John wrote: Tue Jan 11, 2022 9:59 amWhat did the newsletter say?richard5za wrote: Tue Jan 11, 2022 4:22 am The Crestmont Research newsletter of today's date (11 Jan) is well worth reading
The initial series of year-end updates to the Crestmont Research website is now available at www.CrestmontResearch.com. The updates are listed below in this newsletter. Your comments and suggestions are welcomed (Info@CrestmontResearch.com) and often influence future updates and additions.
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The next set of updates should be available on January 21st, and a final set of updates is expected on or before February 4th. An additional distribution of new charts and articles may be sent between updates, since the current conditions are highly unusual.
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Today's updates are listed below. The most significant points are:
(1) 2021: The S&P 500 Index was up 27%. The gap between the level of the stock market and its value is so wide that the follow-on questions relate to (a) the sustainability of the current level as well as any future gains and (b) what may be different this time.
We are all receiving lengthy reports and slide decks as the new year begins. Rather than provide another lengthy analysis, this first-of-three annual update newsletters will address two major points.
First, the stock market appears to be acting on momentum more so than fundamentals. However, it could be that economy-wide profit margins have permanently surged upward, and thus a key fundamental factor of market valuation may be different this time.
Second, if economy-wide profit margins have not upshifted, then normalized earnings and normalized P/E (e.g., CAPE P/E10 and Crestmont P/E) are still relevant and the current level of the market is not justified based upon fundamentals of valuation.
Let's explore the two points individually.
(2) If profit margins have upshifted, then the new future trend for EPS should build upon and grow from the current level. 2020 ended with S&P 500 Index as-reported EPS of $94. 2021 ends with EPS expected to deliver $191. Year-over-year, the level of EPS more than doubled. That could represent a major upshift in the level of profitability.
A graph often tells the message of a thousand numbers: see Earnings Trends: History & Future.
The main graph presents the history of EPS from 1970 (a period long enough for perspective, yet short enough to keep the scale relevant). Longer-term graphs (especially with a log scale) show a fairly consistent long-term trend for EPS growing at near the rate of economic growth (GDP). The recent divergence of EPS away from the long-term trend is visibly noteworthy.
The inset graph shows the history of EPS forecasts from Standard & Poors since 2012. S&P introduces forecasts for each year's EPS about 24 months in advance. The graph tracks the monthly updates for each year's forecast into the final results. For almost a decade, the forecasts generally were tales of optimism that ended lower than they started.
Around mid-2020, with full-on Covid realizations, the EPS trend shifted dramatically. Check out the chart; it's dramatic. Earnings Trends: History & Future.
Whether the new level is temporary or permanent is unclear. Read all that you can to develop an informed opinion. This may be one of the two key issues for stock market returns over the next five to ten years. (The second key issue is the future trend and level of the inflation rate. That will be addressed in the next update's newsletter.)
(3) The second point from this newsletter is the implication if economy-wide profit margins have not upshifted.
Most normalization methods either include a methodology that is slow to adjust or rely upon long-term economic relationships. If profit margins have upshifted, then normalized earnings and normalized P/E (e.g., CAPE P/E10 and Crestmont P/E) would be less relevant until they are revised. However, absent an upshift, the normalized values are as important and relevant now as they ever have been.
That's because normalized earnings specifically serve to adjust for business cycle and other variations in earnings to help investors avoid the misdirection of short-term distortions.
The implication is that Crestmont's Gazing chart still could be foretelling...with insightful implications.
Gazing at the Future
The green bars in Gazing present the annualized return over rolling ten-year periods since 1900 (the first ten-year period ends in 1909). Some decades delivered near 20% annually on average. Some decades delivered near-zero or losses annually on average. The level of return reflected in the bars is presented on a nominal basis.
The graph is overlaid with an orange line that reflects the level of P/E at the start of the underlying decade. This is done by shifting the orange line to the right by ten years. In other words, P/E for year-end 2010 is aligned with the green bar that reflects annualized returns for the decade from 2011 to 2020 (i.e., P/E at the start of the decade is vertically aligned with the return for the subsequent ten years).
Therefore, since the starting level of P/E drives future returns, the orange line effectively "predicts" the outcome of the green bar.
Note that a relatively high orange line relates to relatively low green bars, and likewise, a relatively low orange line relates to relatively high green bars. The fundamental drivers behind this relationship are tenets of Crestmont's research.
Here's the relevant second point from this newsletter. Note the rising trend of the orange line on the right side of the chart, the area without green bars.
The "missing" green bars are the ten-year periods starting nine years ago. They are in process, but not complete. They are the decades that will fill in over the next decade. Those decades start with 2013, 2014, 2015, etc. The starting values for P/E are already known. P/E for 2021 is posted in the history books. That's the point at the right end of the orange line.
The ten-year return for the next ten years, from 2021 to 2031, will be the green bar underneath the point at the end of the orange line in the graph.
The expected level of the green bar for the next decade is an indication of the expected environment for the stock market. The expected environment should inform investors and advisors as they structure portfolios for the next decade.
This does not suggest avoiding the stock market. But it might inform the way that investors and advisors could structure portfolios to achieve returns while controlling risk.
(4) In the next set of updates, we'll see additional insights about stock market valuation and outlook, as well as the significant effect that 2021 had on bond yields and relationships.
(5) p.s. The article Half and Half has been updated. Spoiler alert: the hare Mr. Market has overtaken (barely) the tortoise rowing approach. Nonetheless, the article emphasizes the need to adjust investment approach depending upon secular market type. It explains why it works to "row" with a more actively-managed and diversified portfolio. The article has been updated through 2021. The tortoise couldn't quite keep up under the intense momentum of the stock market last year. But stay tuned...
SELECTED ITEMS:
P/E: Secular Stock Market P/E and The P/E Report
Volatility: Stock Market Volatility: An Erratic Cycle and Volatility in Perspective
10-Year Outlook: Gazing at the Future
Earnings: Earnings Trends: History & Future
THESE CHARTS AND ARTICLES HAVE BEEN UPDATED FOR 2020:
Gazing at the Future
The starting valuation matters! When P/E starts at relatively lower levels, higher returns follow–paying less yields more. When the market P/E starts at higher levels, subsequent returns are lower. This graphical analysis presets the compounded returns that follow over the subsequent ten years based upon the starting P/E ratio.
Components of Return
There are only three components (excluding transaction costs and expenses) to the total return from the stock market: dividend yield, earnings growth, and the change in the level of valuation (P/E ratio). To assess the potential returns from stocks for the next decade, this analysis presents the total return and its components for every ten-year period since 1900.
P/E Ratio vs. Dividend Yield
The dividend yield of the stock market is relatively low by historical standards. Why? Valuation directly affects dividend yields. As the price-to-earnings ratio (P/E) rises, the price-to-dividends ratio rises as well {thus lowering the dividend yield}. This presents another view of the market’s relatively high valuation.
This Secular Bear...So Far
This secular bear began in 2000 and has lasted well more than a decade. The surges and falls are relatively consistent in both magnitude and duration to past secular bear market cycles. With valuation levels still relatively high, as measured by normalized P/E, this secular bear has quite a way to go.
Distorted Averages
Investors only can spend compounded returns, not average returns. This chart presents the difference between average returns and compounded returns for investors. The two issues assessed are the impact of negative numbers and the impact of volatility, as measured by the variability within a sequence of returns. Both issues can devastate the actual returns realized by investors compared to the average.
Generation Returns
Even an extended period of 20 years does not ensure positive cumulative returns in the stock market. Returns appear to be dependent upon the starting level of P/E. When P/E is relatively high and above the average, investors’ returns over the subsequent 20 years have been below average or negative. When P/E is relatively low and below the average, investors’ returns have been above average and rewarding.
Stock Market Yo-Yo
Up today and down tomorrow. The stock market seems to be constantly reacting to good news and bad news….sometimes “because of” the news and other times “despite” the news. In this research, we explore the portion of days that the market is up compared to the number of days it is down.
Secular Stock Market P/E
The preceding secular bull ended with the market valuation (P/E) at levels twice as high as all previous secular bulls. That meant that this secular bear had twice as much ground to cover. The current secular bear market started to deflate the bubble, but the market still remains at or above levels consistent with secular bear starts.
Secular Cycles Explained
The long-term view of the stock market reflects extended periods of surge and stall. These periods, known as secular bull markets and secular bear markets are not optical illusions; rather they are extended periods when market valuation (i.e. price/earnings ratio: P/E) is either multiplying the effect of rising earnings or mitigating them.
The P/E Report
There are numerous versions of the price/earnings ratio (“P/E”), yet there are very few of them that can be appropriately compared to the recognized long-term average of 15. The objectives of this report are to detail the current level of the P/E ratio, to answer frequent questions about it, and to address the status of the current stock market cycle.
Significant Swings
Although the compounded average annual change in the stock market is near 5% over the past century, the range of dispersion in annual returns is dramatic. More than 50% of the years ended with changes in the index exceeding +/-16%, either less than -16% or greater than +16%!
Stock Market Volatility: An Erratic Cycle
This graph reflects a measure of stock market volatility--the statistical standard deviation of monthly changes for the S&P 500 Index. The line on the graph reflects volatility for each trailing twelve-month period starting in January 1951 and continuing with each month to present. There are several insights from the graph. First, volatility is volatile; it cycles erratically over time. Second, periods of extremely high or low volatility often follow the other. Third, volatility tends to spend most of its time around the average (i.e., within 25% above or below the average).
Volatility in Perspective
Is the current level of volatility “normal”? If so, it’s a new normal! The purpose of this presentation is to graphically put volatility into historical perspective. This report will be updated periodically as volatility itself is just too volatile to be ignored.
Stock Market Returns & Volatility
This analysis presents an uncanny relationship between stock market performance and the volatility of the market. In the context of secular bull and bear markets, this relationship further emphasizes the need to consider risk as well as reward in an investor’s investment decisions.
Earnings Trends: History & Future
This graph presents both (1) the historical trend for actual reported earnings per share (EPS), including a forecast by Standard & Poor's, and (2) an inset graph presenting the historical record for S&P's forecast over the past five years. To put the historical trend and future forecast into perspective, the graph includes Crestmont's assessment of the long-term baseline trend for EPS. Crestmont's baseline also puts into perspective whether current and forecast EPS are above or below the long-term trend for EPS.Note: the inset graph reflects S&P's EPS forecasts for recent years; forecasts begin about two years in advance and proceed until the year is finalized.
Half and Half: Why Rowing Works
This article addresses two key questions for investors today: why do secular stock market cycles matter and how can you adjust your investment approach to enhance returns? The primary answer to the first question is that the expected secular environment should drive your investment approach. The investment approach that was successful in the 1980s and 1990s was not successful in the 1970s nor over the past fourteen years. Therefore, an insightful perspective about the current secular bear will determine whether you have the right portfolio for investment success over the next decade and longer. Now, assume for a moment that you must pick one of two investment portfolios. The first is designed to return all of the upside—and all of the downside—of the stock market. The second is built such that it often gets one-half of the upside and one-half of the downside. Keep in mind, rowing does not require market timing; rowing involves the diligent selection of a combination of skill-driven investments to achieve a lower risk profile and better returns over time.
Please note that Crestmont Research maintains the same URL (i.e., the Internet address link) for subsequent updates. The benefit is that you can link to Crestmont's website and always have the latest update. The drawback is that a few computers may be slow to recognize that the file has changed. In those few cases, the computer will reload the last downloaded file from its cache (internal storage). If you don't see the updated version of a chart or article, please try clearing your cache or forcing a reload of the webpage or file.
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