The Mathematics Driving the US Share Market

This is my fifth attempt at writing today’s article.

I’ve agonised over this one.

Distilling a complex topic into a simple, cut-through message is a constant challenge.

What I want to say is the share market is extremely overvalued and to avoid suffering catastrophic losses in the not-too-distant future, then you should reduce your exposure to a level where you can comfortably handle a loss of 75% or more.

But that doesn’t really cut through…because the counter argument from a broker or advisor is that markets still have much more upside.

These conflicting opinions create an emotional tug-of-war. Do we sell or do we stay?

If we sell, then all we’ll get in the bank is a lousy two percent. Not much when compared to our fully franked dividends of five percent.

What do we do? Sell or stay?

Emotions drive investment decisions…for professional and amateur investors alike.

Whereas markets (eventually) function on mathematics…the cold hard numbers.

And proof of this is in the wisdom of Benjamin Graham (Warren Buffett’s mentor) …

In the short run, the market is a voting machine but in the long run, it is a weighing machine.’

Short term, popular sentiment (positive or negative) can move markets. But over the long term, markets weigh the value of a company’s earnings…which is why Tesla and other loss-making tech darlings are destined for bankruptcy.

Why have I sweated over this one?

Because it’s vital that you understand the mathematics driving the US share market.

As soon as you say the word ‘maths’, you lose the attention of at least half the readership.

And the deeper you go into the maths, you risk making even more eyes glaze over.

By the end of the article there might be five percent of readers who ‘get it’.

Well, I’m on a mission to save the other 95% from finding out the hard way how maths matters when it comes to markets.

Emotions cloud judgement. Look at the facts.

Understanding the US share market

Everything in the world involves mathematics.

Time…seconds, minutes, hours, weeks, months, years.

Quantities…litres, mega litres, gallons

Weights…pounds, ounces, kilos, tonnes

Lengths…inches, centimetres, metres, kilometres, miles

Money…cents, dollars

The application of these mathematical variables is how we measure heart beats; build apartment towers; bake a cake; make a dress.

The end result of the mathematical application is what gives us an emotional response…

The relief in being told your heart is in good condition.

The joy of taking possession of your new apartment.

That first bite of a freshly baked cake.

The ‘feel good’ factor when you put on that new outfit.

But none of these emotions would be possible without boring old mathematics.

The same holds true for markets.

We’ve all heard how markets operate within an emotional range of ‘fear and greed’.

Emotions are what create the headlines – ‘Record high’ or ‘Crash’.

In the background, away from the spotlight, there’s a collection of mathematical formulae around which these emotions pivot.

For the sake of simplicity, we’ll look at the most well-known formula…P/E ratio.

P = Price

E = Earnings

Over the long term, a company is valued on its earnings.

In the short term, loss making companies — like Tesla, Uber et al — can be ‘valued’ in the billions of dollars, but at some point they have to deliver a return to investors…otherwise the company is not worth a bean.

Historically, earnings are multiplied by a factor (P/E) of 15 to determine the price of a company.

For example, a company earning $1 billion would be valued at $15 billion.

That’s the logical bit.

But as we know, markets are not always logical.

Emotional drivers — fear and greed — push valuations from one extreme to another.

Markets and emotions operate in tandem — high markets, high spirits and low markets, low spirits.

Voices of reason — based on mathematics — are rarely heard above the noise from the whoops or the wailing.

But here goes…  

When emotions are trending towards an extreme, the multiple applied to a company’s earnings moves (well) above or (well) below the historical average of 15.

The following chart is the PE (applied to smoothed earnings over a 10-year period) of the US share market since 1880.

World's top tourism spenders 2017


Source: Multipl.com
[Click to enlarge]

During the feel good ‘Roaring Twenties’, investor emotions peaked with a multiple high of 30…double the historical average.

A few years later — in the depths of The Great Depression — investor despair pushed the multiple to 5…one-third of the historical average.

Within the space of 3 years, valuations fell 80%…all based on emotion.

Eventually, mathematics prevailed and markets were drawn back to the middle ground…around the 15 multiple level.

Depending upon your understanding of mathematics, the investor experience of the late 1920’s and early 1930’s could have been either traumatic or exhilarating.

Knowing markets had drifted away — in both directions — from the historical anchor could have been highly profitable…selling high and buying low.

Whereas, decisions made on ‘gut feeling’ resulted in that capital destroying equation of ‘buy high and sell low’.

History tells us the majority experienced the latter, and very few the former.

The PE 10 chart looks at one part of the ‘price’ equation — the multiple applied to earnings.

Which in itself is a barometer of social mood — euphoria or depression.

The following chart takes the mathematics a little deeper.

It looks at the other part of the equation…earnings.

There are times in the business cycle when corporate bottom lines are healthier than others. Profit margins — like multiples — also shrink and expand.

The following chart demonstrates the elasticity in US profit margins since 1945.

World's top tourism spenders 2017


Source: Federal Reserve Economic Data
[Click to enlarge]

US Corporate Profits, on average, are around 6% of GDP.

Like the PE 10 ratio, the profit margin numbers drift above and below the average…but eventually there’s a gravitational pull towards the average.

In maths they call this ‘reversion to the mean’.

You’ll notice the current reading is well-above the mean.

When you factor in ‘mean reversion’ for profit margins AND apply these figures to the PE 10 multiple, you end up with a chart that gives you a far more accurate reading on market values …

World's top tourism spenders 2017


Source: Hussman Strategic Advisors
[Click to enlarge]

Based solely on the PE 10 chart, the current multiple of 32.36 is the second highest in history.

However, this multiple is being applied to a period when earnings have been boosted by ‘fat’ profit margins. When you adjust earnings for ‘mean reversion’, the current multiple makes this THE MOST EXPENSIVE in the US share market history.

According to John Hussman (the creator of the chart), at a minimum, the US market will suffer a fall of 65% to revert to its long-term mean.

The beginning of earnings mean reversion

Doug Kass from Seabreeze Partners Management Inc., released a research paper on 21 May 2018, titled…

‘The Cost of Everything is Rising — And Profit Margins Will Soon Suffer’

This is why he anticipates a squeeze in US corporate profit margins…

‘While the cut in U.S. corporate-tax rates has mostly masked these drags and headwinds, the rising cost of everything will likely worsen in the year(s) to come. For example:

Interest Costs Are Climbing. The Federal Reserve is raising interest rates and reducing its balance sheet’s size The European Central Bank will soon follow as it tapers its own quantitative- easing program.

Energy Costs Are Making New Highs. Rising oil prices are a tax on consumption.

Commodity Prices Are Rising. Lumber and steel are just two of the commodities that are bolting higher.

Labor Costs Are Growing. A November midterm-election “blue wave” of Democratic congressional victories might only accelerate the trend.

Trucking/Transportation Costs are Exploding. Every single good that’s transported is costing much more to deliver.

A Strengthening U.S. Dollar. This weighs on U.S. trade, as well as on multinationals who export products.

Regulatory Expenses Are a New Threat to Technology/Social Media. There’s little doubt that Alphabet/Google, Facebook, Twitter (et al. will have to accelerate hiring of compliance people and others who monitor and supervise the dissemination of personal data. This will place a new drag to profits.’

The mathematical law of mean reversion means the purple patch in high multiples being applied to ‘fatter’ earnings appears to be headed for a colour change…a sea of red awaits.

If the maths lost you, I am sorry.

In simple terms, the US share market (and by extension, our market) is in extremely dangerous territory. Any gains from this level are likely to be small and fleeting.

Whereas, the losses are going to be large and lasting (because when people sell low, they lock in their losses).

Unlike the investment industry — brokers, analysts, advisers — the numbers do not lie.

History and mathematics are telling us what’s in our future…ignore this powerful combination at your own peril.

Regards,

Vern Gowdie,
Editor, The Gowdie Letter


Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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