Have We Hit The Top?

[Luke]

If EM would trade at 25x, they would have outperformed the SP 500:

 

Meanwhile these economies still grow faster.

 

 

Edited December 29, 2023 by Luca

[UK]

https://www.bloomberg.com/news/features/2023-12-29/wall-street-s-worst-investing-mistakes-of-2023-from-stocks-to-treasuries?srnd=premium-europe&leadSource=uverify wall

 

All across Wall Street, on equities desks and bond desks, at giant firms and niche outfits, the mood was glum. It was the end of 2022 and everyone, it seemed, was game-planning for the recession they were convinced was coming.

...

Blended together, these three calls — sell US stocks, buy Treasuries, buy Chinese stocks — formed the consensus view on Wall Street. And, once again, the consensus was dead wrong. What was supposed to go up went down, or listed sideways, and what was supposed to go down went up — and up and up. The S&P 500 climbed more than 20% and the Nasdaq 100 soared over 50%, the biggest annual gain since the go-go days of the dot-com boom.

...

For some on Wall Street’s sell-side, doubts are creeping in. At TD Securities, Gennadiy Goldberg, now the head of US rates strategy, said he and his colleagues “did some soul searching” as the year wound down. TD was among the firms predicting solid 2023 bond gains. “It’s important to learn from what you got wrong.” What did he learn? That the economy is far stronger and far better positioned to cope with higher interest rates than he had thought. And yet, he remains convinced that a recession looms. It will hit in 2024, he says, and when it does, bonds will rally.

[ValueArb]

To me it seemed a lot easier to predict the fed would raise rates than to predict a recession, for the simple fact the fed was telling you they would be raising rates. And if the fed is raising rates why would  you want to own treasuries of any significant duration?

[TwoCitiesCapital]

On 12/29/2023 at 9:42 AM, ValueArb said:

To me it seemed a lot easier to predict the fed would raise rates than to predict a recession, for the simple fact the fed was telling you they would be raising rates. And if the fed is raising rates why would  you want to own treasuries of any significant duration?

 

Mostly because you can't actually trust the Fed. 

 

3 weeks ago the Fed said it was too early to be penciling in rate cuts. Now they're predicting 3 themselves. Long duration treasuries absolutely killed it over that period. 

 

In 2021, the Fed said inflation would be minimal and transitory. 6 months later it was 7-9% per annum and has taken 2 whole calendar years to get anywhere close to where it was when they made those comments. 

 

In 2007, Bernanke said subprime was contained. It wasn't. 

 

Can you really trust the Fed? Best to form your own opinions as the Fed pivots 180⁰ all of the time. 

Edited December 30, 2023 by TwoCitiesCapital

[mattee2264]

Consensus for 2024 seems to be:

-Bonds are still a buy because rates are definitely coming down

-Stocks are going up because of a combination of lower interest rates and EPS growth expectations of 10%

-We are going to avoid recession (aka soft or no landing)

 

Would not surprise me at all if markets got this very wrong as well. 

 

Bond market has already priced in a pretty optimistic picture of Fed rate cuts. And ignored the fact that the yield curve will un-invert at some point so Fed funds rate would have to fall a lot for the long bond to go much further below 4%. So IMO bonds are only a screaming buy if you think we are headed for a hard landing or the Fed completely capitulates and reinstates ZIRP to bail out the financial system or allow corporations/governments to cheaply refinance maturing debt.

 

Stock market has already priced in interest rate cuts (which haven't happened and are even greater than the Fed is guiding) and 10% EPS growth seems pretty optimistic in a soft landing scenario. And Mag7 will have to do a lot of the heavy lifting. Which I suppose is possible but not something I would count on.

 

As for the recession call. Obviously the bears have been wrong so far. But I think that in a myopic stock market neither bears nor bulls seem to understand policy lags which are around 1-2 years. When the first rate hike was only in early 2022 and in the previous few years we'd had ZIRP huge amounts of QE and unprecedented fiscal stimulus (which is ongoing if less effective than the pandemic handouts) it was far too premature to call for a recession and understandably bears have lost any credibility. So if a recession does arrive in 2024 and 2025 when the impact of the tightening in 2022 and 2023 is felt in full and fiscal stimulus continues to wear off then it will catch markets by surprise. 

 

The other possibility is while we avoid recession inflation takes off again and the Fed does another U-turn and long bond rates might go a lot higher than 5%. And with all the corporate and government debt maturing higher for longer is not an outcome that anyone wants. Falling inflation has given the Fed an excuse to pivot while maintaining some semblance of credibility. But if inflation takes off again they'd probably have to backtrack.

 

Or something else entirely might happen.

 

 

 

 

[Paarslaars]

Expectations are nice and all but keep a close eye on CPI, Powell can change his mind quickly regarding those rate cuts.

[TwoCitiesCapital]

15 hours ago, mattee2264 said:

Bond market has already priced in a pretty optimistic picture of Fed rate cuts. And ignored the fact that the yield curve will un-invert at some point so Fed funds rate would have to fall a lot for the long bond to go much further below 4%. So IMO bonds are only a screaming buy if you think we are headed for a hard landing

 

Intermediate bonds were a screaming buy @ 4-5% IMO. But I tend to agree with you here. Most of my adds at this point are going to short-duration spread and not adding more duration - can still get ~6-7% in spread products without much interest rates risk. In tax free accounts, that's pretty good with limited risk. And relative to 3.8% on a 10-year treasury? Much of the easy money in intermediate bonds was made in November/December. Gets harder here on our. 

 

15 hours ago, mattee2264 said:

Stock market has already priced in interest rate cuts (which haven't happened and are even greater than the Fed is guiding) and 10% EPS growth seems pretty optimistic in a soft landing scenario. And Mag7 will have to do a lot of the heavy lifting. Which I suppose is possible but not something I would count on.

 

Very optimistic seeing as earnings expectations for Q4 and Q1 are already coming down....

 

15 hours ago, mattee2264 said:

The other possibility is while we avoid recession inflation takes off again and the Fed does another U-turn and long bond rates might go a lot higher than 5%. And with all the corporate and government debt maturing higher for longer is not an outcome that anyone wants. Falling inflation has given the Fed an excuse to pivot while maintaining some semblance of credibility. But if inflation takes off again they'd probably have to backtrack.

 

My only concern with this happening is oil. If the current global conflicts result in oil sky rocketing and/or the cost of sea borne trade rising significantly due to higher war premium/more days at sea/higher energy costs then I can see a small re-acceleration. I'm hedged to that by continuing to own oil producers. 

 

But outside of that, I think think it'll be hard to see inflation reaccelerate. The only thing holding it up at the moment is services. Those will go with the consumer which will go with employment. And employment is a lagging indicator - thus so must services inflation be. 

Edited December 31, 2023 by TwoCitiesCapital

[Sweet]

In terms of PE we aren’t too far away from the from the ~35 year average of 19.

 

Notable that the lowest PE since 1989 has been 13.  

[Luke]

17 minutes ago, Sweet said:

In terms of PE we aren’t too far away from the from the ~35 year average of 19.

 

Notable that the lowest PE since 1989 has been 13.  

SP 500 trades at a PE ratio of 26'35 as of 29th DEC. Getting back to 19 is a 30% crash, very significant. 

[Luke]

Considering there is almost no sharecount shrinkage in the index and margins peaked 2021, youd need 4 years to recover of that drawdown (4% sales growth+2% dividend+19x earnings)

[Luke]

Taiwan attack, war with China etc are an easy -50% drawdown, if not more. 

[ValueArb]

15 minutes ago, Sweet said:

In terms of PE we aren’t too far away from the from the ~35 year average of 19.

 

Notable that the lowest PE since 1989 has been 13.  

 

The 10 year Treasury Rate in January 1989 was 9%, and has been on a long downward trend since then, reaching near half percent in 2020.

 

The corporate income tax rate was 46% from 1979-1986, and dropped to 35% in 1988. In 2018 it was reduced to 21%.

 

Individual capital gains rates were 30-35% in 70s, dropped to 28% in 1987, then 20% in 1997, 15% in 2003, and back to 20% in 2013. 

 

Individual dividend rates were same as earned income until 2003, then became 15%.

 

As a thought experiment, lets assume that with "normal" interest and tax rates (7% interest rate, 46% corporate income tax rate, 30% individual capital gains/dividend rates) and the market should trade at 15x PE. A DCF Calculator will tell you with the same growth assumptions (4%/year for 20 years) reducing the risk free rate from 7% to 4% doubles the value of those future cash flow streams, so the market's PE should roughly double. 

 

Cutting corporate tax rates doesn't increase PEs, but it increases earnings growth rates. A business making $2,000 pre tax will earn $1,080 after tax at 46% rates, but a 35% rate increases after tax earnings to $1,300, 21% rates increase after tax earnings to $1,580. Overall lowering corporate tax rates from 46% to 21% increases after tax earnings by 46%. Over 34 years that increases earnings growth by a little over 1% annually, which increases our DCF value by 15%, so market PE should be roughly 15% higher. 

 

Individual rates don't directly affect PE, but should affect how much investors are wiling to pay for earnings. Decreasing capital gains/dividend rates from 30% to 15% increases investor net gains by 21%, so theoretically they should be willing to pay 21% higher PEs. 

 

Obviously the real world isn't so clean. There are a lot of tax deferred monies invested in the market for one example, non one cares about capital gains or dividend rates for their IRAs. The ten year rate isn't necessarily the "risk free" rate, it's not clear how many were treating it as such when rates were below 1%.  Anyone who was would raise their valuations by 9X when rates dropped from 7% to 1%, but the market PE didn't shoot to 140. Its likely that most investors viewed the lowest rates as temporary, but might still have been using 3 or 4%. Also actual tax rates are affected by brackets, allowable write-offs, etc. 

 

That said my point is that market PE is heavily influenced by interest and tax rates. Even the Shiller PE doesn't adjust for either, making it nearly as wrong as the current market PE.  If we want to believe the market PE in the next few decades will continue to average in the 19-20 range we need to also assume that corporate and individual tax rates won't increase significantly, and that interest rates won't increase much either. Those seem like pretty speculative assumptions to me given our current federal deficits and debt levels. 

[Luke]

23 minutes ago, ValueArb said:

 

The 10 year Treasury Rate in January 1989 was 9%, and has been on a long downward trend since then, reaching near half percent in 2020.

 

The corporate income tax rate was 46% from 1979-1986, and dropped to 35% in 1988. In 2018 it was reduced to 21%.

 

Individual capital gains rates were 30-35% in 70s, dropped to 28% in 1987, then 20% in 1997, 15% in 2003, and back to 20% in 2013. 

 

Individual dividend rates were same as earned income until 2003, then became 15%.

 

As a thought experiment, lets assume that with "normal" interest and tax rates (7% interest rate, 46% corporate income tax rate, 30% individual capital gains/dividend rates) and the market should trade at 15x PE. A DCF Calculator will tell you with the same growth assumptions (4%/year for 20 years) reducing the risk free rate from 7% to 4% doubles the value of those future cash flow streams, so the market's PE should roughly double. 

 

Cutting corporate tax rates doesn't increase PEs, but it increases earnings growth rates. A business making $2,000 pre tax will earn $1,080 after tax at 46% rates, but a 35% rate increases after tax earnings to $1,300, 21% rates increase after tax earnings to $1,580. Overall lowering corporate tax rates from 46% to 21% increases after tax earnings by 46%. Over 34 years that increases earnings growth by a little over 1% annually, which increases our DCF value by 15%, so market PE should be roughly 15% higher. 

 

Individual rates don't directly affect PE, but should affect how much investors are wiling to pay for earnings. Decreasing capital gains/dividend rates from 30% to 15% increases investor net gains by 21%, so theoretically they should be willing to pay 21% higher PEs. 

 

Obviously the real world isn't so clean. There are a lot of tax deferred monies invested in the market for one example, non one cares about capital gains or dividend rates for their IRAs. The ten year rate isn't necessarily the "risk free" rate, it's not clear how many were treating it as such when rates were below 1%.  Anyone who was would raise their valuations by 9X when rates dropped from 7% to 1%, but the market PE didn't shoot to 140. Its likely that most investors viewed the lowest rates as temporary, but might still have been using 3 or 4%. Also actual tax rates are affected by brackets, allowable write-offs, etc. 

 

That said my point is that market PE is heavily influenced by interest and tax rates. Even the Shiller PE doesn't adjust for either, making it nearly as wrong as the current market PE.  If we want to believe the market PE in the next few decades will continue to average in the 19-20 range we need to also assume that corporate and individual tax rates won't increase significantly, and that interest rates won't increase much either. Those seem like pretty speculative assumptions to me given our current federal deficits and debt levels. 

Exactly, higher than average margins, lower than average taxes etc etc. higher tensed macro, onshoring, increasing global hostility. Wouldn't want to take the bet. 

[Sweet]

2 hours ago, ValueArb said:

 

The 10 year Treasury Rate in January 1989 was 9%, and has been on a long downward trend since then, reaching near half percent in 2020.

 

The corporate income tax rate was 46% from 1979-1986, and dropped to 35% in 1988. In 2018 it was reduced to 21%.

 

Individual capital gains rates were 30-35% in 70s, dropped to 28% in 1987, then 20% in 1997, 15% in 2003, and back to 20% in 2013. 

 

Individual dividend rates were same as earned income until 2003, then became 15%.

 

As a thought experiment, lets assume that with "normal" interest and tax rates (7% interest rate, 46% corporate income tax rate, 30% individual capital gains/dividend rates) and the market should trade at 15x PE. A DCF Calculator will tell you with the same growth assumptions (4%/year for 20 years) reducing the risk free rate from 7% to 4% doubles the value of those future cash flow streams, so the market's PE should roughly double. 

 

Cutting corporate tax rates doesn't increase PEs, but it increases earnings growth rates. A business making $2,000 pre tax will earn $1,080 after tax at 46% rates, but a 35% rate increases after tax earnings to $1,300, 21% rates increase after tax earnings to $1,580. Overall lowering corporate tax rates from 46% to 21% increases after tax earnings by 46%. Over 34 years that increases earnings growth by a little over 1% annually, which increases our DCF value by 15%, so market PE should be roughly 15% higher. 

 

Individual rates don't directly affect PE, but should affect how much investors are wiling to pay for earnings. Decreasing capital gains/dividend rates from 30% to 15% increases investor net gains by 21%, so theoretically they should be willing to pay 21% higher PEs. 

 

Obviously the real world isn't so clean. There are a lot of tax deferred monies invested in the market for one example, non one cares about capital gains or dividend rates for their IRAs. The ten year rate isn't necessarily the "risk free" rate, it's not clear how many were treating it as such when rates were below 1%.  Anyone who was would raise their valuations by 9X when rates dropped from 7% to 1%, but the market PE didn't shoot to 140. Its likely that most investors viewed the lowest rates as temporary, but might still have been using 3 or 4%. Also actual tax rates are affected by brackets, allowable write-offs, etc. 

 

That said my point is that market PE is heavily influenced by interest and tax rates. Even the Shiller PE doesn't adjust for either, making it nearly as wrong as the current market PE.  If we want to believe the market PE in the next few decades will continue to average in the 19-20 range we need to also assume that corporate and individual tax rates won't increase significantly, and that interest rates won't increase much either. Those seem like pretty speculative assumptions to me given our current federal deficits and debt levels. 

Yes you are saying that multiple expansion is to be expected given the tailwind and also saying that changes in interest rates, taxes etc can move the needle both up and down in terms of multiples.

 

We are in a different era from the 20s-50s etc.  Just so many different moving parts these days and much more money chasing the stocks through passive indexing and the like.

 

My post is only to point out that things aren’t that out of whack to historical standards. 

[Sweet]

3 hours ago, Luca said:

SP 500 trades at a PE ratio of 26'35 as of 29th DEC. Getting back to 19 is a 30% crash, very significant. 

He may be calculating it differently, I checked other sources and the difference appears to be consistent 

[Dinar]

@ValueArb, your numbers are off.  Federal long term capital gains rate is 23.8% (you are forgetting Obamacare surtax) and qualified dividend tax rate is 23.8% for the same reason.  Also, state income tax rates have generally risen in that time frame.  For instance, CT went from 0% to 7%, NJ from 6% to 11%, and NY from 6.6% to 11-12%.  

[ValueArb]

30 minutes ago, Sweet said:

He may be calculating it differently, I checked other sources and the difference appears to be consistent 

 

 

Shiller PE is 32 and has been 25+ for almost the last entire decade.

 

https://www.multpl.com/shiller-pe

 

I prefer it to using raw PE from TTM because it should smooth out cyclicality.  But as I said it doesn't adjust for changes in risk free interest and tax rates (but claims to adjust for inflation). I've always wanted to take the time to try to make those adjustments to see if with those adjustments match market prices to valuation better, but I suspect it won't make a huge difference as the market is a very complex beast that defies description by formula. 

 

Momentum is just one example. Let's assume the markets fair value PE should always be 19. But anyone who bought and held in the period from 2009 to 2022 made out like bandits from increasing PE ratios. So even if they now think it is overvalued at a 26 PE, why would they sell and abandon what has worked so well? Who is to say it won't trade well above a 30 PE in a few years? And if the overwhelming sentiment remains to buy dips and hold, no matter what a DCF valuation says, then this pattern can't break until a long bear market. Nine months in 2022 wasn't enough to break the majority belief built over the previous 144 months that dip buying will always pay.

 

Its exactly why Ben Graham told that old joke to describe how powerful momentum is in the market:

 

Quote

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence,” said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately, the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

 

[Libs]

4 hours ago, Sweet said:

In terms of PE we aren’t too far away from the from the ~35 year average of 19.

 

Notable that the lowest PE since 1989 has been 13.  

 

Ex the MAG-7, the other 493 stocks have a P/E under 15. The market is not overvalued. If you don't want to pay 31X for Apple, you can easily work around that.

 

Also U.S small and mid caps are even cheaper.

 

 

 

[Gregmal]

1 minute ago, Libs said:

 

Ex the MAG-7, the other 493 stocks have a P/E under 15. The market is not overvalued. If you don't want to pay 31X for Apple, you can easily work around that.

 

Also U.S small and mid caps are even cheaper.

 

 

 

Yup. What was the most obvious lesson everyone shoulda learned the past year? Sitting around wallowing about “the market” and its perceived “valuation”, is a waste of time. So….what do we start off doing in 2024? 
 

Just find shit that works for what you’re trying to do. It’s not hard. Stop finding excuses to pay attention to pointless crap.

[ValueArb]

34 minutes ago, Dinar said:

@ValueArb, your numbers are off.  Federal long term capital gains rate is 23.8% (you are forgetting Obamacare surtax) and qualified dividend tax rate is 23.8% for the same reason.  Also, state income tax rates have generally risen in that time frame.  For instance, CT went from 0% to 7%, NJ from 6% to 11%, and NY from 6.6% to 11-12%.  

 

Sure if you are subject to the NIIT, its higher (which the bulk of individual capital gains are likely to be given the low income threshold). And state taxes also have an impact if you live in a state with an income tax, which again the bulk of individual capital gains likely do (given how many high net worth individuals live in NY and CA).

 

Again more evidence for why the real world is a lot messier than a simple equation can model. But I think it's still clear that overall tax rates on capital have dropped significantly between 1986 and now, and that is one part of the reason for higher PE ratio of the market today.

[Sweet]

24 minutes ago, Libs said:

 

Ex the MAG-7, the other 493 stocks have a P/E under 15. The market is not overvalued. If you don't want to pay 31X for Apple, you can easily work around that.

 

Also U.S small and mid caps are even cheaper.

 

 

 

Exactly.  You pick your spots.  There were large banks trading as low as a PE of 6 just a few months ago.

[ValueArb]

10 minutes ago, Libs said:

 

Ex the MAG-7, the other 493 stocks have a P/E under 15. The market is not overvalued. If you don't want to pay 31X for Apple, you can easily work around that.

 

Also U.S small and mid caps are even cheaper.

 

 

 

 

Thats true too but passive investors in SP500 have to take the expensive with the cheap and are still paying a pretty high price. More than ever total stock market index FTW for passive investors.

[vinod1]

Historical comparisons are not valid for a lots of reasons. Valuation levels need to reflect that. A few of the most important changes

 

1. In the past say 1880 or 1900 or 1920 or 1940... no one can put together a diversified portfolio of stocks at a cost less than 2% per year in expenses. That is direct expenses. Then you have insufficient information, risk with paper stock certificates, fraud, etc in buying stocks. Even if you ignore these indirect expenses, at a minimum you are paying 2% fees annually (brokerage costs, bid ask spreads, over the typical holding period) and unit trusts had loads and annual fees that averaged these as well. So if stocks returned 6.5% real, you still ended up with 4.5% returns and at best not in a very diversified way.

 

Now an investor can buy total stock market fund at 3 bps. To get the same returns as in the past in a much more convenient way, investors can pay a lot more due to lower costs.

 

2. As much as many look down at economists and central bankers,  they did learn a lot. The great depression - the bogeyman for many stock investors, is not going to happen again. We had a good practice run in COVID. Should something really bad happen short of a worldwide annihilation event (when your portfolio would be of little value/use anyway) you can predict what Fed would do. No points for guessing. You should be able to guess what politicians would do (Trump to Biden and everyone in between) - spend and spend some more. And they wont be wrong. 

 

This takes away the greatest risk to stock markets - that aggregate spending would fall i.e. consumers would not be able to spend money. Thus companies revenues are protected. This is a dramatic change from the past.

 

If risk is lower, it is only natural to expect higher valuations and lower returns in future.

 

3. People also have wised up. They are not stupid. They do have 150 years of data that shows, every single time the stocks crashed, it was a buying opportunity. Short of a revolution (Russia, Germany, Japan...) when it does not matter what you hold (ok gold to some extent) everything is going to be worthless. Short of that, it is clear to anyone and their dog, that buying when stocks are down is a no-brainer.

 

4. In the past people worked until they dropped dead. Now people spend several years in retirement. For that they save (not everyone, but anyone who has wealth) and invest in the stock market. 401k, ira, etc. Everyone paycheck vast sums get deposited into these and they are automatically invested in markets. 

 

To expect stocks to get to a PE of 7 or 10 is stupid. Not going to happen except for very very brief amount of time - a few days at most. So valuations are going to average much higher in future.

 

Vinod

 

Edited January 2 by vinod1

[vinod1]

I would think the natural tendency of market would be slightly overvalued. People who are bearish would avoid stocks most of the time anyway. So we have a market which ordinarily would be dominated by optimists (bulls, else they would not be investing) and that should lead to higher than what a totally unemotional investor would pay. So market and many stocks would be perpetually be slightly higher than what we as valuation sensitive investors would be willing to pay. If this causes us to keep a lower allocation to stocks it would undo any stock picking skills we might accidentally exhibit  

 

This is just a wild thought that I have been thinking for a while and I might be entirely mistaken.

 

 

Edited January 2 by vinod1

[mattee2264]

For most of long bull markets stocks trade above 20x earnings. So long as earnings keep going up (which they will do absent a recession) and inflation and interest rates remain moderate it is sustainable. 

 

The basic idea is that if interest rates are 4-5% then that is equivalent to a PE ratio of 20-25x. So long as growth is assumed then there isn't any real requirement for an equity risk premium. It is only during times of heightened fear that investors demand a high equity risk premium because the safety of bonds is preferred to the prospect of never ending losses in stocks. Clearly that mentality does not exist at the moment. We've seen the stock market recover from the GFC, from the Euro debt crisis,  from COVID, from the most aggressive Fed tightening cycle in the last 40 years and countless smaller bumps in the road. 

 

And of course there are other reasons to support higher than average PE multiples such as changing market composition (more growth/quality/defensive, less cyclicality), more interventionist monetary and fiscal policy, and perhaps even a generational change in investors as the old timers who remember the Great Depression have been replaced by Gen Z whose motto is "YOLO" and crowd into tech companies they are familiar with.