With Sam Stovall, Chief Investment Strategist of U.S. Equity Strategy at CFRA
Sam Stovall, Chief Investment Strategist Of U.S. Equity Strategy
Sam Stovall is Chief Investment Strategist of U.S. Equity Strategy at CFRA, an independent equity research firm acquired by Standard & Poor’s equity research department in 2016. Sam is Chairman of the S&P Investment Policy Committee and author of The Standard & Poor’s Guide to Sector Investing and The Seven Rules of Wall Street. In addition, Sam writes a weekly investment piece, featured on S&P Global Market Intelligence’s MarketScope Advisor platform. His work is also found in the flagship weekly newsletter, The Outlook. Sam is a regular guest on the show and always shares unique historical perspectives on the market, valuations, and momentum.
We’re In The Second Longest Bull Market Since World War II
Steve starts the conversation off by noting that everyone seems pretty nervous and unbelieving about the 2017 market rally, and asks Sam how this rally stacks up historically. Sam notes that, historically, this is the second longest bull market since World War II, after the one in the 1990s that ended with the tech bubble bursting. It’s also the second most expensive bull market on a trailing 12-month earnings basis—again, second only to the tech bubble.
What’s also interesting is if you break up all the different inflationary levels since World War II into five different categories, we’re now in the second lowest of those five pieces, and the average price-to-earnings ratio (PE) now almost exactly matches an earlier period of similarly low inflation in the 1990s, and the 1940s and 50s.
The Rule Of 20 Signals A Slight Pullback But No Bear Market
Next, Sam invokes a scene from the classic Raiders of the Lost Ark where the Germans were digging in the wrong spot because they were only looking at one side of the medallion, when they should have looked at both sides. It’s the same with the market: To find your treasure, you’ve got to look at both sides of the coin and not operate on incomplete information. In the case of the stock market, the two sides of the coin are PE ratios and inflation. If the sum of inflation and the broad market’s PE ratio equal 20, you have a fairly valued market; and this is the Rule of 20. If the sum is below 20, the market is undervalued; if it’s above 20, it’s over-valued, which is what we have now based on second quarter earnings expectations. Accordingly, Sam expects a pullback of 5% to 10% in the ongoing 2017 market rally to reset valuations to fair market but does not think we’re headed for a bear market because bull markets go out with a bang, not a whimper. He compares bubble bursts to an incandescent light bulb that glows the brightest just before it goes out. As he puts it, bull markets don’t usually die of old age; they die of fright, and they’re most afraid of recessions.
Steve is keen to do some of the math here. They agree on inflation running at 1.7% on a year-over-year core basis. Steve is conflicted on what number to use for PE ratios because every article he reads quotes a different number for PE ratio. Sam suggests using operating earnings because they most closely reflect operating results without additional accounting shenanigans and says most consensus estimates point to a current PE ratio of about 19.6 for Q2 June 2017 earnings. Adding inflation at 1.7% and PE at 19.6, you get 21.3 which is slightly above 20 and suggests that the market is slightly overvalued. So, Sam expects to see a 5% to 10% decline in the months ahead. This pullback has historically happened at least once every year and is long overdue because the last significant pullback was in February 2016. So, expect some disruption to 2017’s market rally in the second half of 2017.
Sam’s Equity Outlook For The Rest Of The Year
With the S&P 500 up about 9.5% year-to-date through June 2017, with dividends, Sam expects the index to retreat after Q2 earnings, then close the year at about 2,500. He also sees inflation creeping up a little towards the end of 2017 and expects a tepid 50-point rise in the S&P to about 2550 by mid-2018.
Low Volatility Has Historically Been Good For Stocks
Next, they switch to volatility and Sam offers up some more historical data: Going back to World War II, years of below-average volatility have always been accompanied by all-time highs. Sam also addresses what’s on a lot of investors’ minds—whether the full-year equivalent gains delivered by 2017’s market rally in the first half of the year reflect borrowing from the second half of 2017 and presage a market drop. Historical data, Sam states, suggests these fears are unfounded. On the contrary, data shows markets are now in a sweet spot and could see another 5% rise in the second half. Moreover, Sam doesn’t see a recession on the horizon. Steve jokingly reminds Sam, however, that history is no predictor of the future though it does provide perspective.
Housing Starts And The Yield Curve Back Up Sam’s Predictions
In addition to PE and volatility, Sam looks at housing starts for consumer sentiment and the yield curve for the market’s expectations on interest rates.
On a year-over-year basis, every recession since 1960 was preceded by a 25% average decline in housing starts. As of June 2017, housing starts were down 2.4%, so Sam believes this signals only slight weakness, not a full-on red alert that our economy is headed for a recession. Construction is another important early indicator because people don’t buy houses if they think they’re going to lose their jobs anytime soon. Currently, with consumer confidence up about 2%, the market is far from the historical 10% decline in confidence that precedes a recession, so he advises people to not get overly nervous.
Drawing the conversation to a close, Sam says he also looks at the difference between the ten-year interest rate and the one-year interest rate. If the 1-year rate is higher by than the 10-year rate by about one percentage point, he starts to worry. Right now, though, that’s not the case. In fact, the opposite is true, with the yield curve positively sloped by about 1 percentage point.
In a nutshell, Sam sees a small correction happening after Q2 earnings season and believes markets will be modestly higher by mid-2018, despite a few pullbacks in between.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: I’d like to welcome back to the show Chief Investment Strategist of CFRA, Sam Stovall. Sam is a regular guest on the show because he takes a historical approach to the market, focusing on market history, evaluations, and momentum. And CFRA is an independent equity research firm acquired by S&P’s equity research department in 2016.
Hey Sam, welcome back to the show.
Sam Stovall: Steve, always good to talk to you.
Steve Pomeranz: Everybody seems pretty nervous and unbelieving about the current market rally this year. How does this stack up historically?
Sam Stovall: Well, historically it is the second longest bull market since World War II, second longest since the one in the 1990s that ended up at the tech bubble bursting. It’s the second most expensive bull market on a trailing 12-month earnings basis. Again, second only to the tech bubble. However, there is something unique about this bull market, in that inflation is so incredibly low, that, actually, historically, we have normally seen these kinds of elevated PE’s whenever we have had inflation this low.
So, what is sort of interesting is if you broke up all the different inflationary levels going back to World War II into five different pieces, we’re in the second lowest of those five pieces, and the average PE has been exactly where we are now. So-
Steve Pomeranz: When was the other period of very low inflation?
Sam Stovall: Well, we had declining inflation in the 1990s, if you recall, we had that with the peace dividend and just the cost of goods going down as technology improved. But, also, you had very low inflation in the 1940s and 50s.
Steve Pomeranz: Yeah.
Sam Stovall: Really inflation didn’t pick up until you went into the 1970s.
Steve Pomeranz: Yeah, I remember when I entered into the business was 1981, and we were just coming off a peak of inflation and interest rates. Interest rates were as high as 14, 15, 16%, but inflation was running somewhere around 12-plus percent, right?
Sam Stovall: Right, well, that’s why I like to look at something called the Rule of 20 because, if you remember Raiders of the Lost Ark, the reason the Germans were digging in the wrong spot was because they were only looking at one side of the medallion.
Well, you have to look at both sides, so you can’t really look just at PE ratios, you have to look at PEs and inflation. So, there’s something called the Rule of 20; if you add inflation and PE ratios, if it equals 20, you have a fairly valued market. Anything below that is undervalued; anything above that is over-valued. So, right now, it basically says—based on what we expect for second-quarter earnings growth which will be begun to be reported in two weeks from now—is that, yeah, we probably could go through a pretty standard pull back of 5 to 10% to reset the dials.
But I don’t think we’re headed for a bear market because bull markets go out with a bang, not a whimper. They’re like an incandescent light bulb; they glow brightest just before they go out, and they usually they don’t die of old age, they die of fright.
Steve Pomeranz: [LAUGH]
Sam Stovall: And they’re most afraid of recessions.
Steve Pomeranz: Let’s do some of the math here, so inflation would we say is running around 2%?
Sam Stovall: Actually, 1.7% on a year-over-year core basis.
Steve Pomeranz: Okay.
Sam Stovall: And that’s what the Fed is getting a bit worried about, is how low inflation is, even though they want to add interest rates because they want to be able to add arrows to their quiver for the next time to fight another recession. But a lot of people are saying, you know, inflation is too low to be aggressively raising rates.
Steve Pomeranz: Yeah, but you know if they add too many arrows to the quiver, maybe they’re going to be able to shoot themselves in the foot and they’re going to cause the next recession.
Sam Stovall: Very good.
Steve Pomeranz: Listen, so we’ve got inflation at 1.7, we want to add PE ratios to that. The PE ratio thing really bugs me because every article you read quotes another number for PE ratio. What numbers would you want to use for that part of the calculation?
Sam Stovall: Well, I do use operating earnings, which some people call earnings before bad stuff.
Steve Pomeranz: [LAUGH]
Sam Stovall: Whereas if you use something called GAAP, which means Generally Accepted Accounting Principles, also known as, as reported. I call that Prego spaghetti sauce because everything is in there.
Steve Pomeranz: Yeah.
Sam Stovall: Historically, until 1988, it was okay to use GAAP because that’s basically all there was; but, since 1988, Wall Street has essentially been focusing on the operating results, so that’s what I look at.
Steve Pomeranz: Okay.
Sam Stovall: So, if you look to S&P Global, their consensus estimates, you look to Bloomberg, you looked at Factset, whomever—they’re all pretty close in terms of what the operating earnings estimates are. And you can also find them in many financial publications.
Steve Pomeranz: Okay, so what is the number?
Sam Stovall: The PE ratio right now, we are trading at a PE of about 24, which is PE plus inflation, so we are overvalued by, I would say, about 8% right now.
Steve Pomeranz: Well, hold on, I’m a little confused. So, what we’re doing is using your formula, adding inflation to the PE, and use the Rule of 20. Inflation’s at 1.7; what was the operating PE estimate, then? I guess without inflation?
Sam Stovall: Right, so the PE right now is based on the estimates for June earnings, it’s 19.6.
Steve Pomeranz: There you go, okay, that’s 19.6.
Sam Stovall: So, PE is 19.6 on year-over-year operating earnings, and we are then at 1.7 on CPI.
Steve Pomeranz: All right, 21.3 is the number, and so we’re slightly over valued, is that what you’re saying?
Sam Stovall: That’s correct.
Steve Pomeranz: Okay, cool.
Sam Stovall: So, we are slightly overvalued.
Steve Pomeranz: All right.
Sam Stovall: But not overly so; so, basically, it says to me that, yeah, we could go through what I call a pull back, which is 5 to 10% decline, which basically happens at least once a year on average, since World War II.
We have not had anything like that since February of 2016 is when the most recent decline actually bottomed out.
Steve Pomeranz: Yeah, I remember that it was a little bit ugly. Markets got hit by 10-12%, so let’s talk about the rest of the year though.
So, we’ve had the market, the S&P 500—obviously, we’re recording this on a Friday. It’s going to air on the following week, so our numbers are going to be a little bit delayed or a little bit off, but right now the S&P’s up about 9.5% this year or something like that through June?
Sam Stovall: With dividends, right?
Steve Pomeranz: With dividends, okay. So, 9.5%, what’s your thinking for the rest of the year?
Sam Stovall: Well, I’m thinking that we probably could see the S&P close to about 2,500. Again, because I think the market has gotten ahead of itself in terms of anticipating earnings growth, inflation is actually expected to be creeping just a little bit higher as we move forward to the end of this year. So, I believe that we’re probably going to see the S&P 500 around the 2500 level and then go up to about 2550 or so this time next year.
Steve Pomeranz: All right, so we’re at around 20.
Sam Stovall: Low single digit.
Steve Pomeranz: Okay, yes, I was going to say we’re at 2426 right now. So 2,500 minus 2426, that’s 74 points on 2426, 3%.
Sam Stovall: Yeah.
Steve Pomeranz: Can’t you do better than that, Sam? Can’t we do better?
Sam Stovall: [LAUGH] Well, you’re right. Now you’re bringing up a question as to where is the risk? Is the risk to the upside or to the downside.
Steve Pomeranz: Yeah, that’s it.
Sam Stovall: I actually think that the risk is to the upside, and here are a couple of reasons why. First off, before air time, you and I were chatting about how low volatility is.
Steve Pomeranz: Yeah.
Sam Stovall: And people are spooked by that, thinking, my gosh, we’re setting ourselves up for something, when, in fact, going back to World War II, whenever we have had a calendar year in which it had a below average volatility but an above average number of all-time high—that’s happened 17 times—and the market was up that entire year 17 times by an average of about 19%-
Steve Pomeranz: Wow, okay.
Sam Stovall: So, that’s one indicator. Another is people are saying, well, gee, we did well in the first half of this year. The S&P was up about 8% through last night, so the question is, did we borrow from the rest of the year because we had a 12-month return in the first 6 months.
And again, history says no, we’re actually in a sweet spot. Whenever we have had—and, again, breaking all first-half changes into quintiles or five different slices—we’re in the second highest slice, between 7 and 12%, and whenever that happened, the market was higher by another 5% in the second half. The full year was up about 16%, and the second half was higher almost nine out of every ten times.
Steve Pomeranz: Wow, okay, so history is no predictor of the future, but it gives us a little perspective.
Sam Stovall: Exactly.
Steve Pomeranz: Want to be careful out there, right?
Sam Stovall: What worked in the past, there’s no guarantee it’s going to work again in the future, but people frequently ask, without history how would you know if a stock is overvalued if you had nothing to compare it with.
Steve Pomeranz: So, here’s the headline for today’s segment—and I’m going to quote Sam Stovall from CFRA: “No bear market.” I heard you say that, Sam, I’m sorry.
Sam Stovall: Well, and I’m happy to say it again, one reason is because I don’t see a recession on the horizon. I look at four different indicators; I look at housing starts. On a year over year basis, every recession since 1960 was preceded by a decline on average of 25%. We are down 2.4%, so, yeah, maybe you could say we’re in a yellow alert phase, but nowhere near a red alert phase.
Steve Pomeranz: Mm-hm.
Sam Stovall: Construction is important mainly because of consumer confidence. Who’s going to buy a house if they think that they’re going to lose their job fairly soon? So, typically, we’ve seen about a 10% decline in consumer confidence before we slip into recession. We’re in positive territory still; the conference board’s leading economic indicators usually see about a 3% six-month decline, we’re up about 2%.
And then, finally, I look at the yield curve; the difference between the ten-year interest rate and the one-year interest rate. Normally, it is inverted, meaning the short rate is higher than the long rate by about one percentage point, whereas the opposite is true today.
Steve Pomeranz: Yeah.
Sam Stovall: The yield curve is positively sloped by about 1 percentage point. So-
Steve Pomeranz: So, no indication.
Sam Stovall: There’s nothing-
Steve Pomeranz: Mm-hm, no, okay.
Sam Stovall: That can indicate to me.
Steve Pomeranz: Hey, Sam, we’ve got to go. Sorry to cut you off. Sam Stovall, Chief Investment Strategist of CFRA, until next time, Sam.
Sam Stovall: Look forward to it, thanks, Steve.