Butler|Philbrick|Gordillo & Associates is out with a great new post “Triumph of the Ostriches” discussing the market’s current level of overvaluation. Here is the summary of Butler|Philbrick|Gordillo’s forecasts:
Table 1. Statistical Return Forecasts for U.S. Stocks Over Relevant Investment Horizons
Source: Shiller (2013), DShort.com (2013), Chris Turner (2013), World Exchange Forum (2013), Federal Reserve (2013), Butler|Philbrick|Gordillo & Associates (2013)
We have yet to see any evidence-based argument for why the valuation based analysis presented above is not relevant. What do we mean by ‘evidence based’? Show us numbers to support an alternative hypothesis, and then show me how those numbers have served to forecast returns in other periods with statistical significance.
Other memes relate to the idea of a ‘permanently high plateau’ (incidentally, the great 20th century economist Irving Fisher coined that phrase in 1929, just three days before the crash that preceded the Great Depression). Purveyors of this delusion cite the current ‘pollyanna’ environment for global corporations as validation for stratospheric equity valuations. “Corporations have high record cash positions”, they crow, “get ready for the great buy back and merger wave that’s coming!” “Profit margins are high, corporate taxes are near all-time lows, wage pressures are non-existent – corporations have never had it better! Oh and financing is effectively free!”
Unfortunately the wailing equity zealots do not factor in Stein’s Law, which states, “If something cannot go on forever, it will stop.” In a period of record fiscal duress, what is the probability that corporations will continue to receive favourable tax status? According to GMO’s analysis, corporate profit margins are one of the most mean-reverting series in finance, so why would be value markets under the assumption that they will stay high forever? Further, how valuable is the cash on corporate balance sheets if there is an equally large debt balance on the other side of the ledger (there is)?
The Ostriches aren’t concerned with valuation metrics or Stein’s Law, and let’s face it, they’ve been right to stick their head in the sand – at least so far. The problem is that in markets we won’t know who is right until the bottom of the final cyclical bear in this ongoing secular bear market. Only then will we see just how far from fundamentals the authorities have managed to push prices, and only then will we see whether it really is different this time.
Until then, investors can choose facts or faith. The facts say that investors are unlikely to be compensated at current valuations for the risks of owning stocks over the next few years. The church of equities says, ‘don’t worry about it’. So far the Ostriches have it, but all meaningful evidence suggests that over the next few years the Ostriches are going to feel like turkeys – at Thanksgiving.
Read Triumph of the Ostriches.
Order Quantitative Value from Wiley Finance, Amazon, or Barnes and Noble.
Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.