March 2015 Market Commentary

“Nothing sedates rationality like large doses of effortless money.” – Warren Buffett

We are one day away from the sixth anniversary of the equity market bottom that came at the depth of the financial crisis and that brought an end to the previously venerable Lehman Brothers, Bear Stearns and the near end to many others. Since that time, the Fed has maintained not only a Zero Interest Rate Policy (ZIRP) but also quantitative easing programs one, two, and three. This policy and these programs have funneled hundreds of billions of dollars into the equity markets helping to re-inflate that which was lost in the market’s decline following the 2008 financial crisis. While the ascent of the equity markets following the crisis was briefly interrupted in April 2010 and April 2011 with 16% and 19% corrections respectively, the market’s climb has moved up relatively unabated.

As of last week, it has been 41 months since the last correction of 10% or more, which means that we are now experiencing one of the longest correction-free periods in US stock market history. That being said, much has been written about the absence of 10% equity market corrections since 2012. The underlying message has typically been that corrections are healthy for a bull market ascent and that without such corrections the market is increasingly susceptible to a larger “unhealthy” decline. The pull-back we have seen over the past few days leaves the market down just 2.3% from the all-time high set less than a month ago. If very recent history proves prescient, investors will buy the pull-back and the markets will move higher. However, we find that familiar scenario concerning considering current equity market valuations.

Assessing equity market valuations requires distilling many different fundamental data points down to a measure that can be compared historically so that one may have a reference point for determining whether an asset is under or over-valued. Corporate revenue, earnings, cash flow, earnings before interest, taxes, depreciation and book value are some of the many metrics to which valuation multiples are assigned. We have found that when evaluating the overall equity market, though, it is most appropriate to look at earnings-based metrics of which there are three that we consider:

1. Forward Price Earnings Multiple – Also known as forward P/E, this measure allows one to value the market on its 12-month forward prospects which may be better or worse than the past year. The problem with this metric is that we can’t predict the future. The forward P/E of the S&P 500 is today at 16.9, a 24%, 20%, and 5% premium to the 5, 10, and 15-year averages, respectively. Note the 15-year average includes the 1999-2000 when the forward P/E was consistently above 20 and peaked at 25.

2. Trailing Price Earnings Multiple – Also known as trailing P/E, this measure allows certainty as past earnings are facts not estimates. The problem with this measure is that it doesn’t give consideration to future improvements or problems. The trailing P/E of the S&P 500 is today at 19.6, a 26% and 35% premium to the historical mean and median, respectively.

3. Cyclically Adjusted Price Earnings Multiple – Also known as CAPE, this measure is based on the average inflation-adjusted earnings from the previous 10 years. This allows for a “smoothing” of earnings over a period of time that takes into account a full business cycle. While a conservative measure, we give higher weight to this measure than the others. The CAPE of the S&P 500 is today at 27.3, a 64% and 70% premium to the historical mean and median, respectively.

In our view the equity markets are historically over-valued. Given current global economic conditions, in conjunction we have reduced equity allocations and increased allocations to strategies that are less correlated to the equity markets.