Moody Blue

Look around at the broader market and economic landscape, and there’s a good bit to feel uneasy about.  In Europe, even though sovereign debt/yield troubles have been under control of late, very few policymakers, or investors for that matter, feel that we're out of the woods.  Spain continues to engage in a convoluted dance with the ECB.  In the US, approximately 65% of S&P 500 companies reporting so far have missed revenue estimates; year over year earnings are looking at a second flat to down quarter.  The election and the subsequent fiscal cliff situation continue to inject broader uncertainty.  In China, manufacturing indicators continue to hang around in worrisome territory, though in fairness companies and economists feel that there may be a light at the end of the tunnel.  Now, Japan may have its own fiscal cliff to worry about.  

Despite all the negatives that have piled up over the past quarter or two, the market keeps pushing higher, this week's corrective pullback notwithstanding.  The MSCI EAFE has rallied over 15% from the early summer low.  The S&P 500 in the US has been on a similar trajectory.  

Here's what's been particularly interesting.  Normally an improvement in market price action leads to a commensurate improvement in various market sentiment indicators.  While they aren't perfect, generally indicators such as the AAII bull/bear and the put/call ratios in the US have provided decent contrarian signals.  Almost across the board, market sentiment indicators that we follow here are at or near the lows witnessed last fall.  For instance, 4-week average bullish levels in the AAII survey are currently a standard deviation below normal, while the 4-week average of bears is running a standard deviation above normal.  Similar negative readings are evident in the ISE Sentiment Index, which measures the numbers of calls traded per 100 puts in the options marketplace.  During the summer correction this year, sentiment was worse than last fall in several instances.  

Sure, at various points this year during rally periods, indicators have perked up.  The first sign of trouble, however, sends investors almost immediately into a psychological rut.  In the past, levels such as those recently seen have been associated with stabilization in past market price action.

This doesn't necessarily mean that everyone should get out there and load the boat with equities.  But, the quick downward shifts in psychological momentum whenever headlines and market action gets a little hairy seems to indicate there could be some additional upside in equity markets and that a “wall of worry” is in place and ready to climb.  It's never time to get complacent, but markets generally seem to move, rule of thumb, in the direction that causes the most pain to the greatest number of investors.  Sentiment among investors is still seemingly dour.  The pain trade, at least in the short run, would seem to be markets that grind higher.  Below, we've included some of the relevant sentiment indicators.

AAII Bull Bear Data
Source: American Association of Individual Investors, Bloomberg

Bullish levels in the US have remained under historical averages all summer and fall, despite the fact that markets have marched steadily higher. Bearish levels, except for a few weeks following the QE3 announcement have been elevated, significantly so as of late.

ISE Sentiment Indicator
Source: International Securities Exchange, Bloomberg

BNP Paribas Europe Love-Panic Market Timing Indicator
Source: BNP Paribas, Bloomberg

Not necessarily in “total panic” territory relative to where markets were in early 2009, but sentiment overseas remains subdued and near last fall’s lows.

On Margins...

One of the more remarkable stories since the beginning of the "Great Recession" and the subsequent bout of sub-trend growth has been the ever upward march of corporate profitability in the United States.  S&P 500 earnings going into this earnings season are at or near all-time highs and should remain there this earnings season despite what will probably turn out to be another mediocre quarter in terms of quarter over quarter and year over year growth.  Profit growth in the US has received one heckuva tailwind from one source: margin growth.  Corporate profits as a percentage of nominal GDP are now at or near all-time highs (see chart).

Bureau of Economic Analysis, Bloomberg, and IronHorse Capital

Except for the hiccup associated with the 2008/2009 economic crisis, margins have remained high for the past decade.  Of course, companies in the US have been highly effective in terms of doing more with less over the past several years, increasing the productivity of existing workers, cutting costs, and improving manufacturing processes, among other things.  Increasing global, ex-US, sales growth among US companies has most likely helped significantly as well.  Certainly one of the biggest tailwinds has been the fact that labor costs have been subdued over the past few years due to several factors.  High unemployment, hence a high supply of labor has kept wages subdued as workers compete with one another for open jobs.  The continued opening up of global labor pools has also contributed to this phenomenon.  Vast improvements in communication technology and the sophistication of global supply chains have allowed companies to move lower skill work to other countries.  Increasingly, companies have found opportunities to move higher skill service and analyst positions overseas.
 

At some point, however, this well will run dry, maybe sooner rather than later.  As seen below in the chart created by the Cleveland Fed, the Labor share of national income, which had remained in a relatively tight range for about 50 years, began to fall dramatically in 2000.  

Federal Reserve Bank of Cleveland

This provides a stark graphic representation of some of the forces described above.  It's no coincidence that this represents a mirror image of the profitability graph.  Some of the declines represented below are structural and long-term in nature; more than likely the long-term trend has downshifted.  Even so, this has been a mean reverting series as has the profit margin series.  At some point, for whatever reasons economic and/or political, this decline will be arrested and begin to upshift and corporate margins will begin to come back to earth (and will probably overshoot to the downside at some point in the future).  

Profit margin peaks and troughs have been very closely associated with peaks and troughs in the S&P 500 over the past 50 years.  This earnings season and beyond, these forces warrant close observation by domestic investors.  When margins have broken to the downside in past episodes, usually the retreat was swift.  

Animal Spirits

In last week's blog installment, we talked about a simple "back of the envelope" method for estimating future market returns.  A key component to that equation is the "animal spirits" component, i.e. P/E expansion and contraction over time.  As demonstrated last week, P/E expansion and contraction have an outsized impact on annualized returns through a cycle.  Even in environments with robust earnings and dividend growth, P/E contraction and reversion to the long-term mean (or beyond) can negatively overwhelm any of the positives.  The converse holds as well.  In our 2000s example last week, P/E contraction represented a 5% to 6% annualized headwind to market performance.  

What causes P/E ratios to increase or decrease, sometimes to absurdly overvalued or undervalued levels?  We'll try to address that briefly in this post.  First, a few housekeeping items.  When referring to P/E we generally prefer a 5 or 10 year normalized P/E.  This is simply an average of prior 10 year or 5 year earnings.  Because earnings can be quite volatile intra-cycle, using normalized earning smooths out the bumps and helps us get a feel for the long-term trend.  While normalized P/E ratios aren't appropriate for making short-term speculative market timing calls (markets can stay irrational longer than you can remain solvent!), normalized P/E ratios have a strong statistical relationship to longer term future returns.  

Markets have experienced normalized P/E ratios as low as 4x to 5x (during the height of the Great Depression) and as high as 40x during the late stages of the 90s bull market and tech rally.  No two market periods are ever exactly the same, but there are a few factors that figure predominantly in multiple expansion and contraction.  Sometimes one factor dominates.  In other situations, all factors or a combination of factors affect P/Es.

The first generally recognized factor affecting P/E contraction or expansion: expected inflation rates.  In general, markets prefer inflation levels that aren't too hot and aren't too cold.  Crestmont Research has posted a copious amount of research addressing this factor and has summed up the relationship with their "Y-Curve" chart:

In sum, the Y-Curve shows us that markets like environments where inflation expectations run about 1% to 2% per year.  As inflation increases, P/Es contract.  Markets dislike deflationary environments as well.  Why do inflationary and deflationary environments affect animal spirits?  It comes down to understanding that current market prices reflect the sum of "discounted" future cash flows.  Cash flows are discounted back at the required rate of return investors demand to compensate for risk.  If that perceived risk rate is higher, the value of those future dollars is less in today's dollars, resulting in a lower current price.  Conversely, a lower required rate of return, i.e. lower perceived risk, means the discounted future cash flows are worth more in current terms, hence a higher price.  In inflationary environments, perceived risk is higher, and investors require a much higher future rate of return to compensate for inflation risks.  Even though nominal earnings presumably go up in inflationary situations, the increase in future earnings is not enough to compensate for the future risk, thus depressing current prices.  Deflationary environments generally accompany some sort of economic disruption.  Required rates of return may not reach levels seen during inflationary environments, but perceived risk is elevated.  At the same time earnings are either not growing or outright contracting.  Take elevated risk perception and expectations for zero growth in cash flows, and the value of those future cash flows in current dollars is lower.  

Another potential factor affecting P/Es is perception of general economic and/or political volatility.  This can be country specific, region specific, or global.  The general effect is the same.  Increased perceptions of risk and volatility increase the required rate of return.  In an extreme example, a coup in a particular country would certainly increase risk perception and required rates of return.  Or, downshifts in market thinking in terms of future economic prospects reduce the perception of future cash flow levels.  As we discussed above, negative changes in cash flow and risk expectations lower the current or present value of future cash flows.  

Finally, major paradigm shifts among investors can lead to expansion of P/E levels, often to unsustainable levels.  Generally, the transmission mechanism here is increased/outsized expectations for future earnings and cash flows, all other things being equal.  During the 1960s, excitement surrounding the "Nifty 50" created feelings that there would be significant potential for outsized future cash flows.  More recently, the tech/internet boom in the late 1990s (and the housing boom last decade) proved that expectations of future cash flows/profits can get way out of hand in terms of historical reality.  Investors in 2000 were convinced that the internet boom would create a "New Normal."  Home buyers in 2005 and 2006 near the end were absolutely convinced home prices could never decline.  

Whatever the situation, we know long-term earnings growth has been consistent over time and that earnings growth has tracked nominal GDP growth closely.  And, we know from experience that humans are prone to herd behavior and extreme over and under exuberance.  Around the world, investors tend to overemphasize both good and bad news.  No matter the factors driving P/E expansion and outsized market returns, at some point the over exuberance reflected in elevated P/Es reaches its natural ceiling.  Heightened perception meets cold reality, expectations are reset, investors act accordingly, money exits, and multiples return to levels more befitting of the long-term trend.  In 2000 and 2001, investors quickly came back to earth as expected earnings and cash flows didn't materialize in the tech sector to the extent implicitly reflected in multiples.  Companies underlying the market indices were never going to "grow into" those expectations, at least not in the short or intermediate term.  On the other hand, with depressed valuations, at some point psychology becomes far too depressed relative to historical trend.  The early 1980s represents the last time we saw sustained single digit normalized P/E ratios.  This was a period marked by high inflation and interest rates, political certainty, and economic malaise.  Predictions of eternal decline and malaise proved to be far off the mark.  Investors with patience and an understanding of longer-term cycles were rewarded by buying equities in the early 1980s when many others were shying away.  

As individual and institutional investors, its important to understand that P/E cycles have been consistent over time in terms of moving significantly above and below mean levels and that multiple expansion and compression is an important part of understanding returns.  Identifying the factors driving expansion and contraction is important, as is understanding that investors tend to believe that trends will continue indefinitely into the future, despite evidence that the factors driving expansion and contraction will eventually reverse course.  

Back of the Envelope…

There's a certain amount of "behind the curtain" mystique accorded to the equity market analysts, fund managers, and market talking heads that constantly bombard us with information on various business news channels and on the pages of the leading news publications.  What should you buy now?  What's the hottest stock?  What will future market returns look like?  Where should I allocate in the US or around the globe?  This fills a lot of space and does a heck of a job of pushing both institutional and individual investors in many different directions.  I suppose we at IronHorse can be judged guilty considering we send out investment outlooks each month and write these blog posts.  Frankly, judging future returns (not future volatility, but future returns, an important distinction) in just about any region can be pretty easy.  Vanguard founder John Bogle nailed it in a speech last year to the NMS Investment Management Forum.  Basically, you can become the prognosticator of the decade by using three simple numbers to come up with ten year annualized returns: expected nominal GDP growth, dividend yield at the beginning of the decade, and multiple expansion/contraction potential.  Multiple expansion/contraction sounds confusing; actually the concept is pretty simple.  Take a long-term P/E measure like the 10 year normalized P/E (a P/E ratio using the average of trailing 10 year earnings).  Determine how far away P/E is from the historical mean percentage-wise and divide it by 10.  Add the three numbers together and you get the expected annualized returns for a particular market.  For instance, if you expect nominal GDP growth to be 5% per year, the starting dividend yield is 2.5%, and the market is 50% overvalued.  You'd expect annual total returns over the ensuing decade to be approximately 2.5% per year (5 + 2.5 - 5).  

Why should this work?  Well, over time total stock market returns are derived from earnings growth, dividends, and animal spirits, or lack thereof.  Over a long period of time, earnings growth should roughly track nominal GDP growth.  It's not perfect, but it's pretty close.  Since 1930, compound annual nominal GDP growth in the US, for instance, is approximately 6.5%.  Using Robert Shiller's public database of earnings, compound annual earnings growth over that time is just south of 6%.  The average dividend yield over that time period has been approximately 3.5%.  Add 6.5% and 3.5%, and you get 10%.  Compound annual total returns for the US markets since that time are approximately 9.8%.  Again, it's not exact, but pretty darn close.  Focusing in on specific time periods, we see there are times, like the late 1990s in the US, where investors get way ahead of themselves, the "animal spirits" go crazy, and market valuation multiples shoot through the roof.  In 2000, the 10-year P/E was astoundingly around 40x.  There are other times, like the early 1980s in the US, where investors want nothing to do with stocks; single digit earnings multiples reflected this.  Reversion to the mean takes hold and provides either a headwind or a tailwind.  

How did that work out last decade?  Almost perfectly, in fact.  Compound annual nominal GDP growth in the US was 4.1% between the end of 1999 and the end of 2009.  The dividend yield at the beginning of the decade on the S&P 500 was 1.16%.  The 10-year normalized (trailing 10 year average earnings) P/E was 62% overvalued (43.7x vs. a long term average of approximately 16.5x).  Add the numbers together, 4.1 + 1.16  - 6.2, and you get a compound annual number of -0.94%.  What was the actual number for annual total returns over the past decade?  -0.4% per year.  Very, very close.  The point isn't to hit the number exactly.  The point is to understand whether conditions are favorable going forward, or unfavorable.  If one's GDP forecast were a percentage or two higher than the numbers that actually arrived, the investor still faced a pretty discouraging decade ahead.  The multiple contraction headwinds going into the 2000s would have been incredibly hard to overcome no matter the overall economic conditions.  Animal spirits broke out in a big way during the 1990s and investors paid the price during the ensuing decade.

So where do we stand now?  What does the next 10 years look like?  In the US, the current dividend yield is approximately 2.5%.  Let's say this decade economically will mirror last decade in terms of subaverage annual nominal GDP growth of 4%.  The current market multiple is 22x, or approximately 25% above the historical mean.  2.5% + 4% -2.5% = approximately 4% per annum nominal total returns over the next decade.  Put on your  optimism hat and add 2.5 percentage points of nominal GDP growth per year, and the US forecast would come in at 6.5%, about 3% per annum short of the long term average.  Such is the nature of potential multiple contraction headwinds.  On the other hand, apply the analysis to emerging markets, which are currently trading at approximately 13.5x, or approximately 22% below what we'll consider a viable long-term average.  Let's be really conservative and accept that nominal GDP growth in emerging markets slows to a crawl relative to the recent past.  In this case, let's peg them with 5% annual nominal GDP growth, not much above the US.  The dividend yield in emerging markets is approximately 2% right now.  Add 5% + 2% + 2.2%, and you get 9.2% per annum.  Even under very conservative assumptions, an investor is looking at potential double digit returns in emerging market equities.  Last but not least, apply the analysis to global, ex-US, EAFE markets.  Nominal GDP growth should remain constrained, maybe around the 3% level (implies real GDP growth somewhere around zero).  The dividend yield is around 3.5%.  Valuations are roughly in line with historical mean.  3% + 3.5% + 0 = 6.5%. total annualized return, in line with the optimistic US scenario.  

What's the back of the envelope story?  First, understanding and estimating future returns doesn't require a ton of computing power.  And, global stocks seem to provide more promise over the next decade or so than US stocks.  We'll see what happens!

Value Investing: Not As Easy As it Appears

Value investing presents some of the more interesting challenges in the investing world.  Many individual and institutional investors alike classify themselves as value investors or aspire to adhere to value principals, but often fall short.  Like anything else in the investment world, there isn't an absolute, clear-cut definition of value investing.  Generally, value investing at its core is about buying companies at a discount to their intrinsic value.  This is a broad statement.  In practice, the value investor can approach the process from several different angles.  To each his or her own.  Depending on personal style, or the analytical tools at his or her disposal, the investor may incorporate one or all of the following in analysis.  

1. Use a model based approach, such as a discounted cash flow model, to ascertain a company's intrinsic value.  If the model generated intrinsic value number or stock price number is below market price, buy.
2. Use a multiples-based approach.  Look for companies that are trading at a significant discount to market when using one or a combination of multiples such as price to earnings ratios, price to book, price or enterprise value to ebitda, etc.  
3. Incorporate qualitative analysis techniques to determine whether or not a business has a "sustainable advantage," for instance.  

This seems apparent enough.  Who could argue with buying a stock that is trading below its true value?  At some point, it's got to revert to mean, right??  Returns confirm what seems to be an obvious view.  Historically, global value investing has outperformed the index over time.  The MSCI World Value Index, which according to MSCI uses "eight historical and forward-looking fundamental data points" to determine whether a stock falls in the 50% of the MSCI World index allocated to value or the 50% allocated to growth, has outperformed the headline MSCI World index by approximately a half a percent per year since 1974.  The MSCI World Growth Index has underperformed by about half a percent per annum.  These numbers are based on "simple" returns, i.e. no dividends, because the dividends aren't calculated in my machine all the way back to 1974.  If dividends could be included in the MSCI indices, I'll theorize that the difference in performance between Value and Growth would be wider in favor of Value.  

In practice, though, value investing isn't nearly as neat and simple as it seems for a few reasons.  

First, value returns, whether you're talking about an individual security or the broader value sector can be inconsistent.  Surely, the other side of this coin is the fact that growth is lumpy too.  However, value investing carries an extra set of baggage from an investor perception standpoint.  Investors tend to ascribe certain qualities to value investing, such as "safety," or "consistency" when in reality value investing can't necessarily live up to those ideals all the time.  The connection is clear.  Because value investing involves buying securities trading below "intrinsic value," the phrase "margin of safety" has become an oft used phrase to describe the difference between "intrinsic value" and actual value.  Hence, value investing has become "margin of safety" investing in many investors' minds.  If growth funds or stocks underperform for a spell, it seems to be written off more flippantly than if value underperforms for a certain period.  Lets move to the numbers.  Looking at five year increments from 1974 to the present, we see the following returns:

• 1974 to 1979:  MSCI World +10.869% per annum; World Value +12.7767%.
• 1979 to 1984:  MSCI World +7.377% per annum; World Value +8.0907%.
• 1984 to 1989:  MSCI World +24.841% per annum; World Value +25.988%
• 1989 to 1994:  MSCI World +1.743% per annum; World Value +2.414%
• 1994 to 1999:  MSCI World +18.073% per annum; World Value +14.563%
• 1999 to 2004:  MSCI World -3.818% per annum; World Value +0.425%
• 2004 to 2009:  MSCI World -0.015% per annum; World Value -1.270%
• 2009 to Present:  MSCI World 3.451% per annum; World Value 1.218%

Eight periods are represented above (the 8th isn't quite a full five year period, obviously, but we'll throw it in anyway).  During five, value took the prize.  During three, the Index (and by implication growth) took the prize.  Per annum deviations within these periods can be quite large.  This goes for the current period.  These types of deviations from the norm can certainly try investors' collective patience to a significant degree.  Take the internet boom era from 1994 to 1999, the last gasp of the 18-year secular bull market.  For value investors, it was probably quite frustrating trailing the broader index by several percentage points per year over a five year period.  Without a doubt, it was probably pretty frustrating as well for value managers to have to wake up every month and preach patience to investors watching benefits accrue to the growth folks!  Many value managers watched assets walk out the door in late 1999 and early 2000.  On to the next point...

A second bump in the road, and one that focuses on individual securities, is the fact that just because a stock is trading significantly below intrinsic value doesn't mean it can't fall even further or experience significant volatility.  By their very nature, value names often have "hairy" stories.  Value stocks are usually cheap for a reason.  It's a lot more fun buying growth names with positive news galore.  We'd love to say that it's easy to find companies growing at a super fast clip trading at single-digit multiples, and it can sometimes happen that way due to short-term news flow, but more often than not deep dish value names have a negative story behind them.  Sometimes its stock specific.  Maybe management is bum, or there was fraud, or there was a terrible product launch for instance.  Sometimes it's secular in nature.  Technology has been eclipsed in a certain sector or low commodity prices are affecting a group of commodity producers.  Whatever the case, a lot of patience is required of the value investor.  It'd be great if every stock went up immediately after purchase.  More often than not, it takes waiting and enduring volatility as headlines come and go, many of them ugly.  With information coming fast and furious these days, it's very hard to ignore near-term negative news or negative opinions about a value stock in a portfolio.  Emotion is obviously important, and many value investors have to fight very big lumps in the throat sometimes to hold very cheap stocks facing a barrage of bad publicity.  From an institutional standpoint, the value manager often finds himself or herself answering questions such as, "Why on earth would you ever have that name in the portfolio!?"  Intestinal fortitude is required and, yes, there are times when an investment never recovers from the depths or continues a fall into oblivion.  Two phrases come to mind.  "What Wall St. knows ain't worth knowing."  "Buy when there's blood in the streets."  Sounds simple on paper, but a lot harder in practice.  Time and time again, however, dem' bums catch a positive break, a catalyst that helps take multiples back to a more normal posture.  Momentum is powerful too, in these cases, and sometimes you'll see a stock go from wildly undervalued to wildly overvalued in relatively short-order.  

Finally, and this point is associated with the point directly above about buying out of favor names, it's very important not to get stuck in the weeds looking all the time for the next headline superstar like Apple.  If a company has a solid balance sheet for instance and a high degree of what I'll call "survivability,"  it still has the opportunity to be a standout performer over time, even if it doesn't become the best company in the whole wide world, especially in cases where a company is trading at a very deep discount to the overall market and its peers.  Not every company in every sector can be the "best" at what it does at all times.  The "best" are often ascribed higher than median multiples.  The herd mentality prevails, for a while at least.  Somewhere down the road, though, it's possible and often the case that the "best" stumble somewhere along the way; many of the value cast-aways become the big guys on campus over time.  Let's finish with the Apple example again.  Apple can do no wrong now, but in the late 1990s Dell was on top of the world.  Michael Dell famously said that Apple should cease operations and give the cash back to shareholders.  Apple was cheap.  Consensus stated they deserved the valuation.  Apple's viability was questioned daily.  Apple bashers were quite smug.  Yes, Steve Jobs has been proven a genius but nobody in a million years back then thought that he'd be able to take Apple anywhere but niche status.  Besides, he'd already been unceremoniously dumped from his own company once.  Fast forward a decade or so.  Dell is in the doghouse and Apple is the most valuable company in the world.  Positive headlines about Dell are few and far between.  Apple can do no wrong.  Perhaps another value story and reversal of fortune in the making?

Market Insight - 9-18-2012

Recent central banking events have created quite a lot for for all investors to think about.  Tie in a series of seemingly never-ending economic and geopolitical calamities and things get murkier still. In one camp, many long term value investors are pointing to five and ten year normalized P/E ratios and indicating that the return environment, mainly in the US, looks ugly over the next ten years.  In another camp, which we'll term the "Don't Fight the Fed" contingent, Benanke's open ended support statement combined with Monti's aggressiveness means that all of our economic and political worries can be pushed to the side; ample liquidity should keep a solid bid under risk assets such as equities.  Is this an either/or situation?  It's always tricky comparing one equity market environment to another, but there is a situation that bears some resemblance to the current situation: 1997/1998.  If we'd lined up the same debate teams at the outset of 1998 and reviewed the situation a decade later, both sides could have declared a victory.  It all depends on timeframe.  Importantly, the series of market events in 1998, and the subsequent action over the following ten years, shows that market analysis, often boiled down to simple straight line statistical constructs, is far from a straight line game.

Looking back briefly, the global economies in 1997 and 1998 were marked by significant macro turmoil.  In late 1997, the Asian currency crisis started, and the turmoil spread throughout the world over the course of 1998.  Latin American countries such as Brazil and Mexico faced stresses.  During the summer of 1998, the Russian debt crisis exploded.  The IMF was putting out fires everywhere.  Missiles were fired at suspected Al Qaeda camps in Afghanistan in August.  Over the entire period, the US body politic was consumed and paralyzed by the Clinton/Lewinsky affair.  Adding insult to injury, a highly leveraged hedge fund, Long Term Capital Management, nearly blew up amid the turmoil in September and brought Wall St. to its collective knees.  Decisive Fed intervention in the LTCM case prevented a much larger market structure calamity.  Going into the summer of 1998, valuations in US markets, for instance, were already significantly stretched, with both 5 and 10 year normalized P/E ratios above 30x.  With a terrible macro backdrop, if there were anytime for a major secular bear market to begin, it certainly could've been then.  At the valuations seen in June 1998, normalized P/E ratios predicted future 10 year real total returns of around -1% per annum.  Fed Chairman Alan Greenspan had delivered a speech two years prior discussing the "irrational exuberance" in the marketplace.  Looking forward, Y2K loomed on the horizon.  Amidst the turmoil, the S&P 500 in the US declined approximately 22% peak to trough from July 1998 to October 1998.  The MSCI World declined approximately 20% peak to trough.  Global markets looked very similar to what we just witnessed in the fall of 2011.  In response, during the fall of 1998, the Federal Reserve lowered the target Fed Funds rate by a a whopping full percentage point sending risk assets around the world off to the races.  The Fed used other mechanisms as well to inject liquidity into the economy ahead of Y2K, helping broader market sentiment.  Market participants were able to ignore geopolitical concerns and focus solely on the internet and technology boom.  From fall 1998 to the spring of 2000, the S&P 500 rallied approximately 50%, providing much gloating among the new internet valuation paradigm and Don't Fight the Fed crowds.  Value investors around the world lagged significantly, with some famous value investors even retiring in 1999.

That's only part of the history, of course.  That last gasp into spring 2000 proved to be the end of the 18 year secular bull market.  Markets declined dramatically from 2000 to late 2002, and market have remained relatively stuck in the mud from 2000 to 2012.

Again, revisiting the "who won" argument, one can demonstrate that both camps could have "won" in 1998.  Despite valuations never before seen, the market was able to rally by 50% in approximately a year and a half making short-term fools of the value camp.  Being short in 1999 on the basis of valuation was a heartburn-inducing strategy to put it mildly.  Looking forward 10-years, however, from the summer of 1998, normalized P/E ratios and general valuation proved to be a reliable forward predictor.  Between the summer of 1998 and the summer of 2008, total real annualized returns for the S&P came in at around 0% to negative 1% per annum depending on which month you choose as your starting point, very close to to the predicted values.  Over the longer-term, the value camp proved prescient.

Fast forward to today.  We've dealt with the European Debt Crisis, China Concerns, debt rating cuts, muddle through economies, you name it.  The dreaded fiscal cliff sits on the horizon, not to mention a contentious Presidential election, future uncertainty in Europe, and future uncertainty in emerging markets.  Normalized valuations, though not as stretched as 1998, remain well above historical average with 5-year normalized P/E at 23.5x and the 10 year normalized P/E at 22.3x.  Normalized P/Es predict that that future 10 year real total returns in the US will come in at around 2% to 3% per annum, unimpressive by historical standards.  Global developed markets look better, but with the recent rallies valuations are average at best.  Yet, in the face of macro concerns and valuation concerns, US markets are close to market new all time highs (in nominal terms).  The S&P is now up approximately 36% from the intra-day lows set last fall.  The Don't Fight the Central Banks armada is out in full force and markets have maintained a healthy posture, even on down days.  Value Cassandras continue to put out their valuation warnings.  Like 1998, both could be right again.  It wouldn't be a surprise in the least to see risk markets maintain their upward trajectory and to see multiples expand in the US and around the world over the next several months (or even couple of years).  By the same token, current long-term valuations point to a market that should remain choppy, frustrating, and underwhelming from a performance perspective over the next 10 years.

What are the morals of the story?  First, timeframe is incredibly important when dealing with expectations.  Explaining a market view can be extremely complicated.  One can be bullish in the short-term but cautious about the long-term, for instance.  Having a process that takes multiple timeframes into account matters.  Second, long-term valuation indicators are not very good at predicting short-term cyclical moves, but have a darn good record in predicting long-term returns.  This seems obvious, but gets lost in the weeds.  Third, for long-term value investors, patience and intestinal fortitude are often required to make it intact through a treacherous investment journey.  At overvalued points like 1998 or the current timeframe, value investors are often maligned as being out of touch while markets march higher and higher and fear recedes into the background.  Over ensuing years however, the patience usually leads to opportunities to buy assets at better prices.  Of course, when better prices arrive at a future date, many people think you're crazy for touching risk assets.