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While I am a very great admirer of Howard Marks, his fairly sanguine view of equities here seems inconsistent with what he calls “second-level thinking” about how securities are valued, and is almost certainly inconsistent with his observation that “Rule number one, most things will prove to be cyclical. Rule number two, some of the greatest opportunities for gain and loss come when people forget rule number one.”
Second-level thinking requires us to be very careful in recognizing that equities are not simply a claim on next year’s forward operating earnings, but are instead a claim on the very long-term stream of cash flows that will actually be delivered into the hands of investors over time. With profit margins at record highs, easily 70% above long-term norms, current estimates of forward operating earnings are wholly unrepresentative of those long-term cash flows. As a result, second-order thinking would seem to encourage the question “What is more strongly correlated with actual subsequent market returns? Is it the raw, unadjusted multiple of stock prices to expected earnings, or is it the valuation of stocks after properly adjusting for the predictable cyclicality of profit margins?”
This doesn’t have to be a philosophical question, because a century of evidence can be brought to bear on it. The unequivocal answer is that valuation measures that adjust for margin cyclicality are roughly 90% correlated with subsequent 10-year returns, while unadjusted measures such as forward operating P/Es (FOEs) and the Fed Model have a correlation of about 30%. Square those figures and you obtain the proportion of variation associated with each: cyclically adjusted measures explain about 80% of the variation in subsequent 10-year returns, while FOEs and the Fed Model explain less than 10%. (see Investment, Speculation, Valuation and Tinker Bell for a review of this evidence – a variety of recent charts in my weekly comments such as price/revenue and market cap to GDP also illustrate the tight correspondence of these measures to subsequent returns).
It’s interesting that Howard Marks observed “In 2000 everybody would have said equities would give you 11%; they would have been unanimous in that. Now everybody says 6% or 7%.” I’m not sure who “everybody” is, but in 2000, we were (accurately) projecting 10-year nominal total returns between -4% and -6% annually, and we presently project 10-year nominal total returns between 0% and 3% annually. Between those points, the same methods projected 10-year prospective nominal total returns between 11% and 14% at the 2009 lows. Our record on this is often dismissed because my insistence on stress-testing against Depression-era outcomes interfered (as similar valuations in the Depression were followed by an additional two-thirds decline in the stock market). Still, our estimates of 10-year prospective returns haven’t missed a beat in nearly a century of data. The exception was a brief period in the early 1990’s. Though our estimates were still very positive, earning me the title of a “lonely raging bull” in the L.A. Times, even the best valuation measures underestimated the bubble that would occur by 2000.
On the assertion that equities are somehow “underowned” institutionally, it follows that they must be “overowned” by retail investors, because I guarantee that every share of stock in existence is presently owned by somebody. My impression that Howard Marks is really (and legitimately) observing a general increase in the debt holdings of institutions relative to equity holdings. But that isn’t evidence that equities are underowned. It’s evidence that massive amounts of debt have been issued in recent years. Total credit market debt is now 345% of GDP, which swamps the market capitalization of equities to GDP (currently about 126% of GDP for non-financial companies, based on Z.1. Flow of Funds data), even though market cap / GDP is about double its historical norm prior to the late-1990’s bubble, and strongly correlates with subsequent 10-year market returns.
The bottom line is that I think Howard Marks is absolutely correct about the importance of second-level thinking, as well as the importance of recognizing that “most things will prove to be cyclical.” Unfortunately, I am also absolutely convinced that a proper consideration of these principles should have long-term investors running for cover.
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