movements based on price patterns and trends. Charts may not accurately predict future price movements. Current prices of securities may not reflect all information about the security and day-to-day changes in market prices of securities may follow random patterns and may not be predictable with any reliable degree of accuracy.
Any indicators or analyses of past market performance shown in this article are hypothetical and do not reflect the performance of any actual client account managed by HW, any past decisions made by HW, nor the total fees and expenses that would have been paid by a Hesperian client account, which include Hesperian’s investment management fee in addition to the operating expenses and fees of the underlying funds and other investments.
Any reference to a market index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indexes are unmanaged vehicles that do not account for the deduction of fees and expenses generally associated with investable products.
Investing involves substantial risk, including the potential loss of principal. HW makes no guarantee of financial performance nor any promise of any results that may be obtained from relying on the information presented. HW may analyze past performance, but past performance may not be indicative of future performance.
1 Source: Hesperian calculations, Portfolio Visualizer, Ibbotson, US Bureau of Labor Statistics. Geometric average return over months when the most available year-over-year change in headline CPI is greater than 5% and above the year-over-year figure six months prior. Data as of April 30, 2022. US stocks represented by the Vanguard 500 Index fund extended by the S&P 500 Index and Ibbotson’s Year Book record for US large-cap stocks.
2 We make some small adjustments that increase the predictability of the Shiller P/E and also properly represent a real-time implementation of a model based on it (we call it the Shiller P/E 50):
First, we use the recent Total Return Shiller P/E calculation that adjusts for any distortion caused by share buybacks.
Second, we take a 50-year (not 10-year) average of inflation-adjusted earnings because, as fund manager John Hussman has pointed out, you can observe abnormal profit margins over even a 10-year period. By adding in more data, the predictive power and model fit increase materially. However, by doing so, we are in effect assuming that the average profit margin over the last 50 years is representative of future profit margins.
Finally, we have tried to present a model that could have realistically been used by an investor if hypothetically they had “known” about the Shiller P/E. So at any given point in time, we run a linear regression based only on the Shiller P/E ratios and future 10-year returns that could have been observed by that date. It doesn’t “look ahead” and know all the future ratios and returns. Then each month, an additional data point is added to the regression so that it “learns” over time. By 1965, it has had about 30 years of data since 1926 to learn from, enough to be pretty accurate going forward. Though again, it is making assumptions about what compensation investors require for risk and what future profits will be that may not hold.
3 Meb Faber, “Where the Black Swans Hide & The 10 Best Days Myth“, August 2011.