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- The Weekend Edition # 154 - Richie Rich Valuations
The Weekend Edition # 154 - Richie Rich Valuations
Ayesha Tariq
November 24, 2024
Welcome to another issue of the Weekend Edition!
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Here's what we cover
Market Recap - Bitcoin is the star!
18 Nov - 22 Nov
It’s been a busy week with Nvidia earnings dominating most of the headlines, aside from the new administration’s nominees.
We also saw an escalation in the conflict between Ukraine and Russia. This saw some risk-off in the market. Defense and nuclear stocks saw some gains after Russian President Vladimir Putin signed a new nuclear doctrine that expands the conditions under which Russia could use nuclear weapons, including a potential first-use scenario if a conflict threatens Russia’s sovereignty or territorial integrity.
The longer term trajectory still remain in tact for the US markets and given that we’re entering a period of favorable seasonality, we continue to lean bullish on the markets, amid these market pullbacks.
The big news this week has been Bitcoin, and its meteoric rise to towards the $100,000 mark. Bitcoin continues to remain a speculative asset though. The recent price surge is based more on momentum and sentiment, than any fundamental reason. We think 100,000 could mark a temporary top, and could definitely see increased profit-taking at this level. Can the price cross 100,000 and move higher? It very well can if we see fiscal support reintroduce liquidity into the system, under the new administration.
Macro - Richie Rich Valuations!
Over the past few days, I’ve come across a number of different comments about the market’s valuation. More specifically, the US Markets. I looked at this comparison from Barclays, and it showed clearly that the US Markets are significantly stretched when we look at it from a valuation perspective.
So the question is: Where do we go from here?
Because we know, that most measures that are stretched, tend to revert to the mean, or at least pullback to a certain extent. It's not very different from stretching a rubber band.
So, how stretched are we?
The First Row shows the Price to Book Value (P/B), the second row shows the Price to 12-month Forward Earnings, and the third is the 10Y CAPE Ratio. And they all have Mean, and Standard Deviation Bands.
“The CAPE Ratio (also known as the Shiller P/E or PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio. The ratio is calculated by dividing a company's stock price by the average of the company's earnings for the last ten years, adjusted for inflation.” (Source: Corporate Finance Institute).
What’s very clear from this picture is that US Market Valuations are stretched by all three measures. And that’s where the concern starts to come into play.
The Buffett Indicator is also stretched
Before we talk about whether this sustainable or not, there’s one more indicator that we should look at, and that the Buffett Indicator. I like the Buffett Indicator because it take the total market cap and divides is by the GDP. In the macro environment that we have been in, with increased levels of government spending driving GDP and liquidity, this measure seems to be quite appropriate because it should translate GDP growth to an increase in market value.
To take it one step further, GuruFocus, has also added in the Total Assets of the Fed to the GDP, in the denominator of the equation. This now gives us : GDP Growth + Liquidity, and how much it is supporting the increase in Market Cap. So, the Buffett Indicator 2.0.
Well it turns out, that the market is significantly overvalued by both these measures as well, and we can see this in the very helpful chart below. Both these measures are quite a bit higher than the 20Y average and theoretically, the market should return -0.3% in the next one year, according to GuruFocus’ calculations.
So now that we’ve established that the market is significantly overvalued by historical standards, and that theoretically, we should revert to mean / normal, or at least see a negative return, where do we go from here?
There are three things that we have to bear in mind when it comes to this.
1. Earnings Growth
An upward revision in Earnings growth can mean we will see P/E ratios decline, and therefore some normalization, and the market can keep moving higher.
Over the last two quarters, we’ve seen the US markets, specifically the S&P 500 move out of an earnings recession, i.e., we’re seeing earnings start to grow again year-on-year. The chart below shows us that the EPS for the S&P 500 is moving higher, and this can very well keep the market in balance.
However, we are starting to see some concerns about the forward earnings, and there have been several analysts who are revising earnings growth lower for 2025. The uncertainty surrounding the Fed’s rate cuts, and the new administration’s policies could mean
A higher USD puts pressure on corporate earnings
Higher wages because of a tighter labor market, and fewer foreign workers, offsetting the tax cut benefits.
Tariffs leading to higher input costs and overall economic slowdown
Inflation could temporarily benefit stocks but it hurts purchasing power.
2. Multiple Expansion and the 10Y US Treasury Yield
Just because the market is overvalued by historical standards, doesn’t mean it can’t remain overvalued. If conditions are right, we could see further multiple expansions.
A decline in yields usually leads to multiple expansions, i.e., the P/E multiple starts to increase. So here is where things start to get tricky. The proposed policy actions suggest that inflation is likely to move higher and that means fewer Fed cuts, and higher rates. We see the long-term yield remaining high at least for the first two quarters of next year.
There is also the issue of fiscal spending, and treasury refunding for next year. We expect that some of the shorter term issuances will turn into longer term issuances, requiring a premium and pushing down the price of long-term bonds, and consequently pushing up longer term yields.
3. GDP growth and Liquidity
Based on the Buffet Indicator 2.0, if GDP Growth and Liquidity both increase, the ratio could move lower, and/ or support a higher market cap.
We have some indication that GDP growth will likely slow, albeit not down to recessionary levels. But, we may see some pullback in the strength that we’re currently seeing for the US. Some of this is based on the policies for Tariffs, others because of a stronger dollar.
However, if there’s anything we know, it’s that the market loves liquidity. And liquidity may remain in the system with added government spending and Fed reducing their pace of QT. This could very well support higher market values.
Closing Thoughts - A bumpy path higher
We talked about a bumpy path for equities last week, and while the path of least resistance is still higher, we think caution is warranted. While macro factors played a part in the steep ascent of the market over the last year, the major catalysts were the themes - AI, and to some extent GLP-1 and a few other minor themes.
The catalysts have not gone away, and we may see renewed interest next year. In fact, we may see a shift to other catalysts as well. Who knows? What we do know is that until the new administration’s policies are made clearer, we remain surrounded by uncertainty.
As we’ve noted today, we have several obstacles to overcome for this market to move higher, and we will need those macro tailwinds, thematic catalysts, and general positive momentum to see significantly higher levels.
Have a safe trading week out there!
Sincerely yours,
Ayesha Tariq, CFA
There’s always a story behind the numbers.
Calendars
US Earnings Calendar
US Economic Calendar in Eastern Time (Source: Trading Economics)
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