The financial news cycle is markedly different than it was six months ago. In Q3 2022, it was almost as if everyone in independent and corporate financial media agreed that the combination of high inflation and high rates would put the US economy into a substantial recession. Earnings of S&P500 companies were enjoying their last breath of gains before they would slump. Commentators believed that the bear markets in the major indices were "pricing in" the recession and would not rebound until the Federal Reserve started cutting rates again.
Quick Non-legal Disclaimer: This information is for readers who manage their own investments as well as those who entrust that role to a financial advisor. In my view, most people should have a financial advisor. Just as I do not have the expertise to repair my own engine or perform surgery on my own organs, most people do not have the knowledge or time to manage their own nest egg in an intelligent way. This content will help you to ask your advisor the right questions. Professionals in this sector should always have a thesis on whether assets are cheap or expensive, and should be equipped to get you greater diversification than the two most heavily invested asset classes: broad market stock indices and bonds. Like a doctor, they should also be abreast of the latest research in the field.
Everything changed when the S&P500 and NASDAQ rebounded 8 and 16 percent, respectively. Though it’s worth noting that Goldman Sachs went against the current in November of 2022, placing the chances of a 2023 recession at 35 percent. The reversal in sentiment among commentators is palpable. ETF investors have piled back into risk assets:
What's in it
2023 Year to Date Flows
JPMORGAN BETABUILDERS EUROPE ETF
LARGE DEVELOPED EUROPEAN ECONOMY STOCKS (LARGEST COUNTRY SHARE UK 22%)
ISHARES CORE MSCI EMERGING MARKETS ETF
DEVELOPING ECONOMY STOCKS (LARGEST COUNTRY SHARES ARE CHINA 29.21% AND INDIA 15.45%)
SPDR S&P 500 ETF TRUST
US STOCKS IN THE S&P500 INDEX
ISHARES IBOXX USD INVESTMENT GRADE CORPORATE BOND ETF
DEBT (BONDS) OF LARGE US COMPANIES WITH AAA CREDIT RATINGS (TOP 6 HOLDINGS ARE BANKS, MAKING UP 15% OF TOTAL)
VANGUARD VALUE ETF
US LARGE-CAP COMPANIES THAT PAY HIGH DIVIDENDS, LARGEST SECTOR HEALTHCARE WITH 20.5%, FOLLOWED BY FINANCIALS 19%
When the masses start pouring back into stocks, and tenured managers like Milton Berg are making the podcast rotation with the view that a recession has already come and gone, it's reasonable to ask - should I buy back into stocks? Or, if you did not sell in 2022, should I stay invested or sell my positions?
Typically, this conversation involves some kind of forecast of whether or not the US and other markets will enter a recession in the next year. It's easy to understand why: the average recession includes a drop in the earnings of publicly traded companies, and a fall in equity prices. With half of S&P 500 companies reporting so far, the earnings decline for the quarter ending December 31, 2022 is 5.3 percent. If further drops are ahead, to buy now would be to catch a falling knife. A recent Oxford Economics Analysis reported that the average market drop in a "mild recession" is 34 percent and the average drop in a "severe" recession is 43 percent. (https://www.marketwatch.com/story/what-the-s-p-500s-slide-from-its-peak-says-about-a-recession-11663179069)
While the present writer is confident that further earnings cuts and a recession are ahead in 2023, this is not the criterion on which investors should be deciding if they will buy or sell. Whether the economy is growing fast, growing slow, or shrinking, the question that must be answered is always the same - are equities cheap, or are they expensive?
Let's start with one basic measurement of that question. Adjusted by the consumer price index (the world's favorite measure of inflation), the price of the S&P500 is still higher than it was two years ago, even after a year of "correction". The index hasn't dipped below the highs of the late 90s tech bubble since February 2016.
Source: Robert Shiller, Standard & Poor's.
We determine if they're cheap (a buy) or expensive (a sell) by first thinking about what equity is: the right to share in the ability of a company (or in this case, hundreds of companies) to generate future profits. At current prices, how many dollars will I pay for each dollar of future earnings, and, is that a decent price? Though its usefulness is debated, the Shiller Price-to-Earnings Ratio does an excellent job of grounding current equity prices in the reality of past earnings.
The Cyclically Adjusted P/E ratio, or "Shiller" ratio, is inflation adjusted ratio of the Price per share over the 10-year average of earnings per share. In other words, it tells you how many dollars you must spend to get one dollar of 10 year average earnings. Here's the frequency distribution of the Shiller PE from 1985 to 2023. If it's been a while since you've seen one of these, here's how to read it.
We see that the tallest bar, in the middle, is labelled with range (23,27). The corresponding value is 96. That means that out of the months from January 1985 to January 2023, there were 96 months where the "Shiller Ratio" was between 23 and 27.
Source: Robert Shiller, Standard & Poor's, author calculations
Investors must currently pay about 29 dollars for every one dollar of ten year average earnings. That's only three dollars less than the peak Price-to-earnings ratio before the infamous stock market crash of October 1929.
Source: Robert Shiller, Standard & Poor's, author calculations
The second most important rule of investing is, "Buy Low, Sell High". While it is impossible to know with certainty what equity returns will look like in the future, probabilities help. If the most frequently occurring Shiller ratio was between 23 and 27 over the last 38 years, and you buy the market at a level higher than that, the probability of stocks appreciating after you've bought them is lower. Obviously, we are making the assumption that price behavior over the next 10 years will look something like the last 38.
Oh, and the most recent sum of dividends you'll receive from one "share" of the S&P500 is about 63 dollars, a pathetic dividend yield of 1.6 percent. Even the US Treasury will pay you 4.3 percent to borrow from you for two years.
Why do I reference the last 38 years when there is a century and a half of data available? I answer that question here (https://supplyndemandobserver.com/1437/)
Conversely, if you buy at ratios less than 23, there is a higher probability that stocks will appreciate after you've bought them. Price to Earnings is not a one stop shop for making investment decisions; it is the starting point.
Given the current condition of this starting point, now is not the time to jump in the pool, especially since there are alternatives with significantly less risk. The present writer sold his equity positions in November of 2021, and is still glad he did.
One final thought: investors who went long US equities through S&P 500 funds, any time before December 2020, can still get out of the pool without losing money on the price, and having gained some on dividends.
Follow me to the next post for less risky investment alternatives than US equities.