Don't Let Valuations Drive Your Investing Decisions

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Landon Whaley

17 Mar, 2017

in Fundamental Analysis and 1 more

Everywhere I turn these days, I see articles discussing how over-extended U.S. equity valuations have become. If I took a shot of mouthwash every time I came across an article that talked about U.S. equity valuations, I’d be leaving Las Vegas, Nic Cage-style, minus Elisabeth Shue. I monkey-hammered the idea of valuation as a catalyst for an equity market drawdown several weeks ago, but this week it’s woodshed time for Mr John Hussman.

Hussman has a brand new commentary beating the same dead “S&P 500 is overvalued” horse, but this time he’s coined a new phrase to describe the S&P 500: “offensively overvalued.”

While I obviously can’t say for certain what this guy uses to make investment decisions, it’s not a stretch to assume that valuation is a core part of his process, given how outspoken he is on the topic and how often he writes about it. Hussman’s  favorite measures of valuation have registered as overvalued since 2012, which might explain why his flagship fund is in the midst of a four-year, 32% drawdown. His best-performing fund has mustered a positive 0.44% annualized return over the last five years with an 8.4% drawdown, which is still ongoing.

The point of this commentary is not to pick on the John Hussmans of the world, but to highlight the dangers of relying too heavily on valuation as part of your process. Let’s not rely on narrative and valuations to drive our investment decisions; let’s instead be data-dependent, process driven and risk conscious.

The Real Equity Market Risk
The primary risk factor that could derail the U.S. equity market’s ascent since the election is not a correction due to valuation, but rather a decline in the U.S. economic data.

U.S. GDP growth has accelerated for two straight quarters and based on early data this year, it’s accelerating in Q1 as well. The economy is improving in all aspects across both the service and manufacturing sectors. Not only that, but consumer-specific data shows strength not seen in well over a year.

Since the crisis bottom in March 2009, U.S. growth has undergone a complete cycle of accelerating to a peak and slowing to a trough on three different occasions. The three accelerations lasted an average of 15 months and the three decelerations lasted an average of 14 months.

We know January’s data was solid, which puts the U.S. at seven months of acceleration and counting. Given the post-crisis precedent, we could see growth accelerate for as long as another six months before the slowdown occurs.

The $64,000 question is: if the risk materializes and U.S. growth starts to slow, then what’s the downside and where is the opportunity?

The Downside of Waiting to Invest
Hussman and his ill-fated followers of valuation models are calling for anything from a 30% to a 50% correction. I, on the other hand, am not. If the U.S. falls into a recession, then a steep correction is definitely on the table, but we are months, possibly even a year, away from a recession being a real possibility.

Do you really want to miss opportunities for the next six to 12 months waiting on a recession?

If U.S. growth starts to slow, don’t expect that the S&P will automatically follow. In fact, during the last three economic slowdowns, the S&P averaged a +7.3% cumulative return over the 14-month average duration, with a maximum drawdown of around 13%. So, while there is roughly twice as much potential downside as upside, the S&P still came through those slowdowns ahead of the game.

If we look further back, the data tells us that the S&P 500 posted positive returns in 57% of the quarters during which U.S. growth was slowing. Being data dependent tells us that it takes more than just a slowing of U.S. growth to materially impact U.S. equities. The data also tells us that Hussman and his ilk aren’t likely to get the market tumble they are looking for during 2017.

The Playbook
If you want to know the best way to trade during waning U.S. growth, you need to look at one more fundamental factor: inflation.

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