"The individual investor should act consistently as an investor and not as a speculator."
- Ben Graham
Markets ended the year with a boom. A new President is heading to Washington, regulations are expected to ease, and we could see much needed corporate tax reform in 2017. We view these as positive and we’re not alone.
According to the American Association of Individual Investor Sentiment Survey, just 23.6% of investors felt bullish in the week before the election. Following the vote, the figure jumped to nearly 50% then settled at a still-high reading of 45.6% by year’s end.
Along with driving the indexes to new records, the euphoria led to a rush of cash into equity funds. For the first time in nine months, bond portfolios saw outflows while equity strategies were flooded with more than $58 billion in assets* during the weeks after the election. We’ve long believed stocks were a better bet for capital appreciation in a low rate environment and we welcome the reversal.
But while we share in the enthusiasm caution is required. The meteoric rise for equities has left valuations for many stocks inflated. The value of U.S. common stocks is near historic highs versus gross domestic product, as shown. The upshot is investors are paying more for each dollar of production generated by the nation’s businesses than at almost any period in the last 90 years.
Stock Market Capitalization as a Percentage of Gross Domestic Product
Source: © Copyright 2017 Ned Davis Research, Inc. Chart #A702, 1/31/1926 to 11/30/2016
Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Stock market capitalization is a proprietary data series which includes the estimated value of 3900 U.S. common stocks and references NYSE Market Capitalization prior to 1973 and Dow Jones Total Stock Market Capitalization from January 1973 to September 1980. Gross Domestic Product (GDP) is calculated by Ned Davis using estimates of fixed-weighted GDP from January 1926 to February 1946 and chain-weighted GPD after February 1946.
Past performance does not guarantee future results.
Metrics for the Russell 3000® Index paint a similar picture:
Price-to-earnings ratios are at 19.0x versus a historical average of 17.7x.**
The Index trades at 1.8x price-to-sales, above a long-term average of 1.5x.**
These high valuations are particularly alarming given that the money flowing into equities has mostly gone to flavor-of-the-day passive products. Many of these index funds blindly buy stocks based on market cap with no regard to fundamentals. To us, that sounds more like speculating than investing.
In contrast, our work continues to lead us toward cheaper areas of the market where we are finding plenty of opportunities that can boost bottom-line growth and are still at valuations that have the potential to mitigate downside risk.
Navigating between a bright future and an expensive present isn’t easy. It’s necessary to wade through quarterly reports, balance sheets, and meet with management teams to gauge strengths and weaknesses. That’s been our approach over the past three decades and one we think will always be relevant.
Looking forward, we believe most companies will have to navigate some common factors:
Interest rates could go higher and those with strong balance sheets will have an advantage.
Inflation may be poised to edge up, meaning companies with unique niches should be better suited to pass along rising costs.
Current valuations will place a greater emphasis on the need for businesses to grow sales or margins.
We continue to leverage a disciplined process to identify companies that should thrive under the scenarios listed above. Our bottom-up analysis has helped unearth niche companies that have unique product offerings or idiosyncratic drivers and capable management that may help them thrive in the quarters and years ahead. We believe this approach is consistent with Graham’s advice on investing.
We thank you for your continued trust and confidence.