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As I said in my post and video a couple of days ago link here for that, step three of your annual financial health check was to form a market view, and as this was a slightly complicated topic I have created today’s post and video to discuss this in more detail.
So let’s get straight into it, as it’s quite a fun topic!
And please read to the end as I will try to summarise this topic and share my own personal view!
Now what was I talking about previously…? Assessing the market valuation for the markets you are invested in… vs… the outlook and viewpoint you and other investors in that market have for that market. So how do we actually do this…?
Obviously, we can’t see the future, but it’s important to establish your own personal view so you can determine as time passes and information comes to light whether what is happening right now is still supporting your view and therefore you should remain invested as you are…OR… is the new information that is coming to your attention every day…NOT supporting your view, and therefore should you change your asset allocation. This is portfolio management 101 folks!
So what are some of the fundamental principles to discuss today:
First, price of the asset today relative to history. Second, earnings of the asset over the past 12 months and relative to history and of course, most importantly, expectations for earnings for the next 12 months and beyond.
These two points are basically the most important factors in determining valuation on an asset specific / micro scale. Of course, there are bigger issues like global politics and supply chain impacts and central banks and a myriad of other issues which affect the entire macro market… and should indeed be considered for both direct impact on earnings but also the bigger picture of the macro impact…and by macro I mean the entire market picture.
So, the entire debate is around how you complete this process and analysis for your specific timeframe and what estimates do you use and what issues do you consider. The countless issues will not be covered in this post and video today because I just want to tailor it for what is relevant today and where can most people begin this process. More and more in-depth posts and videos will be released over time.
So based on the complicated nature of completing these two steps there is no right or perfect way to complete each process. That is why so many different investors have different views and one key reason we get volatility in asset prices, as all the different investors and traders express their differing view moving prices up and down. Now, as I said in my very first YouTube video, link here, each investors’ timeframe is often different and thus how you determine your view for your investment is different based solely on how long you plan to hold that investment.
So, time to begin, first topic! Assessing the price of the asset! One of the most and heated topics. Where do we begin? Where many investors seem to focus, especially at the moment, and that is how far the market has moved in recent history. As I said in my last post and video a few days ago link here for that, this can be quite a distraction in my opinion. It is of course important, but it also catches a lot of people out who get fixated on charts and how much it appears a stock or market has moved. This is especially true as many people don’t understand how large numbers affect stock charts over longer time periods and why we should always look at them using a logarithmic scale to represent growth proportionately.
I will try to illustrate this point on the S&P500 over the past 10 years, where it has tripled in value, although just know that triple over 10 years is actually just an 11.3% compound annual return.
Here is a line chart, not using a logarithmic scale. And allow me to draw a straight trend line. Somewhat arbitrary to use 10 years but for example’s sake it will do. As you can see the chart clearly looks way above trend right! Yikes, quick, must be time to sell!!! Hold on. This is where many people panic and where many others scream bubble.
Here is the same chart, but using a logarithmic scale. What is a logarithmic scale you say? This means that the chart will represent the gain from 2,000 to 4,000, which is a 100% return, it doubled! Yay!, twice as large as the subsequent gain from 4,000 to 6,000, which by comparison is a 50% return. Whereas on the non-log chart they are represented as the same change because in number terms they are the same, 2,000 point change and then another 2,000 change, but the market did not double again. So, now allow me to draw the same straight (again arbitrary 10 year) trend line. Not so skewed towards the large numbers now right? This is how all long-term charts should be represented. So be careful out there folks. Many people love screaming panic, as it gets the views but knowledge and prudent long-term investing is what brings wealth. So stick with me and I will continue to share what I can to break down this wonderful world of investing.
And side by side, you can see that the log chart is a fairly linear growth line with the ups and downs of the short-term cycles but otherwise a very similar growth trajectory over these 10 years. Whereas the non-log chart is skewed towards the larger numbers, which appears to look like too much growth in recent years and scares poorly-informed investors. The example can be shown in a similar way over different time periods.
Allow me to explain another way, all markets have trends and they sometimes become overvalued or undervalued relative to their long-term trend. Sadly, they can also remain off trend for a very long time. The famous market quote is “The market can remain irrational longer than you can remain solvent.” So always bear that in mind. But if we look back at the past and see where the market has come from and over what time period. We can assess where it is relative to history and its trend.
If we take the clearest example that everyone appears worried about right now, is the S&P500 has gone up by over 20% in 2024, which is about double the long-term trend of around 10-12%, but, and here’s the key, now look back two years. Sorry, what, it has gone up close to 50% Jan 1 2023 to Jan 1 2025 in total price return…so what am I saying? And what is the key question here? … The key question is, what’s the compounded annual return, over these two years? It is 22%, which is again double the 10-12% long-term trend. Okay, so there we are, two years of clearly outsized returns. Time to sell, right? Well on that basis, we would have said that last year after just one year of outsized returns right? And how wrong we would have been, but surely this year, after two years of over 20% is clearly a sell signal, right?
Well, again, you can’t stop here, look back three years, there you will see a change, just 29% total price return, boom, here we go, there was a decent correction in 2022 so what was the compounded return over the past three years? It is now actually 9.0% annually and therefore back under our long-term trend. How about over five years, 81% total return and 13% compounded. Ten years, 192% total, but 11% compounded. One more just for fun, twenty years, 400% total price return, compounded annually is 8.4%. This includes the enormous Global Financial Crisis beginning around 2008 and continuing well beyond, when quantitative easing on a massive scale really began. Then many regional crisis’ since then, the European Debt Crisis being one and of course COVID being the next major global crisis. Yet still here we are, largely on long-term 20-year trend.
Now, I’ve done the numbers for every year. The price trend has followed the growth trend. The world is growing economically so the stock market is growing. So what does this mean for us right now, today? Well…nothing is certain in this business but I will say that all the folks out there pushing the chat of being in a market bubble right now are somewhat right when looking over a 1-2 year time horizon but looking over anything longer than 2 years the S&P500 has produced quite close to an average annual return. So even after two years of over 20% the ten-year trend is at 11.3% and comparing the 10-year compounded growth trend to the large down year, in 2022, right before a 13.4% down year the ten-year trend was at 13.4% which was the end of an aggressive turnaround from the COVID lows and became a little over stretched on the long-term trend. So while that created a 13% pullback in 2022 we are not in the same price position today Jan 18, 2025.
But…does it mean we are due for a correction? Who knows? Nobody can see the future, but purely on a market-price-performance relative-to-trend question, which everybody seems to get a bee-in-their-bonnet over, there’s a strong argument to say the market is largely on trend at the moment, at the top end of the trend perhaps but within the trend and not excessive and way above trend like the dot.com bubble for example. So, in my humble opinion, any pullback over the coming months is very likely to be bought by long-term investors, who look more so at the long-term trend, and therefore not be a pullback for long. We have also had a record amount of inflation in recent years, but that has almost returned to trend of 2-3%. I doubt I need to tell anyone inflation has been well above trend. Having it return to trend and allowing interest rates to now come down is typically a positive economic step for stocks, especially growth stocks.
So after all of that, you should hopefully be able to begin to form your own view for your timeframe based on the P(rice) side of the PE multiple. Now, what is next? And what is equally, if not more, important than price? The other half of the most famous equation in valuation terms of course, the E, in the PE, for earnings! For price to make any sense it really needs to be referenced against something, like sales or growth or earnings. And earnings is the most common reference. So where do we stand?
The S&P500 is roughly trading around 29x price to (trailing) earnings, with the long-term average around 20x with a very broad PE ration range of 10-30x assuming 1 standard deviation. So based on trailing earnings the S&P500 valuation is clearly at the top end right? But…what do I mean by trailing earnings? This is actually a key point. When compared to S&P earnings over the prior 12 months the price of the S&P today is about 29x but should we be valuating it against earnings over the prior 12 months or earnings over the coming 12 months? We should almost always be referring to future earnings, as the whole point of the stock market and valuating an asset is to assess it’s value today based on its future potential. So while historical earnings are important, what matters more, are future earnings. So whenever you see a PE multiple you need to be sure it is based on the future 12 months of earnings. But what is the key problem with focusing on future earnings? Nobody can see the future!!! And therefore future earnings are always based on estimates and thus there is variation, as each analyst, research house and portfolio manager has a different estimate. It is of course based on the information each company shares (officially called their guidance) but not every company gives guidance and even the ones that do it’s often a little under estimated to help management look good by being able to then beat their guidance. Although each management team is different so there is not one rule for them all. Plus, all that said, even companies themselves cannot see their future and based their own guidance on estimates. Clearly somewhat informed based on what they know is in their pipeline for the coming quarter but estimates nonetheless. And I haven’t even pointed out that most guidance is only for the coming quarter and we need to forecast future earnings for the entire year (or more ideally). Yeah exactly, what hope do we have? So here we are, all trying to estimate current value based on future ESTIMATED earnings when countless future events will likely have a material impact on future earnings.
So that’s the earnings side of the equation folks. A bit messy, right? Anyway, that is the best system we have and that’s what creates so much debate. But, surprisingly whether for a stock or for the entire market, the estimates are often pretty good. Then…each quarter, the next quarter, and often the entire rolling 12-month forward estimates, gets updated and therefore so should your view. Asking yourself, is my view still in line with the new information? Hence the four earnings cycles each year create the most volatility as all the estimates and therefore each individual investors’ views are changing!
Back to the key question though, where are we now? And what is the current earnings estimate for the S&P500 for 2025? – officially called forward earnings. Knowing it is all estimate based, the estimates I have put the market valuation around 21-23x forward earnings, which is a little above the long-term trend of around 20x but not by much.
So there we have it, we have price roughly on trend historically, maybe a little high and FUTURE earnings roughly on trend historically, maybe a little high, and yet many people are calling for some crazy bubble to pop. Based on fundamentals, I seriously call the bubble theory into question but who am i?
So all that said, as I have said repeatedly, most investors should realise that timing the market is typically not the best long-term strategy. Time IN the market, not timING the market is generally better for most who are just trying to save and invest regularly for their future.
So that’s more than enough for today, but before I go, if you are forming a bearish view you need to evaluate two keys things before you do anything. First, how much cash do you want as a proportion of your portfolio? If you are a long-term investor then going less than 60-70% invested is generally quite risky for any significant length of time, in my opinion. Whereas if you need to withdraw the majority to buy a house or some other large expense then that capital is not long-term invested capital and you are in a different category. Second, you must decide how long do you want to be out of the market for and therefore also what triggers are you waiting for to go back to 100% invested? This is key, as being out for and missing getting back in at a lower or equal price (factoring in taxes on realised gains!) can be just as bad as selling at the lows on a panic. As a loss is not a loss until it is realised and if you have followed some of my previous posts and videos you will know that typically the best approach for most is to try to invest regularly and ideally be a contrarian (buy when everyone else is selling) on any decent 15-20% market pullback. And you do that by doubling or even tripling your regular investing amounts during those down months to hopefully enhance your overall long-term returns. Assuming of course, your very long-term view is still holding true, that the US and global market will continue to succeed.
As a side note, it is worth bearing in mind what your fellow investors are thinking and making decisions on. Right now, many investors appear very worried about the 50% return over the past two years and that likely means an increase in volatility, which we have seen recently, and maybe even a pullback until the noise settles down and the majority return to focus on the more important longer term trend, the impact of reduced inflation relative to recent years and thus likely lower or at least stable interest rates then focus on earnings and earnings growth – which is looking quite strong at the moment.
So in summary, look at the price trend over multiple time periods, one year, two, three, five, 10 and even 20 years or more. And be careful with long-term charts! Ensure you use a logarithmic scale to proportionally represent returns, as when numbers grow larger they can be deceiving on a chart. Then assess earnings based on future (known as forward) estimates and review and update those estimates each quarter along with the quarterly earnings cycles. And beware of the doomsayers focusing on short-term soundbites and half truths. Of course, markets most certainly go down just like they go up. The famous market quote is bulls go up the stairs and bears jump out the window, meaning markets go up somewhat slowly step by step and markets go down somewhat quickly – falling out of the window!
Finally, for anyone still watching, as promised, perhaps you are asking what is my view? First, it is worth mentioning that outside of the million things that can happen between now and tomorrow and every day after that, with strong earnings growth currently forecast for this year, albeit that strong growth forecast has been dampening with the earnings which have been released over recent weeks, I currently have my base case outcome for a slightly below average 7-10% market return this year, so that would mean we see the S&P500 close out the year around 6,400-6,600, but who am I to proclaim the future! And of course, this is not financial advice and just my humble opinion and every day new information, earnings, political decisions, etc. occur which can make my, and any, opinion completely null and void in an instant! Also worth adding that with Trump’s second term beginning next week and global politics and wars where they are, plus trade wars on the precipice of kicking off, there are many known wildcards in play and obviously also so many unknown wildcards to likely play out! So that means I would expect more volatility this year due to the increased uncertainty of so many wildcards in play. And like any year, there are often pullbacks, on average from peak to trough it is not uncommon to see one 10-15% pullback and certainly 2-3 mild 5% or so pullbacks throughout the year. So in my view, for this year, with the likely increased headline risk of a Trump presidency, I see a higher probability of it being a year with a 10-15% pullback, and more likely in the first half…but…based on the information available today, I think that would present a great buying opportunity and therefore where the market is likely to find strong support and still end the year around 6,500. So there may be some above average bargain hunting opportunities this year! So, as always, it’s wise to be ready to consider adding a little more than usual during those times.
So good luck out there folks! This is one of my favourite topics to discuss and debate and I’ve only started to scratch the surface on how to form a market view. So please consider bookmarking my website and subscribing on YouTube and even sharing this post and/or video, as most importantly it’s free … and it is therefore the best free way for you to support my work, and it really helps tell Google and YouTube to share this content to more people. And the whole reason I’m sharing this is to help educate as many people as possible with quality financial education, so thanks for your help.
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