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Peak reported earnings based valuation:

Peak reported trailing twelve month earnings for the S&P 500 index were 197.87. The index achieved this during 2021 Q4 quarterend. Using the latest Aug 2023 CPI of 307.026, this translates to real earnings of 222.86. Let's round it up to 225.

Granted current earnings run rate is a lot lower at around 185, but markets are forward looking. One could take the perspective that the index has proven it can earn 225. It's only a matter of time that level is reached again and then surpassed.

Using today's (9/26/23) closing price of 4273, that's a multiple of 19. Not a screaming bargain, but not absurdly cheap either.

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Sales and profit margin based evaluation:

I am firmly in Buffett's camp that making macro economic predictions regarding interest rates, recessions, etc. is a fool's errand. The only thing we can reliably say is that index sales have grown at 1.5% real over the long term. This makes sense because sales will track GDP which has also grown at the same rate over the last century.

So let's take 2022 yearend sales of 1816 and grow them at 1.5% for 10 years. That gives 2,108 real sales at 2032 yearend. Profit margins hit a peak of 12.63% in 2021, but let's assume they come down to around 9% a decade from now. That gives you real earnings of 2108 * 0.09 = 190.

At an 18 multiple, that puts the index real price at 190 * 18 = 3420 at 2032 yearend. Starting from today's price of 4273, that's a CAGR of -2.20%. But we will get dividends of 2% or so along the way. Adding that gives a real return of 0% for the next 10 years. At least you are keep up with inflation!

Your nominal return will of course be higher depending on what inflation does. Possibly 3 - 4% as a base case.

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My conclusion is that continuing to dollar cost average, for those that have the index as a foundation of their portfolio, is not a bad idea. This is especially true for retirement accounts like 401k where individual stocks may not be an option. Given the restrictive policies currently in place, the price most likely won't run away from us. It may just wander around with periods of low prices likely in the future. Blindly dollar cost averaging should result in a low single digit real return for holding periods of at least a decade or longer.

Very nice.
Head and shoulders above most of the analysis you see out there.

At an 18 multiple, that puts the index real price at 190 * 18 = 3420 at 2032 yearend.

This is the biggest wildcard.
Though that sounds entirely plausible as a number, and I have no particular argument with it, it's extraordinarily difficult to forecast what a "normal" market multiple might be in future.
I have given up making strong assumptions about the future normal valuation of the broad market, hedging all my thoughts and comments with "if it's like what has been typical since 1995..."

Consider:
In 1982 the market was trading at 5.9 times smoothed real earnings.
In 2000 the market was trading at 42.6 times smoothed real earnings.
What's strange is not the variation as such, but that each of those was considered normal at the time--each extreme was, almost axiomatically, the world's consensus.

Jim


PS, extremes do have a bit of predictive power.
From that date in 1982, the forward real total return over the next seven years was +18.1%/year.
From that date in 2000, the forward real total return over the next seven years was -4.1%/year.
Unfortunately, there is no sign that lights up when we reach an extreme.

'In 1982 the market was trading at 5.9 times smoothed real earnings.
In 2000 the market was trading at 42.6 times smoothed real earnings.
What's strange is not the variation as such, but that each of those was considered normal at the time--each extreme was, almost axiomatically, the world's consensus.'

Great zoom out and thank you for taking the time to share it.

The extremes in market valuation, over very long periods of time are just so interesting. It causes me to think of the buyers and sellers as different groups of individuals and organisations.

So many ways to categorise using attributes, with all kinds of combinations. No doubt there is research out there.

Length of time in the game?

Longest held stock?

Concentration by decade?

Realised losses >10%

Realised losses as % of net worth?

Biggest % gains?

Biggest % dollars gains realised and unrealised?

Managing own funds or others?

Use of leverage and what kind?

% charge for managing other people's money?

Net wealth created for others in relation to own net worth?

Consumption/lifestyle over the years?

Investors style by decade (value, quality, momentum, investor, trader etc.)?

CAGR over 1, 5, 10, 20, 50 years?

Inherited wealth?

How was the first $1M was made?

Net worth by age adjusted for inflation?

No doubt, there are important questions I have omitted.

I was thinking about Buffett writing those questions. It would be interesting to me, at least, to consider how all the different market participants, (over those years since 1982 and back to when Buffett started) would answer the questions.

Here we are in 2023. The correction of 2022 has reversed somewhat. The world is still awash with liquidity. The notion that intrinsic value is linked to PV of FCF is deeply out of fashion. The world is incredibly uncertain almost everywhere. Few have any clue about what lies ahead, for markets, or the world.

Maybe Buffett is wrong. Maybe meme stock day trading with leverage is the way forward. Or crypto. Or taking advice from CNBC. Who knows.

As for me, I plan to compare myself to Buffett and try to move closer in his direction, in the areas that make sense for me, as an individual, not managing other people's money.

After decades studying Buffett, it is always pretty clear, when I ask myself: what would Buffett do, if he was you. There is no one like him.

'Unfortunately, there is no sign that lights up when we reach an extreme.'

From a quick search on Buffett's favourite yardstick, which he admits is flawed. But still. Perhaps a concern.

'For the U.S., the Buffett Indicator is now 182%. As of July 2023, the total U.S. market cap (generally based on the Wilshire 5000 index) was $48.97 trillion, and annualized GDP was $26.91 trillion. The ratio fluctuates with the stock market, but 82% into overvalued territory by most standards is noteworthy.'

My personal attitude as someone still working and saving, is: Don't attempt to time markets. But no need to be a total idiot about it.

At an 18 multiple, that puts the index real price at 190 * 18 = 3420 at 2032 yearend.

This is the biggest wildcard.
Though that sounds entirely plausible as a number, and I have no particular argument with it, it's extraordinarily difficult to forecast what a "normal" market multiple might be in future.
I have given up making strong assumptions about the future normal valuation of the broad market, hedging all my thoughts and comments with "if it's like what has been typical since 1995..."

Above are all good points. I will recalculate by bumping down P/E a few notches from 18 to 15 which is the average over the last 150 years according to https://www.multpl.com/s-p-500-pe-ratio . It's not a strong assumption that it will be 15 ten years from now, but we need to pick a number, and selecting the very long term average seems reasonable.

Profit margins are also a wildcard. Historically they have varied between 6 & 12. In recessions, they are lower but that's temporary. There is a limit to how high they can go because labor and society in general will demand its pound of flesh from capital. They are unlikely to go very low either because technology improvements will continue to increase productivity for the foreseeable future. So let's settle down on 9 in the middle.

Recalculation

2022 yearend sales:  1816
2032 yearend real sales:  2108 (growing at 1.5 real per year)
2032 profilt margin:  9
2032 real earnings:  2108 * 0.09 = 190
2032 P/E multiple:  15
2023 real S&P 500:  15 * 190 = 2850
2023 Oct 3 price:  4229
10 year real CAGR:  -3.87%
10 year real CAGR including dividends:  -2%

The actual result will obviously depend on what the actual P/E multiple and profit margin turn out to be. However, if they turn out to be close to what we have assumed above, the result is not pretty. The 10 year TIPS which closed today at 2.45 will turn out to be a much better buy.

Although Jim has been saying this for years, it took me a while to realize that it's better to ignore the distraction of nominal interest rates and estimate future returns in terms of real rates.

Since we don't know what inflation will do, it's best to avoid nominal bonds. But TIPS for a portion of the portfolio is looking increasingly attractive. If holding till maturity, the price gyrations don't matter. A guaranteed 2.5% above inflation is not bad at all. One could easily end up doing much worse in pursuit of higher returns.

https://home.treasury.gov/resource-center/data-cha...

Profit margins are also a wildcard. Historically they have varied between 6 & 12. In recessions, they are lower but that's temporary. There is a limit to how high they can go because labor and society in general will demand its pound of flesh from capital. They are unlikely to go very low either because technology improvements will continue to increase productivity for the foreseeable future. So let's settle down on 9 in the middle.

As an aside, it's possible that 9% might still be pretty optimistic.
US net corporate margins have been high since around late 2004. Presumably some mix of low interest rates, low share of national income to labour, and low tax rates.
But what if this recent stretch is just a slow transient bump in the very much longer history of such things?

During the "old normal", say from January 1950 up till mid 2004, the absolute peak quarter net margin figure was 8.48% and the median was 6.11%.
https://fred.stlouisfed.org/graph/?g=cSh

If you're looking ahead a number of years, I for one would not count on profitability averaging near the 9% range.
It might be, but I wouldn't bet on it.

Jim

It might be, but I wouldn't bet on it.


You should. Because your analysis did not include the composition of the US stock market by market cap.

I have a slight hunch that it's different than the railroads and utilities that dominated in the early 1900s (OP). Or industrials and consumer staples in the 50s and pharmas and WalMart in the 80s (your period).
Tech companies are qualitatively different in their "raw materials" and "widgets" and "sales". It's hard to see why old rules based on flesh-and-blood products should apply.

It might be, but I wouldn't bet on it.
...
You should. Because your analysis did not include the composition of the US stock market by market cap.
I have a slight hunch that it's different than the railroads and utilities that dominated in the early 1900s (OP). Or industrials and consumer staples in the 50s and pharmas and WalMart in the 80s (your period).
Tech companies are qualitatively different in their "raw materials" and "widgets" and "sales". It's hard to see why old rules based on flesh-and-blood products should apply.

It's a popular narrative, but personally I don't really buy it as key main explanatory factor, other than in the rounding error. It's rarely good to go too far down the "it's different this time" road.
(also, my comments are about the corporate sector as a whole and their sales and profits...market cap doesn't come into it)

To be sure, I absolutely agree that there are some "new economy" firms with substantial output and extraordinary net margins. But that isn't the only story in the world.

Things one might consider:

Though there are some big tech firms that have very high net margins (most of them, other than Amazon), their fraction of headlines is much higher than their fraction of the economy. A lot of pretty ordinary stuff still happens, but doesn't get much press. The US manufacturing sector is bigger in real terms than it has ever been before (just a pinch down from the all time high set a year ago).

The huge drop in corporate tax rates is kind of staring us in the face.
Ditto real interest rates.

There is some "push down there, pop up there" effect at work. There is only so much GDP to be divvied up. If some corporates are getting an outsized piece of the profit pie by having glowing business models, it's likely at least partly at the expense of other firms, not just pesky things like workers and tax. Verisign is fantastic at 48%, but don't forget (say) the New York Times now down to 7%. The margins of a whole lot of once-formidable retailers and publishers have been crushed like bugs by the internet. But both groups participate in the averages. I think the killer economics of (say) Apple are more explanatory about how they eat their previous-era competition than about how that explains the larger size of the overall corporate profit pie.

The numbers don't seem to support it.
For example, an average of 20.4% of medium-to-large non-financial firms had net profit margins over 10% 1986-2004.
Since then (a period covering the credit crunch and the pandemic), 33.0% of firms are managing that level of net margin on average.
There just aren't enough tech "it's different this time" wunderkinder to come close to explaining that sort of rise in the breadth of the trend to higher net margins.

It has always been the case that companies will charge whatever they can get away with, and pay as little as they can get away with to get that done. It's not something new. If US companies--both giants and tiddlers--are getting much better at getting a bigger slice of the GDP pie, I think the Occam's razor explanation is that their power is simply now relatively greater relative to the other competitors (mainly labour and tax, also lenders) than used to be the case.
Interestingly, the next largest factor is probably the cost of materials, which for a variety of reasons has oil as a good proxy metric. The average real price of oil has been much lower in the last 20 years than in the prior 20, so that strengthens the argument of the relative weakening of labour and tax in the fight for pie.

Jim

"I have a slight hunch that it's different than the railroads and utilities that dominated in the early 1900s (OP). Or industrials and consumer staples in the 50s and pharmas and WalMart in the 80s (your period).
Tech companies are qualitatively different in their "raw materials" and "widgets" and "sales". It's hard to see why old rules based on flesh-and-blood products should apply."

So, it's different this time?

:)

Tech companies are qualitatively different in their "raw materials" and "widgets" and "sales". It's hard to see why old rules based on flesh-and-blood products should apply."
...
So, it's different this time?

Well, to be fair, to some extent it is.
It's very hard to come up with examples of historical firms that were gigantic in sales and profits but required trivial amounts of equity capital to delivery their product.

It used to be a pretty safe statement that people overpaying for growth (the statistically usual thing to do) were doing so most often because they overlooked the cost of growth. If a car manufacturer is to grow at 40%/year, they will have to raise capital from debt or equity to pay for the new factories. Both of those are costs that will be borne by current shareholders. But the incremental cost of goods sold for (say) an internet advertising business doubling in size is negligible by comparison. (I know, I co-founded one!) You could say with some confidence that it's really is something the world hasn't really seen before, at least not at scale.

I just think that the amazing economics of these relatively few firms are unlikely to be the biggest explanation of an economy-wide rise in the share of aggregate national corporate revenue ending up in aggregate corporate after-tax profits.

It's not really all that hard to do the math, if one were so inclined. If effective tax rates and real interest rates returned to (say) their 1950-2000 average, aggregate US corporate profits would be down by a lot. A guess based loosely on some articles I've read, maybe a third? Labour share of GDP is down by about about 4.6%, or by 6% comparing the 2010s to 1950-1980. If all that ended up in the hands of companies, that alone would explain the rise in net margins.

It has been a great time to be a capitalist with capital. But such trends can't continue forever...there is only so much pie to divvie up, so the numbers will forever be bound in a range.

Jim

Besides the valuation aren't we heading into (or already are in) a situation that as bond rates rise, more people will invest in them instead of stocks thus causing stocks to drop further? And the more stocks drop, unless rates drop, more people will continue to move money into bonds?

While 5% interest isn't huge, it is likely to gain you a real return (although small) which for many is sufficient as compared to the risks many see in the stock market. I know there are others who aren't afraid of stock market drops but many investors are. Throw in TIPs that are providing 2% or more above inflation many may prefer safe returns than watching money drop in the market.

Of course now I see on other forums people panicking and running away from bond funds since they were under the illusion bond funds are safe and wouldn't lose them money and now seeing a 15-20% drop is causing them serious heartburn.

I've rarely ever owned bond funds and usually just own stocks/ETFs and cash. Since I recently retired I have most of my money needs in various treasuries (owned directly and not via any funds) to cover the next decade and my other account mostly in stocks or a guaranteed income fund (roughly 90/10).

Besides the valuation aren't we heading into (or already are in) a situation that as bond rates rise, more people will invest in them instead of stocks thus causing stocks to drop further?

Seems plausible.

Consider:
I have a clutch of models which estimate a plausible one year return from Berkshire stock.
The built in assumptions are that value growth will be typical compared to the last 15 years, and that the ending valuation multiple will also be typical of that era.
Even after the recent wee price drop, the median forecast is still only inflation + 4.3%.

One year TIPS are paying inflation + 3.41%

I can certainly see that some people might prefer the certainty of the TIPS, given that this alternative is only likely to get you 0.9% more!

Note, higher rates don't mean a share of Berkshire is worth any less, merely that, as you say, it's pretty plausible that there might be some more sellers switching to bonds, which would bring down the stock price in the short term.

I see on other forums people panicking and running away from bond funds since they were under the illusion bond funds are safe and wouldn't lose them money and now seeing a 15-20% drop is causing them serious heartburn.
I've rarely ever owned bond funds...

They may have more heartburn than you imagine.
TLT, the most popular T-bond fund, is down -50.6% from its peak as of Friday's close. Down "only" -47.1% when you count the coupons since then.
The peak was a while ago: it has been falling at a rate of -20%/year compounded for the last 3.7 years.


If you will indulge me a bit of retrospection, the absolute highest closing price for TLT was 2020-08-04
That was only 6 trading days after this post of mine: http://www.datahelper.com/mi/search.phtml?nofool=y...

"I am working on the idea of balanced QQQE, BRKB and TLT portfolio, in combination of 1/3 for each or various other allotments.
...
Do not buy TLT. If you own it now, sell it.
Add cash, or more of the other two, or something else.
Negative real return with huge risk of a big fall in prices? Just say no.
Or paste a "kick me" sign on your back.
Cash is really quite nice. Bonds only *seem* to have a yield."

Berkshire has beat TLT by 38%/year compounded since that post 3.2 years ago.


Jim

Jim,

Do you have a view on QQQE these days? The ratio of QQQE to BRK-B is about 0.216 right now, which is well within the 5-year range of 0.20 to 0.24 that you noted in your 2020 post.

Thanks,
Andy

more people will invest in them instead of stocks thus causing stocks to drop further? And the more stocks drop, unless rates drop, more people will continue to move money into bonds?...
Throw in TIPs that are providing 2% or more above inflation many may prefer safe returns than watching money drop in the market.

I spotted a great quote today, possibly applicable to market turbulence

"Le tourment des précautions l'emporte sur le danger que l'on veut éviter, il vaut mieux s'abandonner à sa destinée" --Napoleon Bonaparte


The torment of precautions outweighs the danger one wishes to avoid; it is better to abandon one's self to one's destiny.

Jim

The torment of precautions outweighs the danger one wishes to avoid; it is better to abandon one's self to one's destiny.

Did Peter Lynch read Napoleon? "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.'

So, it's different this time?

That's a convenient put-down, but it's based on an 800 year history.
I could (or could not, either way) care about 800 years or even 100 years.
All that matters to me is the previous, say, 30 years, and the next 30 years. And by me, I mean an average investor with a normal life expectancy, who has an extremely finite amount to make money.
If US companies' profit margins stay elevated for the next 30 years, they can all go to zero in the next century or millenium. I don't care. Only historians and pundits who think "long term" care.
Perspective matters. When you are dead you are dead.

I realize short-termism is a selfish view, and the West excels in it. Hence the indiscriminate industrialized slaughter of Earth's species, and microplastics. ("Plastics, it's the next great thing!") But it is the reality at least of my lifetime.

<That's a convenient put-down, but it's based on an 800 year history.
All that matters to me is the previous, say, 30 years, and the next 30 years...
If US companies' profit margins stay elevated for the next 30 years, they can all go to zero in the next century or millenium. I don't care...>

Not a "put-down." Just quoting Sir John Templeton:
"The four most expensive words in the English language are, This time it's different."

And maybe you are correct that the businesses of today deserve higher margins than the businesses of yore and those margins will never go down. Anything is possible.

I tend to agree with Howard Marks, who had this to say recently...

If the declining or ultra-low interest rates of the easy money period aren't going to be the rule in the years ahead numerous consequences seem probable:
Economic growth may be slower
Profit margins may erode
Default rates may head higher
Asset appreciation may not be as reliable
Costs of borrowing will not trend down consistently
Investor psychology may not be as uniformly positive; and
Businesses may not find it so easy to obtain financing.

Much love to all, Banksy out!

https://www.oaktreecapital.com/docs/default-source...

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