Like many sports fans, I love this time of the year. High school sports are wrapping up their championship games and the theatrical, always unpredictable NCAA basketball tournament is in full swing. I’m in two NCAA bracket pools this year, with my final teams still vying for the overall championship. While you might not care, there is a purpose for sharing this.
To show you just how hard it is to predict the winning teams, only 3% of all bracket entries still have all final 4 teams alive after the first two rounds of play, per ESPN. I’m lucky enough to be among the top 3% in one bracket, but am among the lower 97% in the other bracket (I have 3 of 4 correct).
I bring this up because financial markets are very similar. It’s almost futile to predict, with a very high degree of accuracy what exactly will happen next month, let alone in five years. That’s why it’s important to tune out any noise in the markets that have little correlation to subsequent market returns and focus on valuations and probabilities.
But what about the market experts that never seem to miss you ask? While you may hear of some great calls in the market that led to huge wins, any false predictions that person may have had along the way, along with the money lost on those false predictions will be buried as deeply and quickly as possible. While being in the right place at the right time is nice, it’s a long track record through various market conditions that separate the true experts. Buyer beware when it comes to sales pitches.
Now let’s get back to valuations. As you’re aware from past newsletters, most valuation metrics are in the 90th-98th percentile of historical valuations. I don’t want to waste time going over each one again individually.
Now for probabilities. Mathematical projections are showing a slightly negative return over the next 5 to 10 years for the U.S. stock market IF optimistic growth expectations are met. If optimistic growth expectations (which have already baked in deregulation, low inflation and a modest interest rate environment) are not met, returns are expected to fare much worse.
In looking for possible new buys (which I did not find this month using my models due to high valuations), a disturbing trend has started to appear.
During times of economic growth and stock price appreciation you’ll see revenues, cash flows and book values expanding. In looking at some key stocks, these 3 metrics are showing signs of declining at a time when valuations are high. This is a disturbing trend that typically doesn’t show up except during periods of market declines.
While this trend may reverse itself, I’ll be keeping my eye on these metrics to see if there’s any further deterioration going into the summer months. If the trend does continue; a further rate increase, black swan event or President Trump struggling to get his key initiatives passed would spell trouble for the markets.
Investors don’t seem to be paying attention to these key pieces of information or the growing disparity between GAAP and non-GAAP earnings. Torsent Sløk, Deutsche Bank’s Chief International Economist, recently noted to clients that “Despite enormous political uncertainty both in the US and Europe, stock markets continue to see very limited downside risks on the horizon with implied probabilities of a +20% correction in the S&P 500 at the lowest levels since 2008,” Sløk wrote.
Although all this information will help contribute to beating the market in the medium to long-term, it doesn’t always correlate to the short-term. There will be times when the stocks we watch lag the market and times when they’re absolutely crushing the market. Again, it’s the results over time WITH the risk that you take to achieve those returns that matter.