October 2017 – Strength and Weaknesses Send Mixed Signals
Despite new growth in the global economy and still historically low interest rates, institutional investors are divided about whether the stock market is over-valued or poised to move higher. Warren Buffet recently stated his opinion: “Valuations make sense with interest rates where they are.” Yet other smart investors like Ray Dalio, Jim Rodgers and John Hussman think a market correction is overdue. Clearly there is more market uncertainty but who is right?
ProActive Advisor’s view of the market is “constructively optimistic” in the near term and “worried” in the longer term. Company valuations of many sectors are above historical averages, but lower worldwide interest rates are improving global growth. Deregulation and promised tax cuts in the US offer near term upside, but that assumes Congress can agree to pass tax reform. It also ignores the potential of some military event in North Korea or the Middle East derailing progress. There is geo-political risk to factor in.
Technology, consumer staples, consumer discretionary, and biotech appear to have above-average valuations, though Microsoft, Google, and Amazon recently all reported blockbuster earnings and the same is expected from Facebook. The fact that retail, drug, media, transportation and raw materials are languishing is a bit troublesome. We question the strength of recovery absent growth in raw materials, a prerequisite element of making more. Experienced with uncertain markets and valuation multiples stretched enough to correct, we long ago adapted our investment methodology to be dynamic and employ flexible asset allocations. Like Mr. Buffet, we believe lower interest rates do support higher stock price valuations at present and today’s low interest rates mean stocks have little competition from bonds. Additionally because businesses have dramatically lower cost of capital, greater earnings can be put to the bottom line. Investors are anticipating additional upside in earnings and expect lower regulatory burden on business combined with lower tax rates to justify even higher market prices.
Conventional economic theory disagrees. It posits that investors are paid a “Risk Premium” to assume risk above the return they can earn on a risk-free treasury and that the valuation of a company is the sum of its future cash flows discounted back into present day dollars.
Today this valuation formula suggests the market is over-valued by nearly 100%, but we and others argue that conclusion has to do with the math of the formula1. In reality the relationship of price and valuation is not always linear. The classical model ignores stock price appreciation, a significant component of investments Total Return. When included, companies are only over-valued when their expected future cash flows, plus gains that can be harvested, (together their Total Return) when discounted into present day dollars are improbable by historical norms.
The formula is also riddled with bias to historical data sets even though you can plug in current interest and market return rates. Our methodology considers that real time events can temporarily skew both optimism and pessimism and that astute “Active” management can capture a good portion of the upside. Managers who allocate portfolios into a market index like the S&P500 or some fixed percentage of stocks & bonds routinely produce lower returns applying the formula or automatically rebalancing without consideration to market dynamics. Passive managers buy & hold suffering the brunt of market corrections which produce the lower, assumed market return average.
ProActive Advisors 360Portfolios’ Methodology worked well navigating the 2008 financial crisis. It employs flexible asset allocations using dynamic selection and combats loss pro-actively. All to say as long as there are value opportunities it rotates to them reducing risk exposure to overvalued assets and sectors. Today this means we see further upside and are cautious but still remain invested.