Video: Market Valuations and Opportunities

I recorded a video that discusses some risks I see in the general stock market and opportunities that have resulted in part because of passive index flows

Index investing is simply making an investment into stocks. Like any investment, this can be a great investment at one price but a risky investment at another.

I recently did a talk where I pointed out how expensive the S&P 500 currently is and how that might impact returns that index investors achieve going forward.

The market is priced at 29 P/E (using ttm earnings), which is more expensive than anytime in the last 40 years outside the waning years of the late 1990’s tech bubble.

I can’t predict where the market will go over the next few years, and it’s hard to predict what the market’s P/E ratio will be at any given point in time, but I do think we can estimate the longer term earnings growth using 50 years of history as a guide. S&P 500 earnings are extraordinarily consistent if we look at rolling 10-year periods (see video for more thoughts here).

I break down the 3 engines of the S&P 500 results over the last decade as well as over the last 40 years, and try to come up with a range of possible outcomes.

In short, I think it’s fair to assume we’ll see similar 6% earnings per share growth on the S&P 500, but we won’t likely see the 5% per year tailwind from the rising P/E ratio. That could prove to be a headwind, which is why it’s possible or even likely that the S&P 500 returns low to mid single digits over the next decade.

I think investors should be considering the risks of owning the index at these levels. It very well could continue to rise over the next few years as expensive markets can always get more expensive as they did from 1996-1999, but I do think there are risks to longer term results at these levels (i.e. the S&P underperformed cash in the period from 1965-1981 and also from 1997-2010).

There is good news in my view: the reality of the popularity of index investing has led to expensive stocks in one part of the market but very cheap stocks in another. Some of these stocks are yielding double digit FCF yields and returning cash to owners via buybacks and dividends.

This is not new. The market has had periods in the past that rhyme closely with this current period. Index investing (or its ancestor) was quite popular in the late 1960’s. Everyone wanted to own a basket of quality companies nicknamed the Nifty Fifty. A decade later, investors were not so enamored with index investing, as the risk of overpaying for stocks as a group became apparent. This was, of course, the best time to become an index investor again. It’s hard to believe now, but I remember clearly the popular talk in 2010 of how long-term investing was dead (simply because stocks had gone nowhere for a decade). This cycle will continue to repeat.

Index investing, like markets in general, rise and fall in popularity just like glamour stocks do. I don’t think this is a problem. I think it’s an opportunity for those who are seeking good quality cash on cash returns and aren’t worried about tracking the index’s results. There are lots of opportunities for stock pickers.

In the video below, I outline some numbers on the market’s valuation and also highlight a few opportunities, summarizing a few companies we’ve discussed earlier this year.

As I wrote to Saber investors in a recent note: