As of last week, the S&P 500 has declined to the point where we now expect 10-year total returns averaging about 5.7% annually on the index. This is certainly higher than the 3.4% prospective return we observed earlier this year, but is still a prospective return more characteristic of market peaks than of long-term buying opportunities. Wall Street analysts continue to characterize stocks as cheap on the basis of completely specious approaches like "forward operating earnings times arbitrary P/E multiple," or worse, "forward operating earnings yield divided by 10-year Treasury yield." Unfortunately, despite a few anecdotal successes, there is no correlation between "valuation" on these measures and actual subsequent market returns.
There are numerous reasons why these toy models based on forward operating earnings are misguided, but the four most important ones today are 1) forward operating earnings presently carry the embedded assumption that profit margins will achieve and indefinitely sustain the highest profit margins observed in U.S. history; 2) the duration of a 10-year Treasury bond is only about 8 years, while the duration of the S&P 500 is about 42, meaning that any given yield increase implies 5 times more loss for stocks than it does for bonds, and there is no reason in the world why investors should treat those risks as equivalent; 3) the current conformation of evidence strongly suggests the likelihood of an oncoming U.S. recession, and forward earnings expectations tend to be stunningly off-base in those instances, and; 4) the norms typically applied to forward operating earnings are artifacts of the recent period of bubble valuations, and use norms for "trailing net" as if they are equally applicable to "forward operating." In fact, the correlation between forward operating P/Es and other normalized P/Es having far longer history suggests that a forward multiple of even 12 is quite rich.
As it happens, forward operating earnings, when used properly, can actually be very informative about prospective market returns (see Valuing the S&P 500 Using Forward Operating Earnings ). However, the phrase "used properly" can't be emphasized enough. Here and now, our forward operating earnings model delivers nearly identical prospective return estimates for the S&P 500 as our standard methodology. Stocks are emphatically not undervalued here on any reasonably long-term horizon.
At the same time, we have a menu of prospective returns that is simply dismal here. Three-month Treasury bills are literally yielding less than one basis point annually. 10-year Treasury bonds are yielding just 2.1% (which makes one wonder what Ben Bernanke can possibly hope to accomplish with further attempts to distort the investment opportunity set). Corporate bonds yield just 3.4%, providing dangerously little compensation for volatility or default risk - particularly since corporate yields have typically shot to about double that level or higher during recessions, even when Treasury yields have been contained. By our estimates, utilities have 10-year prospective returns around 6.6%, which is enough to justify a modest exposure to this sector in Strategic Total Return, but even here, the durations are well over 20, so they have the potential for price weakness if debt concerns accelerate.
Despite prospective long-term returns that remain quite thin on a historical basis, some segment of investors may be willing to accept market risk in stocks and utilities based on comparative returns in an environment where Treasury yields are abominably depressed and distorted. On a long-term basis, I think that significant exposure is an mistake, because it relies on risk premiums to stay compressed indefinitely. Even so, on a near-term basis we've observed enough of a decline to taper our disdain for market valuations at least modestly. On the technical side, short-term market action is extremely compressed and oversold. Also, we saw a variety of "non-confirmations" last week - downside leadership eased, trading volume tapered off, new lows in more volatile indices such as the Nasdaq and Dow Transports were not confirmed by new lows in the S&P 500, Dow Industrials, or Dow Utilities, and so forth.
The overall picture is clearly tenuous, but may be enough to support at least a few weeks of consolidation. Any material market break would quickly reverse that hope, particularly if it featured a breakdown in balance-sheet sensitive sectors such as corporate bonds and utilities. We're willing to extend a benefit of the doubt to the coupled improvement in valuations and internals, but we're holding very close to the vest.
For our part, on Friday's weakness, we covered about 20% of our hedges in Strategic Growth, but retained a very strong line of defense a few percent below current levels using index put options. We also covered about 20% of our hedges in Strategic International Equity, but are again keeping a fairly tight leash on our willingness to accept market risk.
Suffice it to say that we continue to anticipate an oncoming recession and the potential for substantially deeper market losses over the next 12-18 months. At the same time, however, the ensemble of evidence on a variety of fronts has shifted our return/risk expectations, probably temporarily, above the zero line, allowing us to accept a small amount of market exposure, as we've briefly done on a handful of occasions this year.
Ideally, present conditions will be associated with what we've observed historically - a few weeks of moderate advance to clear the deeply oversold condition of the market, most likely followed by a fresh shift to a defensive stance. Given that the expected return/risk profile has just peeked above zero, we would prefer not to immediately experience the market's version of "Whack-A-Mole," but are prepared for that possibility as well. A break below the area around 1050 on the S&P 500 would put us in a situation much like 2008, where nearly every expectation of short-term stabilization was promptly dashed. For now, we don't see the sort of uniform breakdown that we observed then. A break to fresh lows by numerous indices, an explosion of new lows in individual issues, and steep weakness in utilities or corporate bonds would quickly change that assessment, and we will respond accordingly.
