My favorite equity valuation indicator has long been the median price-to-earnings ratio. The P/E ratio is the measure of the share price relative to the annual net income earned per share outstanding. It can be measured by looking at a specific company, or an index like the S&P 500 Index.
I believe that valuations matter and can ultimately tell us a great deal about what the S&P 500 Index’s future 10-year annualized return may be. In the chart that follows, you can see that if you buy into the market when it is expensively priced, your subsequent annualized returns are low (red). The reverse is true when you buy into the market when it is inexpensively priced (green).
If you bought into the market on December 31, 1989, when the median P/E was 13.9, you earned an annualized gain of 15.28% per year over the next 10 years. However, if you bought in on December 31, 2000, you lost at an annualized rate of -0.48% over the next 10 years--a lost decade. On December 31, 2015, the median P/E stood at 22. It stood at 21.5 at the end of last month with the S&P 500 Index at 1932.23. Valuations are high, but they most certainly could go higher.
The above chart selects just a few periods in time. Ned Davis Research looked at each month-end median P/E and sorted them into five categories or quintiles ranging from the 20% lowest to the 20% highest and then took a look at the subsequent 10-year annualized returns (again taking the median). This is what the data look like from 1926 through 2014:
What happens when most investor portfolios are more aggressively weighted to equities? What do the returns look like when investors are underweight equity exposure? This next chart looks at the percentage of household equity ownership. Think of it this way -- when investors are heavily committed in their portfolios to equities, much of the buying power is already in the game.
Here is how you read the chart: The blue line measures the equity percentage and the black dotted line shows what the annualized return was 10 years later. The red circle shows the extremely high equity exposure in 2000 and the dotted line within the circle shows what the actual annualized return turned out to be. The green circles and the green arrows show when equity ownership was low and returns high. The yellow rectangle shows where we are in terms of equity ownership and it tells us to expect 3.75% annualized returns over the coming 10 years.
Finally, note how closely the actual returns, the black dotted line, tracks the percentage ownership line over time. In summary, both current high equity market valuations and household assets allocated to stocks tell us to expect low forward 10-year annualized returns.
When valuations are high, I favor hedging equity market exposure. This is because risk is also greater when valuations are stretched. What we want to do is protect ourselves from the -30%, -40%, -50% and higher types of market declines that tend to come during recession. These steep declines tend to be greater when valuations are high.
To hedge, I buy 15% out-of-the-money put options on an ETF such as SPDR S&P 500 (SPY). I like looking at put options that mature in about three months out in time. If you own a lot of U.S. large-cap exposure, then put options on SPY may be a good ETF to use. Today, the cost to put on a hedge going out about 100 calendar days is about 0.61%. Do that three times a year and the cost is 1.83%. If you are willing to protect against losses of 20% or more, annual cost goes down to about 1% per year. If you also choose to write covered calls, you can reduce that cost further but you may limit some of your upside.
If you have small-cap exposure, you could consider buying puts on the Russell 2000 iShares ETF (IWM). If you have international exposure, put options are available on iShares
Talk to your financial advisor about using put options to hedge your downside. As you do, keep in mind that the goal is to avoid the large declines. We often forget that the mathematics of loss is more painful than the mathematics of gain. Print out this next chart and keep it on your desk at all times (and share it with your children).
Overcoming a -10% loss requires a subsequent gain of 11%, overcoming a -20% loss requires a 25% recovery gain, overcoming a -30% loss requires a 43% gain, overcoming a -40% loss requires a 67% gain and overcoming a -50% loss requires a 100% gain.
Note that 75% of the investable money will be self-directed by retirees and pre-retirees within four years. Can that money afford negative to low single-digit returns over the next 10 years? Can pension plans, which are significantly underfunded, expect to return the 7%-8% bogey their actuaries have set? If they are intending to overweight to equity (absent hedges) and find income exposure (at today’s ultra-low yield), the math just doesn’t line up.
I do believe in the long-term investment and innovative abilities of our publicly-traded companies. I just like them much better when I'm buying them at a fair price. Hedge that equity exposure.
Click this link for important disclosures. This is not a specific investment recommendation. Blumenthal and his firm CMG may have investments in the securities mentioned in this piece.
