Wednesday, March 16, 2005
Morningstar on Historical Market Trend Analysis
Outsmarting Market Trends
by Curt Morrison, MD, FACC | 03-16-05 | 06:00 AM
Shortly before the stock market crash of 1929, Yale economist Irving Fisher famously declared that stocks had reached what appeared to be a permanently high plateau. Undoubtedly, Fisher was neither the first person nor the last one to believe that prevailing conditions would never change. Those ideas appear to be as common at market bottoms as they are at market tops. Yet if history reveals one permanent feature of business conditions or stock returns, it is this: They change.
In fact, they tend to change cyclically. If the cycles lasted only one week at a time, then no one would be fooled by them, but bull markets, bear markets, and business cycles can last for years, and their relative durability seduces investors. Among other reasons, I think this occurs because many investors lack a historical perspective, and many more have a short-term focus. Patient, knowledgeable investors can avoid this pitfall by valuing securities and the broad market based on normalized results.
This sort of analysis warns investors away when market prices imply that peak performance will be sustained over the long term, and it invites them to take advantage of a sort of arbitrage opportunity when prices imply that adverse conditions will never improve. That is, patient investors can profit on the arbitrage between their long-term horizon and the short-term focus of many other market participants.
Estimates of normalized results can be made with moderate confidence for mature companies, and with greater confidence for entire industries. Because we have more than 130 years of data on the broad stock market, and because it represents a major portion of the entire national economy, we can estimate its normalized results with the highest degree of confidence. I've described some examples below.
Be wary when peak operating margins are projected over the long term.
Aetna AET, Humana HUM, and UnitedHealth Group UNH have all posted rising operating margins during the last several years, and all three companies have enjoyed a sharply rising stock price. However, the same could be said for most of their peers. In my opinion, managed-care companies have enjoyed an optimal environment between 2002 and 2004, but industry conditions have been cyclical in the past, and there are signs that the cycle peaked in 2004. Despite this, current stock prices appear to discount a continuation of recent peak or near-peak operating margins and organic sales growth rates over the long term.
Drug companies have stumbled, but long-term prospects probably haven't changed.
Contrarily, opportunities are created when short-term industry difficulties lead to lower long-term expectations. Last year's headlines were full of bad news for pharmaceutical companies, and their stocks fell to valuation levels last seen a decade ago (you can read more about the subject here and here). Although the research labs have been relatively unproductive at a number of these companies in recent years, the pharmaceutical industry has been extremely profitable for decades. Dry spells have always been followed by a new wave of discoveries, and it seems unlikely to me that the progress of medicine will slow in the decades ahead. Ground-breaking drugs create their own demand, and as long as the normalized productivity of future pharmaceutical research approximates that of the past, these companies should continue to post stellar growth and profitability in the decades ahead.
In bear markets, investors expect bad times to last.
In a similar vein, Warren Buffett wrote an article in 1979 explaining that the broad stock market offered excellent value. Inflation was high then and stock returns had been poor for seven long years. That was also the year that BusinessWeek famously ran a cover story titled "The Death of Equities." Irving Fisher described a permanently high plateau in 1929, but 50 years later, investors thought they saw a permanently low valley. Although it's possible for individual companies or even whole industries to suffer a permanent impairment, investors can be much more certain about the future of the entire market.
Measured by the normalized P/E or the Q ratio (read more about these metrics here), the stock market sold at only 60% of fair value in 1979, but over the very long term these measures must revert to fair value as long as markets function freely. Insightful investors had an opportunity to profit on the arbitrage between their long-term outlook and the shorter term gloom reflected in market prices. As it turned out, a long-term outlook was required because the market's valuation fell to only half of a fair level by 1982. As Buffett is quick to admit, he has no idea what the market will do in the short-term--and three years is a short period in the stock market. Nevertheless, conditions did change eventually, and 1982 marked the beginning of the greatest bull market in history.
Today's prices assume peak margins and high valuations are permanent.
Unfortunately, I think that today's stock market is a polar opposite of 1979. It is markedly overvalued by the normalized P/E or Q ratio, as well as by Buffett's favorite metric, the ratio of total market capitalization to GDP. That ratio was recently about 1.3 against a long-term average near 0.62 and a long-term median of roughly 0.56. There are probably many contributing reasons for this unhappy state of affairs (unhappy because it means that prospective returns are low), but one might be analogous to the situation described for managed-care companies.
Jeremy Grantham calls corporate profit margins the most reliably mean-reverting series in finance, and Buffett wrote that the margin (total aftertax corporate profits as a percentage of GDP) generally remains between 4% and 6.5%. He remarked that it's rare for the rate to go above 6.5%. However, that margin reached 7.92% last year, according to a report by Arnold Van Den Berg. That value was exceeded only once during the last 80 years--in 1929. Given that profit margins are mean-reverting, investors ought to assign low P/E ratios to high-profit margins and vice versa. In this way, investors could properly account for normalized long-term results. Yet, according to data presented by Grantham, they tend to do just the opposite.
Investors in 1979 shared the outlook of their peers from 1932, a terrible year in the stock market, but today's investors have more in common with those of 1929, in my opinion. Too much importance has been assigned to unsustainable current conditions, and too little attention has been given to normalized estimates of profit margins, interest rates, and earnings growth. Just as independent-minded investors with a long-term focus profited by recognizing that bad conditions were likely to improve in 1979, like-minded investors today should heed the warning flags the market is waving: The normalized P/E, Q ratio, and market-capitalization/GDP ratio are unsustainably high.
Curt Morrison, MD, FACC, is a stock analyst with Morningstar. He can be reached at curt_morrison@morningstar.com.
by Curt Morrison, MD, FACC | 03-16-05 | 06:00 AM
Shortly before the stock market crash of 1929, Yale economist Irving Fisher famously declared that stocks had reached what appeared to be a permanently high plateau. Undoubtedly, Fisher was neither the first person nor the last one to believe that prevailing conditions would never change. Those ideas appear to be as common at market bottoms as they are at market tops. Yet if history reveals one permanent feature of business conditions or stock returns, it is this: They change.
In fact, they tend to change cyclically. If the cycles lasted only one week at a time, then no one would be fooled by them, but bull markets, bear markets, and business cycles can last for years, and their relative durability seduces investors. Among other reasons, I think this occurs because many investors lack a historical perspective, and many more have a short-term focus. Patient, knowledgeable investors can avoid this pitfall by valuing securities and the broad market based on normalized results.
This sort of analysis warns investors away when market prices imply that peak performance will be sustained over the long term, and it invites them to take advantage of a sort of arbitrage opportunity when prices imply that adverse conditions will never improve. That is, patient investors can profit on the arbitrage between their long-term horizon and the short-term focus of many other market participants.
Estimates of normalized results can be made with moderate confidence for mature companies, and with greater confidence for entire industries. Because we have more than 130 years of data on the broad stock market, and because it represents a major portion of the entire national economy, we can estimate its normalized results with the highest degree of confidence. I've described some examples below.
Be wary when peak operating margins are projected over the long term.
Aetna AET, Humana HUM, and UnitedHealth Group UNH have all posted rising operating margins during the last several years, and all three companies have enjoyed a sharply rising stock price. However, the same could be said for most of their peers. In my opinion, managed-care companies have enjoyed an optimal environment between 2002 and 2004, but industry conditions have been cyclical in the past, and there are signs that the cycle peaked in 2004. Despite this, current stock prices appear to discount a continuation of recent peak or near-peak operating margins and organic sales growth rates over the long term.
Drug companies have stumbled, but long-term prospects probably haven't changed.
Contrarily, opportunities are created when short-term industry difficulties lead to lower long-term expectations. Last year's headlines were full of bad news for pharmaceutical companies, and their stocks fell to valuation levels last seen a decade ago (you can read more about the subject here and here). Although the research labs have been relatively unproductive at a number of these companies in recent years, the pharmaceutical industry has been extremely profitable for decades. Dry spells have always been followed by a new wave of discoveries, and it seems unlikely to me that the progress of medicine will slow in the decades ahead. Ground-breaking drugs create their own demand, and as long as the normalized productivity of future pharmaceutical research approximates that of the past, these companies should continue to post stellar growth and profitability in the decades ahead.
In bear markets, investors expect bad times to last.
In a similar vein, Warren Buffett wrote an article in 1979 explaining that the broad stock market offered excellent value. Inflation was high then and stock returns had been poor for seven long years. That was also the year that BusinessWeek famously ran a cover story titled "The Death of Equities." Irving Fisher described a permanently high plateau in 1929, but 50 years later, investors thought they saw a permanently low valley. Although it's possible for individual companies or even whole industries to suffer a permanent impairment, investors can be much more certain about the future of the entire market.
Measured by the normalized P/E or the Q ratio (read more about these metrics here), the stock market sold at only 60% of fair value in 1979, but over the very long term these measures must revert to fair value as long as markets function freely. Insightful investors had an opportunity to profit on the arbitrage between their long-term outlook and the shorter term gloom reflected in market prices. As it turned out, a long-term outlook was required because the market's valuation fell to only half of a fair level by 1982. As Buffett is quick to admit, he has no idea what the market will do in the short-term--and three years is a short period in the stock market. Nevertheless, conditions did change eventually, and 1982 marked the beginning of the greatest bull market in history.
Today's prices assume peak margins and high valuations are permanent.
Unfortunately, I think that today's stock market is a polar opposite of 1979. It is markedly overvalued by the normalized P/E or Q ratio, as well as by Buffett's favorite metric, the ratio of total market capitalization to GDP. That ratio was recently about 1.3 against a long-term average near 0.62 and a long-term median of roughly 0.56. There are probably many contributing reasons for this unhappy state of affairs (unhappy because it means that prospective returns are low), but one might be analogous to the situation described for managed-care companies.
Jeremy Grantham calls corporate profit margins the most reliably mean-reverting series in finance, and Buffett wrote that the margin (total aftertax corporate profits as a percentage of GDP) generally remains between 4% and 6.5%. He remarked that it's rare for the rate to go above 6.5%. However, that margin reached 7.92% last year, according to a report by Arnold Van Den Berg. That value was exceeded only once during the last 80 years--in 1929. Given that profit margins are mean-reverting, investors ought to assign low P/E ratios to high-profit margins and vice versa. In this way, investors could properly account for normalized long-term results. Yet, according to data presented by Grantham, they tend to do just the opposite.
Investors in 1979 shared the outlook of their peers from 1932, a terrible year in the stock market, but today's investors have more in common with those of 1929, in my opinion. Too much importance has been assigned to unsustainable current conditions, and too little attention has been given to normalized estimates of profit margins, interest rates, and earnings growth. Just as independent-minded investors with a long-term focus profited by recognizing that bad conditions were likely to improve in 1979, like-minded investors today should heed the warning flags the market is waving: The normalized P/E, Q ratio, and market-capitalization/GDP ratio are unsustainably high.
Curt Morrison, MD, FACC, is a stock analyst with Morningstar. He can be reached at curt_morrison@morningstar.com.
# posted by Tom @ 7:45 PM 
