QVM Clients:

• Current stock and bond trends are mostly up and S&P 1500 breadth indicators have normalized
• S&P 500 is approximately at consensus 2016 price level
• Mean reversion risk is substantial but timing of realization is unknown
• Institutional long-term asset return assumptions are lower and portfolio return expectations should be tempered
• Specific mean reversion risks presented in charts

CURRENT TRENDS
The current trend is generally up, with non-US developed markets struggling, and emerging markets transitioning to clear up trend. Here are the trend ratings for ETFs representing key asset categories commonly found in portfolios. The ratings are based on the monthly four factor indicator used by QVM:

• Direction of tip of 10-month moving average
• Position of price above or below the 10-month moving average
• Net buying or net selling pressure
• Price position versus a progressive threshold changing at a geometric pace

As additional information, the table provides the price percent below the 12-month high price; the price position within the 12-month high-low range, the overbought or oversold condition based on the money flow indicators, the positive or negative signal from the MACD signal line, and whether the MACD is above or below the center line.

Even though current trends are up, the Bull is aged and probably in late stages, with significant long-term risk associated with eventual withdrawal of central bank market distortions. Cautiousness and conservatism is warranted.

DISCLAIMER ABOUT CAUTIONARY LONG-TERM VIEWS THAT FOLLOW
Fear of loss and risk avoidance are important emotional and behavioral factors that are about twice as strong as satisfaction with gains and opportunity seeking emotions and behavior. That gives us some pause talking about long-term risks. We do not want to frighten anybody or cause them to, as Jeff Gundlach said, “Sell Everything”. Market performance problems that are certain to be upon us someday are not upon us now, and within reason, we must take advantage of current positive trends. But we want you to be aware of the nature of the problems that will most certainly be realized some uncertain time in the future. There are important setups of valuations that are too far from long-term mean levels to be permanently sustained, and that are the basis of multiple institutions cautioning investors of subdued returns over the next decade.

PREVAILING EXPECTATIONS FOR YEAR-END S&P PRICE LEVEL

In June a survey of institutional investment strategist saw the S&P 500 ending 2016 at around 2100 to 2200. We are pretty much there now, suggesting not a lot of upside over the remainder of the year, which also dovetails with the likely reluctance of investors to be fully exposed to market risk during this unusual presidential election.

THE LONG-TERM IS MUCH ABOUT MEAN REVERSION

We have been in the Great Distortion for years now, and “mean reversion” can gettcha if ya don’t look out. Unfortunately, while mean reversion is a near certainty, when reversion takes place is not. Wide deviations from “normal” levels can go on for long periods (but can also revert quickly). Our central bank and those of Europe, Japan and China have been doing things to prevent mean reversion for years now. Someday the forces of mean reversion will defeat the central banks if the banks don’t toss in the towel on their distorting efforts first.

Before a general look at overvaluation and mean reversion in the S&P 500, here from 720 Global is one of the worst cases today of yield chasing that has put utilities into rarefied territory with very strong mean reversion risk.

The image below shows the S&P 500 sector ETF (XLU) Price-to-Sales ratio is more than 3 standard deviations above its average since 1990; and the Price-to-EBITDA ratio is nearly 3 standard deviations above. Valuations 3 standard deviations from the mean have odds stacked well against them being sustainable.

The price would be cut in half to get back to average Price-to-Sales ratio, or cut by about one-third to get back to average Price-to-EBITDA. That is not an attractive risk for a slow-growing industry. This problem caused by the frantic search for yield that has raised the price of typically high yield or strong dividend growth companies to unattractive valuation levels.

The need eventually to move valuations back toward the mean levels in key asset categories is the reason so many forecasters see muted portfolio returns in coming years.

The current trends in US stocks, and bonds are up right now, which is itself unusual as a pair. They are all marching to the tune of ZIRP and NIRP (zero interest rate policy and negative interest rate policy), which cannot go on forever – a long-time yes, but not forever. When rates normalize (revert to mean), so too will stocks and bonds. Interest rates are at the base of most aspects of investing, and tend to drive valuation of other assets. Having some idea what normalization would be is important to setting expectations.

A wide variety of institutional voices have concluded and published their expectation of lower portfolio returns over the next several years, as a result of the significantly above normal returns of the past several years. They talk of interest rates rising, profit margins declining, revenue growth slowing or not accelerating, valuation multiples compressing, debt servicing costs rising, reduced stock buybacks resulting in less boost to earnings per share, and just general world GDP slowing or moderation.

Looking across their prognostications and generalizing, it seems they expect a 4% to 5% total return over the next 5 to 10 year for a 50/50 stock/bond balance portfolio.

WHAT THEY ARE SAYING ABOUT LONG-TERM RETURNS

McKINSEY & COMPANY (largest independent management consulting company)
In May of this year McKinsey & Company published a report titled “Diminishing Returns: Why Investors Need to Lower Expectations”. They see much lower asset returns, and therefore lower portfolio returns, in effect due to mean reversion.

Based on the mid-point of McKinsey’s view a 50/50 US stock/US bond portfolio would tend to return an approximate 5.25% nominal annual return over the next 20 years.

BLACKROCK (largest asset manager in the world – $4.5 trillion AUM)
BlackRock sees similar lower asset returns.

Based on BlackRock a 50/50 US stock/US bond portfolio should expect a long-term nominal annual return of about 2.55% over the next 5 years and about 3.5% over the “long-term” (undefined length of time).

VANGUARD (second largest money manager – $3.3 trillion AUM)
Vanguard had this to say last December with a less pessimism:

“Vanguard’s outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment …The growth outlook for developed markets, on the other hand, remains modest, but steady … our medium-run outlook for global equities remains guarded in the 6%–8% range. That said, our long-term outlook is not bearish …the high-growth “goldilocks” era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate “sustained fragility” … China’s investment slowdown represents the greatest downside risk.”

JOHN BOGLE (Founder of Vanguard Group)
6% nominal (non-inflation-adjusted) equity returns during the next decade; 3% bond return

Based on Vanguard’s view a 50/50 US stock/US bond portfolio would tend to generate a 4.5% annual nominal over the next 10 years.

STATE STREET GLOBAL ADVISORS (third largest money manager – $2.3 trillion AUM – sponsors of SPDRs including SPY)

Based on the State Street forecast a 50/50 US stock/US bond portfolio should expect an approximate annual nominal returns as follows over various time frames:

• 1-year: 1.85%
• 3-years: 3.60%
• 5-years: 3.95%
• 10-years: 4.4%
• 30-years: 4.85%.

JP MORGAN ASSET MANAGEMENT (prominent high net worth, private wealth manager)

This is the long-term view from JP Morgan Asset Management as of their annual outlook for nominal returns over the a 10-15 year time frame:

Based on JP Morgan forecasts a 50/50 US stock/US bonds portfolio might expect an annual nominal return of 5.63% over the next 10-15 years.

NORTHERN TRUST (prominent high net worth private wealth manager)

“We expect developed market equity returns of 5.4% annually, bookended by emerging market returns of 7.3% at the top end, and US returns of just under 5% at the low end. … We expect real assets to perform relatively well, led by a forecasted return of nearly 7% for natural resources. .. We expect the US 10-year Treasury to support a yield of just 1.5% [over five years], capped by the German 10-year yield of just 0.5% and the Japanese 10-year at 0%. … We do expect an uptick in high-yield bond defaults, but project a 5% total return, which is attractive compared to the outlook for the equity markets. … While we expect to see some modest deterioration in corporate credit quality, continued low rates and strong investor demand should lead to further spread tightening for investment-grade bonds [that suggests continued gains as spreads to Treasuries compress]”

By interpolating/hypothesizing perhaps a 3% aggregate bond yield from Northern Trust comments, a 50/50 US stock/US bond portfolio may generate an annual return of about 4% over the next five years.

GOLDMAN SACKS (prominent high net worth private wealth manager)
Goldman Sachs “Last Innings” 5-year nominal return assumptions.

Based on Goldman Sachs forecasts, a 50/50 US stock/US bond portfolio (it’s a little hard to say because they do not specify US aggregate bonds or investment grade bonds), but let’s take the mid-point between their cash return and high yield return (2.5%) and tweak it up to 3%. That would give a possible 5-year expectation of about a 3% nominal portfolio return.

RESEARCH AFFILIATES (pioneer in “factor-based” investing)
1.1% real returns for U.S. large caps (the S&P 500) during the next 10 years; 1.1% real returns for the Barclays U.S. Aggregate Bond Index

Based on Research Affiliates forecasts a 50/50 US stock/ US bonds portfolio would generate about a 1.1% real return (perhaps 3% to 3.5% if inflation were to be in the range of 2% to 2.5%) over the next 10 years.

HOW MIGHT WE LOGICALLY GET TO LONG-TERM EXPECTED PORTFOLIO RETURNS?

The 50/50 forecasts we estimate from the selection of institutions above are:

• McKinsey 5.25% over 20 years
• BlackRock 3.5% over the “long-term”
• Vanguard 4.5% over 10 years
• State Street 3.95% over 5 years
• State Street 4.4% over 10 years
• JP Morgan 5.6% over 10-15 years
• Northern Trust 4% over 5 years
• Goldman Sachs 3% over 5 years
• Research Affiliates 3% to 3.5% over 10 years

Based on their range of thoughts, let’s go with 4% over 5 to 10 years and see how one might get there logically:

• Stocks return 5% consisting of 2% dividend yield and 3% growth in earnings due to global GDP growth
• Corporate bonds return 3% average interest, and no capital gains due to rising interest rates
• 50% x 5% + 50% x 3% = 4% portfolio return.

A 70/30 stock/bond portfolio with the same underlying asset returns would return 4.4% (70% x 5% + 30% x 3%).
A 30/70 stock/bond portfolio would generate a 3.6% return (30% x 5% + 70% x 3%).

One way to potentially do better is to own stocks that pay more than 2% (index level) yield and that are not terribly interest rate sensitive, and that can grow earnings (and revenue) at least at 3% over the next 5-10 years – to get more of the return in regular cash with less reliance on price change.

Another way might be to overweight less popular stock categories, with more favorable valuation, with at least the potential to growth faster than US stocks, perhaps such as emerging markets

A third way could be to have a non-core tactical component of the portfolio that, if successful, could outperform the core.

WHAT ARE SOME OF THE DATA THAT SUPPORT LOWERED EXPECTATIONS

In great part, long-term assumptions come down to reversion to the mean whether analyzing core portfolios, or tactical opportunities — so let’s look at some prime examples of assets far enough from their mean that significant value changes are in store, when the forces of Great Central Banks Distortion are withdrawn.

Before the mean reversion sets in, there needs to be some sort of catalyst. Central banks are expected to provide that catalyst in one way or the other, either by raising rates, or cutting rates with minimal intended effects. Another catalyst could be investor recognition of obvious problematic divergences.

Figure 1 shows an important problematic divergence.

The S&P 500 price is in black and its reported GAAP earnings are in red. Trailing earnings are falling and the price of the index is rising. That is a divergence setting up for a reversion to the mean (unless of course earnings catch up with the strong price rise). Note that the last two time earnings declined for several quarters, the stock index declined significantly as well. This is a cautionary signal.

FIGURE 1:

Figure 2 shows a problematic divergence based on forward operating earnings similar to the one in Figure 1 which is based on trailing GAAP earnings.
S&P 500 forward operating earnings expectations are relatively flat, but the price of the index rising significantly, This divergence is not normal and sets up for a reversion to the mean (a return to a normal relationship). This is a cautionary signal.

FIGURE 2:

Figure 3 shows that not just earnings, but also profit margins are in decline, and are also above their long-term average. This is a set up for return to the mean, which would be a negative for the S&P 500. If all other valuation factor remained constant, profits (and presumably prices) would come down 8.3% for profit margins to reach their 10-year average.

FIGURE 3:

Here are some important comments about profits and mean reversion:

Warren Buffet (1999) CEO Berkshire Hathaway
“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.”

Jeremy Grantham (2006) CIO GMO (Grantham, Mayo, & van Otterloo)
“Profit margins are probably the most mean-reverting series in finance…”

John Hussman (2013) President Hussman Investment Trust
“In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is … above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period …”

Jason Zweig (2013) writes Wall Street Journal, Intelligent Investor column
“… regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

Figure 4 shows aggregate public and private corporate profits as a percentage of GDP. There are way out of line with the norm. This is a setup for return to the mean, in a way that would reduce stock returns going forward. If all other valuation metrics remained constant, the value of American corporations would decline by 27% to reach the mean profits to GDP ratio.

Note the use of the 85th and 15th percentiles as indicator lines. When at the 85th percentile, there is 6 times more room below than above that level (5 times to the 15th percentile level); and at the 15th percentile, there is 6 times more space above than below (5 times to the 85th).

FIGURE 4:

Price-to-earnings ratios are the most popular metric. Figure 5 shows the Shiller CAPE ratio (an inflation adjusted 10-year average reported GAAP P/E ratio). If all other valuation metrics remained constant, the price of the S&P 500 would have to decline by 33.6% for the CAPE to reach the mean.

FIGURE 5:

Figure 6 shows the P/E ratio based on the 12-month trailing reported GAAP earnings. It too is way above normal and set for mean reversion. Such elevated P/E ratios may be justified in the short-term due to exceptionally low interest rates, but when rates eventually rise, as they must, the math used to set reasonable P/E ratios adjusts, and lower P/E multiples will be in order. Note that much of the increase in price in the past few years has been due to multiple expansion and not to underlying organic growth of the companies. When interest rates rise, some of those stock multiples must be given back.

To revert to the 25-year median, the S&P 500 would have to decline by 20% at the current earnings level. To revert to the 135-year median, the S&P 500 would have to decline by 40%.

FIGURE 6:

Figure 7 shows the P/E based on forward operating earnings. Like the 10-year inflation adjusted GAAP P/E, and the 12-month trailing GAAP P/E, the forward operating earnings P/E is also well above its average. To revert to the 10-year average, the S&P 500 would have to decline by 16%.

FIGURE 7:

Figure 8 provides a much longer view of the forward P/E ratio (courtesy of Dr. Ed Yardeni, Yardeni Research inc., http://blog.yardeni.com). Here he has plotted P/E isobars, representing what the index price would be at different P/E levels for the forward earnings view at the time. We added the color shading to make it a tad easier to see stages of valuation at different levels. This chart plots from 1979. You can see that the current forward P/E is in the elevated range (light orange) between P/E 15 and 20. That suggests mean reversion vulnerability.

FIGURE 8:

Really it is easier to think of stock valuation relative to interest rates by expressing stock valuation as an earnings yield versus a Treasury bond yield (yield-to-yield, instead of P/E-to-yield). Earnings yield is simply the inverse of P/E. Instead of P/E it is E/P. Figure 9 shows the earnings yield (“EY”) of the S&P 500 for the past 135 years versus the US 10-year Treasury yield (precursors of S&P 500 before 1957 and precursors of 10-year Treasury in early years, based on data assemble by Dr. Robert Shiller of Yale).

As it turns out the earnings yield is just about right at the median level, meaning the index is properly priced for the current interest rate situation. But the current interest rate situation isn’t priced right and has to change eventually, possibly sooner than later. At that time, the S&PP 500 would be overpriced and prone to price reduction.

FIGURE 9:

Figure 10 shows the US Treasury 10-year rate and precursors back to 1881 (135 years). The recent rate is 1.59% and the median is 3.76%. It has been all over the yield range for the past 60 years, showing its can go much higher under some circumstances. But it is currently at the lowest rate in 135 years, which suggests the only logical probability is up (even if down more for a while). When rates rise, all other investments will make adjustments for the relativities to this theoretically zero credit risk vehicle. As it approaches mean level (or shoots past the mean). Mean reversion will be the name of the game for other assets too.

FIGURE 10:

QVM S&P 1500 BREADTH INDICATORS

Back to the present, the breadth damage done in the second half of 2015 and the first quarter of 2016 is healed, and breadth indicators support the current rally.

FIGURE 11: S&P 1500 BUYING AND SELLING PRESSURE
3-month (gray), 6-month (blue) and 1-year pressure within the S&P 1500 is net to the Buying side and rising after a long period of decline and into net Selling territory in 2014 and 2015.

FIGURE 12: PERCENT OF S&P 1500 IN CORRECTION, BEAR OR SEVERE BEAR
The percentage of S& 1500 stocks in Correction, Bear or Severe Bear condition has returned to pre-Correction levels and is improving.

FIGURE 13: PERCENT OF S&P 1500 NEAR 1-YEAR HIGH
The percentage of S&P 1500 stocks within 2% of their 12-month high is in good shape.