Three Dials Deep Dive: Valuation
Ethan Pollard | March 30 2020
As you may know, our firm uses a proprietary asset allocation model we call “The Three Dials”, wherein we look at three primary indicators in the markets and the overall economy that tend to determine the performance of financial assets.
The Momentum / Sentiment dial gauges the current appetite for stock buying and whether continued demand will lead to higher prices in the stock market. The Economic Fundamentals dial measures growth in the real economy and whether underlying data supports investments in equities versus fixed income. Finally, the Valuation Dial indicates whether the price we are paying for equities is fair compared to historical norms. Together, these Three Dials present a coherent picture that guide our recommended allocations to equity, fixed income, alternative assets, and cash.
In an effort to help clients and the investing public to understand our methodology, this post is the first in a three-part series that dives into the weeds on each of our Three Dials. The goal of this series is to provide clarity on why these dials matter and how we interpret them to arrive at our asset allocation decisions. To kick us off, we will start with what may be our most controversial of the Three Dials, at least at this time:
At its core, the goal of valuation is to determine the appropriate price of an asset. It is an inherently subjective exercise, as two equally informed and intelligent investors can assign wildly different values to the same object. For example, Leonardo da Vinci’s painting Salvator Mundi was sold at auction in 2017 for $450 million – the price determined by the buyer to represent the “fair value” for that work. Whether this was the “correct value” for the painting may never be truly known. The buyer may be able to re-sell the painting at a reasonable profit in the future; alternatively, the painting may generate in excess of $450 million in museum revenue, or it may represent an equivalent value of non-monetary benefit like joy and happiness. If so, then one can argue that the purchaser obtained the painting at a fair price. On the other hand, what if some experts are correct in believing that Salvator Mundi is not an authentic da Vinci, or that the extensive restoration renders the painting essentially worthless? We would then be forced to say that $450 million was an absurd price to pay for the work, and was thus a catastrophic investment decision.
You may be asking yourself: what does Leonardo da Vinci have to do with my investment portfolio? While we are not buying priceless works of art for our clients, we are buying collections of stocks, bonds and other financial assets, for which we must attempt to discern if we are paying “fair value”. If we were reasonably certain that we could sell a particular investment five years down the road for $100, then we might be willing to buy that asset for $75 today, but we most certainly would not be willing to pay $125 to invest in that same asset. Unfortunately, only God knows what that future price will be, and we are left to make our best inference at the current fair value based on a variety of metrics.
There is no shortage of measures that attempt to gauge stock market valuation. Investing legend Warren Buffett espouses the use of the “Market Capitalization to GDP Ratio”, which compares the combined value of all US publicly traded stocks to the country’s Gross Domestic Product. A ratio less than 1 would suggest that stocks are underpriced compared to the value they provide to the overall economy, and this indicator would suggest stocks can be purchased below fair value and provide above ordinary returns. However, the most recent number published by the Federal Reserve Bank of St. Louis puts the Market Cap to GDP ratio at 1.43, suggesting that equities are currently overpriced relative to their intrinsic value.
An alternative valuation measure, and perhaps the most widely followed, the Forward P/E Ratio is measured as current price divided by the projected 12-months’ corporate earnings per share. Looking at the S&P 500 Index, the Wall Street Journal puts the Forward P/E ratio at 17.2, roughly in-line with long term averages and a suggestion that stocks are fairly priced at current levels. As we can see, different valuation metrics can suggest different measures of “fair value” for stocks and other financial assets. In fact, competing valuation tools help the market as a whole to come together to determine the prevailing price for an asset at any given time. As long as one investor views an asset as under-priced by his or her preferred valuation metric, there will always be a willing buyer to accommodate the seller who believes that asset has reached or exceeded its “fair value”.
While no one measure exists that will “correctly” value stocks 100% of the time, our firm’s current preferred valuation measure is the Cyclically Adjusted Price to Earnings (CAPE) Ratio, developed by Yale economist and Nobel Laureate Robert Shiller. This measure is similar to the Forward P/E Ratio described above, though the denominator is replaced by a ten-year smoothed average of corporate earnings, essentially adjusting this ratio for fluctuations in the business cycle. Current readings on the CAPE Ratio suggest that the S&P 500 is currently valued as the second most expensive market of all time, behind only the Dot Com Bubble of the late 1990’s. Although stocks (like any asset) can remain “overpriced” for extended periods and still provide reasonable returns over the medium- and long-term, we would always be more eager to buy when an asset is fairly priced (or even underpriced, if we were to be so lucky). Indeed, a study from The Vanguard Group in 2012 suggests that, of the most popular valuation metrics, the CAPE Ratio has the strongest predictive value of 10-year forward equity returns.
In summary, certain metrics suggesting overheated stock prices result in Archetype’s Valuation Dial remaining in the “off” position for the time being. From an asset allocation perspective, this leads us to moderate our equity exposure in light of our Sentiment and Fundamental Dials being in the “on” position. Despite a negative reading on the Valuation Dial, positive signs from our Sentiment and Fundamental dials result in our moderately bullish outlook for stocks.
http://www.wsj.com/mdc/public/page/2_3021-peyield.html (retrieved as of June 01, 2018)
Disclaimer: Our intent in providing this material is purely for informational purposes, as of the date hereof, and may be subject to change without notice. This article does not intend to constitute accounting, legal, tax, or other professional advice. Visitors and readers should not act upon the content or information found here without first seeking appropriate advice from a trusted accountant, financial planner, lawyer or other professional.