Investing In Action: Valuation Insights


Carl Hall, CFA
Chief Investment Officer

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First Quarter 2017

The Fed raised rates again in March with the target Fed Funds rate now at 0.75-1.0%. It is anticipated that this rate hike will be the first of a few this year but as we have come to learn, the plan Fed policymakers present in one quarter can be significantly different from the actual changes in the policy rate in subsequent quarters. If inflation continues to take hold, it can be expected that the Fed will respond with another hike or two this year. However, there are no shortage of external factors that could put additional rate hikes on hold in 2017. No matter what happens the rest of the year regarding monetary policy, we have already witnessed something this year that had not happened since before the financial crisis: increases in the Fed Funds rate in consecutive quarters.

Despite the strong start to the year in US and global equity markets, the torrid pace slowed down in March. The S&P 500 returned 0.12% in the final month of the quarter while the MSCI All Country World Index rose 1.22%. US markets continued to rise in the quarter following the inauguration of President Trump. Similar to the post-election stock market rally at the end of 2016, the performance in US markets is largely attributable to the new administration’s pro-business rhetoric: tax cuts, regulatory reform and infrastructure spending. Some have said the pro-business talk has revived the “animal spirits” in the US. While it certainly seems like markets have become increasingly confident in the future business environment backed by strong hiring numbers and consumer confidence surveys, we are a little more skeptical. In our view, the post-election rally that continued into the first quarter of this year “priced to perfection” the anticipated pro-growth policies that Trump would pursue with the help of a Republican-controlled House and Senate.

In a way, March was a wakeup call for markets as investors seemed to realize that talking about major tax overhaul and spending plans is much different than implementing such legislation. The discrepancy between campaign rhetoric and legislative change was highlighted by the House’s plan on repealing the Affordable Care Act. The infighting that surrounded the bill in the House, combined with Senators proclaiming the bill would be dead on arrival and an ambivalent President, made clear that any legislative changes would be challenging to accomplish. Even in a best-case scenario, legislative change takes time. The health care debate showed that large-scale overhauls not only will take time, but may not come to fruition at all, or be much smaller in scale that Trump campaigned on.

Tax reform is another big-ticket item that Republicans want to tackle early on, but even if Trump is more personally invested in tax reform than he has been with health care reform, the task is still monumental. Even if some Democrats are convinced to support a tax reform bill because of middle class tax cuts for example, they are unlikely to provide the bipartisan support needed before the 2018 midterm elections to minimize the chance Trump gets a big “win” in the first part of his term. This supports our belief that stock markets, already sitting at high valuations, got ahead of themselves early in the quarter and this was followed by a slight pullback at the end March. In sum, while we are hopeful for a pro-growth corporate tax reform bill, we are not anticipating a major change just yet—although any progress towards one in Congress might be enough to guide equity markets even higher.

On the short-term horizon, increased market volatility may be in store for the second quarter of 2017 for a number of reasons. First, if the Fed raises rates again investors may be enticed to move money out of equities and into higher-yielding US Treasuries. Additionally, if economic growth in Europe continues to pick up, European debt may begin to look more attractive relative to yields over the last year, which could also draw money out of stock markets.

On the flipside of positive economic growth in Europe however lies the potential for destabilizing effects if Marine Le Pen wins the French presidential election. Her anti-Euro, pro-nationalism platform could serve as a knockout punch to the European Union. Based on current polling Le Pen has been gaining momentum recently, although she is still likely to lose to Emmanuel Macron. The French election, set to begin later this month, may be the biggest event with serious market-moving potential on the calendar for both the quarter and the entire year. If 2016 taught us anything, though, it is that unexpected outcomes in political events may send markets down in the short-term but that they have yet to derail the US equity bull market. The French election may prove to be different, but US equity markets have been resilient over the last 5 years. The escalation of conflict in Syria may also provide a case study in geopolitical driven volatility in the short-run that is outweighed by stronger market fundamentals over the course of the year.

Constructing durable asset allocations remains our primary focus, given all of the various economic and political puts and takes. We will also continue to take advantage of market dislocations during periods of uncertainty when we believe compelling opportunities present themselves. As always, please do not hesitate to call with any market-related questions.

Carl Hall, CFA
Chief Investment Officer
Phone: 781-393-6092

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Price vs. Value

A Good Starting Point

P/E ratio analysis (both absolute and relative valuation) is not a silver bullet when it comes to stock picking. All else equal, it is of course better to pay less for a stock (or any ‘widget’) than more, so the ratio provides a 'quick and dirty' snapshot. At the very least it provides a starting point in the valuation process. It is worth noting that the P/E only considers the accounting earnings a company reports; at the end of the day what really matters is cash flow generation. Even better than cash flow, a firm’s free cash flow profile is a more quantifiable way to understand management's historical and future value-creation (or destruction) acumen. P/E market data is bountiful than other more nuanced valuation metrics.

Data Viz in Action

A nice way to communicate the meaning and hopeful value of any quantitative data is through data visualization. In particular, violin plots allow us to visualize the full distribution of historical valuations along with additional insights we consider when seeking index-level and stock-specific insights. Century Bank's Wealth Management Group has turned to the 'R' software environment for statistical computing and graphics. R is the global 'lingua franca' for data scientists. We believe possessing even the most fundamental understanding of its value empowers us to communicate often complex investment concepts in a more intuitive and user-friendly way for clients.
Below is a violin plot for the S&P 500 TR index:

Data Source: Bloomberg©

Initial Interpretation

Right away we can see the index’s month-end P/E has been between 15.2 and 18.2 50% of the time (last 10-years). How do we know this? Each horizontal line represents 25% of the observations so the observations between the top line and bottom line represent 50%. Furthermore, we see there is a tighter clustering between the middle and top lines, or 17.08 & 18.24. The width of the violin plot reflects the data observation frequency. But what about the most recent month-end valuation? What does the valuation look like today as compared to the last 120 observations, spanning 10-years? Is the market trading where it usually does, on average? By adding a statistical summary function we can now see March’s month-end P/E level:

Data Source: Bloomberg©

Layering the Analysis

First we learned about the distribution of the month-end P/E ratios. Now, adding some more code, we see the most recent month-end level. The interpretation is that based on this metric, the index is more expensive than usual. Given the fact the yellow dot is in the top quartile, we can conclude “the market has been cheaper at least 75% of the time compared to today’s valuation”. Going one more step, we finally add a vertical red line that spans “two standard deviations” from the average valuation. Without getting too detailed about what this means, it can be summarized as follows: the top of the red line represents the most expensive 2.5% occurrences while the bottom of the red line reflects the cheapest valuations. We are currently trading at the top of the line:

Data Source: Bloomberg©

Cleaning it up

We all like a nice looking chart, so let’s add the “Economist” theme to the plot and include attribution and a quantitative summary:

Data Source: Bloomberg©

Summary Statistics: Price-to-Earnings Ratio for the S&P 500 TR Index®
Min. :12.04
1st Qu.:15.23
Median :17.08
Mean :17.04
3rd Qu.:18.24
Max. :24.24
Last :21.76
Data Source: Bloomberg®


Aside from reassuring the readers that we are not trying to psychoanalyze them with an inkblot interpretation, the above discussion shares our valuation analysis process. As we stated above, a high P/E does not mean “sell stocks”. What may explain today’s high levels? First, the data we are looking at is ‘trailing P/E’ data. P/E ratios reflect future expectations. The “Trump Bump” has driven valuations higher because the investment community believes there will be corporate tax cuts, regulatory easing, and greater capital mobility. From our perspective, we currently believe there is more downside risk than upside potential given how difficult it is to legislate any change in D.C. As a result, our focus is to focus on companies with strong balance sheets and ones with superior cash flow generation. At the asset class level, it means ensuring we assess relative global valuations while constructing portfolios with a defensive posture should volatility rise.
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