Warren Buffett is famous for stating that luck determines much of our success in life. When and where we were born imparts a huge impact especially if you are an investor. Americans who entered the workforce in the middle of the last century enjoyed advantages in gaining employment that subsequent generations would scarcely recognize. Those who reached the same point in life in the early 1980’s would find a mixed blessing. Employment options were limited but the investment opportunities during their employment lifetime would dwarf those of previous generations.
For investors, boom and bust cycles will determine how investing success is ultimately viewed. Understanding history helps temper exuberance and find hope at the bleakest of times. As 2021 began, the market sat at all-time highs. In March 2020, the market had dropped 30 percent in record time. The recovery from that level to new highs was also astonishingly quick. The economic and real-life implications of the pandemic are still with us, however. While investment returns have been strong, few would call the last year a good one.
Still, the split nature of the economy in the wake of lockdowns has meant for some investors, returns have been stellar. Those who came to investing in recent months and chose to bet on companies that benefitted from remote work have enjoyed the kind of market that appears once in a generation. The return on the NASDAQ for 2020 was 44 percent. To put the 44 percent gain in perspective, it is the 4th highest yearly gain since 1971. Only 1999 (85.6%), 1991 (56.8 %), and 2003 (50%) rank higher.
While pandemic trend beneficiaries like Peloton racked up gains of 434% and Tesla’s (+743%) market capitalization moved ever upward as it entered the S&P 500, old school tech soared as well. Microsoft added more than 40% and Apple doubled that.
If we look at daily NASDAQ price data from 1971 and find every possible one and two year period, we can put the returns achieved by the end of 2020 in some context. On December 31st, the aforementioned one year return of 44% was in the 92nd percentile while the two year return was close to the 98th percentile. It gives an idea of just how strong this market has been. Still, the raw percentage figures are less than half the return achieved as the market crested in March of 2000. This is the market that many have compared the current one to and as a result sounded a cautionary note.
The table below compares trailing two year returns above the 90th percentile to all other periods. The data covers 1973 to 2018, the last dates where we have forward results. While the subsequent returns are subpar, results above the 90th percentile are still positive. Periods like today, where both one and two year returns are above the 90th percentile have tended to be negative.
Forward Returns By 2 Year Trailing Percentile 1973-2018
Ptile |
Total |
Avg 1 Yr Fwd |
Avg 2 Yr Fwd |
90+ |
1137 |
7.78% |
6.79% |
All Others |
10407 |
13.18% |
29.58% |
But the 2020 endpoint does not begin to describe the volatility that the year engendered. On March 20th, as lockdowns began and the bear market was in full force, the two-year return on the Nasdaq was negative and a little below the 14th percentile. In retrospect, it was a perfect time to buy but take a good look at the newspaper headlines of that date. Remember what the feeling was in the moment. There were very few voices emphatically calling out to jump in with both feet.
For the long-term investor, buying into weakness has been a strategy that has worked for over a century in the United States. There have been periods that took an amazing amount of fortitude but ultimately the bet has paid off. As a result, many tools have been developed or used to determine when the odds are in your favor.
VLMAP Redux
Several years ago, we examined Value Line’s Median Appreciation Potential (VLMAP) figure as a market timing device. This number appears each week on the Summary and Index section of the Value Line Investment Survey. As the name suggests, it is the “median estimated 3 to 5 year estimated price appreciation potential” of the 1700 Value Line stocks per company literature.
We noted research by Daniel Seiver and the writing of Mark Hulbert that found higher figures to be good entry points to the market. The former examined data dating back to 1966. The latter had used 55% and 100% as over and under valuation figures. Though the 100% figure has been breached in comparatively few periods over recent decades, examining 4 year returns our own research from 1998 to 2012 found it to be an excellent entry point using four-year subsequent time frames.
Since 2012, 100% had not been approached before 2020. The closest case occurred at the end of 2018 when the S&P 500 flirted with a bear market. On that occasion the VLMAP touched 80. In retrospect, this turned out to be a good entry point as buying the dip continued its success as a strategy. The century mark was finally breached in late March of last year and the figure peaked in the Survey that was published on March 30th at 145. While we only have the short term to look at, the time period again appears to have been a strong entry point.
This, however, was the quickest recovery from a bear market ever. In many bear markets, quite a bit of pain is endured before the validity of a buy decision is confirmed. The worst markets have had drops of 50 percent or more. If you were scaling in, you hardly got started before the market recovered in 2020. These are the decisions that the benefit of hindsight papers over. It has ultimately been a very successful strategy, but sometimes has given a lot of sleepless nights.
In our previous article, we found that VLMAP figures below 40 resulted in the weakest returns between 1998 and 2012. Since then, in timeframes where results are available, VLMAP figures below 40 continued to greatly underperform for one, three, and five year periods.
On the other hand, underperforming does not mean negative. Those who would have used low numbers as a sell signal would be disappointed. This continues a pattern with valuation strategies including popular approaches like Robert Shiller’s CAPE. It is important to remember that while the late nineties run ended in tears, valuations were stretched for a long time before the crash. A lot of money was made before the bill came due.
Morningstar
Aggregated assessments based on analysts’ valuation methods tend to mirror the work of different firms, each looking at the same underlying data. Morningstar is another independent source of analysis with a long history. Looking at data from mid-2012 through the end of the year you get a recent history of aggregated star ratings and price to fair value metrics for stocks that are covered by the company’s analysts. Four and Five star stocks are gauged to be the most appealing from an investment standpoint. The highest figure I found in tracking this data came in the third week of March 2020 where nearly 78% of stocks carried one of these two ratings. Again, the end of 2018 is tops outside of the pandemic bear market at about 58%. (The one year forward return from here was about 30 percent in the S&P 500 index) In the 3rd week of March 2020, the average price to value was 0.66, far below any other period in the data.
The lowest percentage of four and five star stocks during the period studied occurred during mid-2014 with percentages in the low teens. The forward S&P 500 one-year return from this time frame was indeed negative. The rating at the end of 2020 was in the low 20’s. While market timing using precise buy and sell points has a sordid history, using aggregated analysis to point out periods where bargains are plentiful or scarce can be a useful exercise.
Morningstar users have access to a wealth of this type of information in graphical form. The Market Fair Value tool gives median Price/Fair Value readings back to 2007. You can also filter by market capitalization, sector, and business quality. As expected, the lowest P/FV figures come at the March 2009 market low followed by this past March. The most overvalued median figure at 1.11 came in the last week of January of 2018. The S&P 500 Return for the next year was -7.24%. The current market is approaching those highs. Technology is currently at its highest P/FV level over the 14 year tracking period. Energy is close to the lowest.
Again, rather than a guide by which to live, the figures for different industry groups or capitalizations allow you to investigate the reasons for under or over-valuation. You can then determine if you feel the market has miscalculated and place your bet accordingly.
Risk Management
Despite the steady march higher, U.S. markets have provided many opportunities to invest when securities are undervalued. This will continue to be the case. Sometimes these periods represented many years, others a brief period of months or weeks. The current market benefits from an accommodative Federal Reserve and the lowest interest rates investors of any generation have ever seen.
Still, with an enormous amount of good news incorporated into current prices, employing risk management makes sense. This could be as simple as using some profits to buy reasonably priced put options and placing a floor on any losses. New investments could include option spreads where profit and loss parameters are clearly defined. For equity and ETF investments, it could mean looking at historical valuations and avoiding plays that look extremely stretched.
Cost
One benefit accrued to investors in the current year is unlikely to go away anytime soon. The cost to put money to work in the markets has never been lower. Commission rates are at zero, bid/ask spreads tight, and expense ratios on ETFs are as low as they have ever been.
When you compare investing to other speculative endeavors, the trend is clear. Putting the effort in to research investments will continue to reap rewards. The individual investor is in a better position than any other time in history.
Conclusion
Market returns over the last year have been unique in their bipolar nature. As such, we sought to put them in context and examine some tools that present metrics which can be used for valuation purposes. With a persistently positive expectation for medium- and long-term time frames, periods of low valuation have tended to be more reliable entry points for investors. Choosing a top has been a much more difficult exercise.
