Posted on 11 January, 2010 | 67 Comments
2009 turned out to be a great opportunity to not only gobble up stocks but to borrow on leverage at ridiculously cheap interest rates. Indeed, clients of Frontwater Capital saw returns that well exceeded that of the market.
But that was last year when any handful of conservative quality stocks including Diageo, Unilever, Proctor & Gamble, Enbridge, Transcanada, Fortis Inc, BFC Waste, Waste Management Inc traded at the lowest P/E ratio in 15 years with dividend yields exceeding 5% in many cases.
2010 is shaping up to be a much more difficult investing environment although at this point, it seems that the stock market does not know it. That’s because investors have yet to factor in rising interest rates that are due to kick in June. Meanwhile average P/E valuations are in the 21 range — whether that means the market is 5% overvalued or 30% overvalued is difficult to say but I do believe there is limited upside at this point with downside risk.
For our Canadian comrades, I am personally concerned when I look at the yields on a number of REITs. Many Canadian REITs including RIOCAN, Cominar, H&R, Boardwalk are trading at yields below 6-7%. To me that is dangerous territory especially for an asset class that is very sensitive to rising interest rates.
At Frontwater, we continue to overweight higher yield asset classes. At the same time, we are now starting to sell call options be it on the index or on individual stock positions as we see limited upside. Undoubtedly, the stock market in both US and Canada (especially Canada) is starting to get ahead of itself. Once again, we see investors trying to catch up on missed opportunities.
Regards,
Jeff Kaminker PM, CFA, MBA, P.Eng
President, Frontwater Capital
****************
For additional reading, I recommend the following snippet taken from The Business Insider, Jan. 11, 2010:
Nothing like free money and the remembrance of good things past to drive stocks into the stratosphere.
As the latest update of Professor Robert Shiller’s cyclically adjusted PE ratio shows, US stocks are now more than 30% overvalued, at 21X earnings. That’s more reasonable than the 100%+ overvaluation in 2000, but it’s closing in on the level of the three other bubble peaks of the 20th Century: 1901, 1929, and 1966.
Note also in this chart the fallacy of the “Fed model”, which argues that PEs should be high because interest rates are low, and vice versa. That relationship has held for the last 30 years, but not earlier. For two decades after the Great Depression (and, today, in Japan), interest rates were very low — and so were stock valuations.
Of course, today’s overvaluation doesn’t tell you much about what stocks will do next week, next year, or even the next 5-10 years. So don’t come whining to us if PEs temporarily zoom into the 30s and the market (temporarily) takes out its old highs.
As the chart above shows, before the 2007 market crash, stocks were overvalued for the better part of 20 years–and observing that didn’t help you make money. On the contrary, it usually got you fired.
What today’s valuation does suggest is that stocks are priced to return a bit less than average over the next decade, perhaps 3%-4% real per year (inflation adjusted), as compared to the 6%-7% average.
Today’s valuations also suggest that stocks may have gotten way ahead of themselves, especially in light of the structural problems that will continue to bog down the economy.
Every one of the prior mega-busts in the past century has been followed by a “trough” in which the cyclically adjusted PE ratio hit the high single-digits. We didn’t quite make it there in March (the P/E bottomed around 12X), although we did get close.
This, combined with what is likely to be a decade of deleveraging, consumer retrenchment, and sluggish growth as we work off our debt binge, suggests that we still yet might hit that single-digit low before we take off on another secular bull market again. This could be achieved either through another market crash, or a prolonged period of backing and filling as earnings growth gradually reduces the long-term PE ratio (this is what happened in the 1970s).
On the other hand, it is possible that that enormous stimulus and zero interest rates over the past two years will produce that “v-shaped” recovery. At this point, given the extent of the recent rally, it would presumably have to be one heck of a “V” to send stocks soaring from here. But the last eight months have already made idiots out of almost everyone.
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