Caution: We Are Entering A "Prove It" Market

 

• In my recently released book, The HIdden Power of Rising Dividends,(available at Amazon) I make the case that dividend growth is highly correlated with price growth for many stocks and indices.

• In the book, I suggest that dividend growth alone is highly correlated with price growth for 25-35% of S&P 500 stocks. For an additional 50% of stocks, dividend growth is the most important indicator of value, but the correlation scores rise when we add some portion of sales and earnings growth, along with changes in interest rates.

• The consensus view of many stock market prognosticators today is that stocks, now trading at 27 time operating earnings, are extremely overpriced and are due for a big correction.

• My S&P 500 valuation model is telling a much more balanced story:

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• The above chart is what I call a Value Bar chart. The green bars show my model's annual predicted price of the S&P 500 going back to 2005. A quick look at the bar farthest to the right on the chart shows the model's current predicted price of the S&P 500. That figure is approximately 5,400. With the current price of the S&P 500 at around 6,000, the model is saying stocks are overvalued by about 10%. That, however, is before we factor in 2024 year end earnings and 2025 forward earnings.

•  Before we take a deeper look at the current predicted price, let's look back over the years to see how the model has fared.

• Simply speaking, if the red line (actual price) is above its corresponding Value Bar, we would say stocks are overvalued. If the the red line is lower that the Value Bar for the same year, we would say stocks are undervalued. For the last 20 years, the red line has stayed very close to the top of the Value Bars. A significant divergence is evident in only 2007, 2008,and 2022. In almost all other years, the Value Bars and actual prices of the S&P 500 are very close.

• Stocks continued to climb heading into the beginning of the Great Recession in 2007. At some point during the year, the model would have issued an overvalued signal. The model clearly signaled the market was overvalued in 2008.

• After the bear market of 2008 and 2009, the Value Bars stayed in fairly-valued or undervalued territory until the end of 2021, when they gave an overvalued reading. That signal correctly foresaw the selloff in 2022.

• That brings us to the current modest overvaluation. Plugging in Wall Street's current estimates of sales, earnings, dividends, and interest rates give us a figure of 6,500. 

• We are now entering what I call a "Prove It" market. This means, tech stocks, where the majority of the growth is coming from, must "Prove It" that they can continue with mid 20% sales and earnings growth. If they do, we should have another pretty good year. If not . . . .
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If any of you would like to discuss this article privately, please email me at info@gregdonaldson.com.

Don't Fret, It's Picks and Shovels Time in the AI Gold Rush

• Fears of a sharp economic slowdown, and worldwide heavy selling of stocks have hit U.S. stocks in recent weeks.

• Recent economic releases have shown that unemployment is rising, home sales are slowing, manufacturing production is softening, and wage gains are flattening out. These weaker economic data points have caused fears of a recession and a move out of stocks and into bonds. 

• This flight to safety has seen 10-year U.S. Treasuries to fall from near 4.75% a few months ago to 3.75% on Tuesday. The slowing economy fears have caused the S&P 500 to fall by nearly 10%. 

• The sell off in stocks and specifically in the tech stocks is hard to reconcile in the face of the solid second quarter earnings growth reports across almost all industry sectors, from AI leaders to banks and industrial companies.

• Does this big sell off mean the AI gold rush is already over? Moreover, does it mean the bull market in non-tech stocks, which was signaled in recent weeks, is also only a head fake?  

It is important to remember that gold rushes are driven by forces other than “there’s gold in them thar hills.”  At times, reality sneaks in to play a role in the pricing. The reality in this case is investors have become worried that the tech stocks have come too far too fast, and they no longer offer value at their inflated prices. There is nothing new about that worry. It’s very realistic and has been around as long as the tech stocks have been. The techs are trading at about 30-35 times earnings and projected to have earnings growth of 15-25% over the next 3-5 years. In an earlier post, I stated that if the current earnings projections for the techs and the S&P 500 prove correct for year-end 2024 and 2025, the market will go higher. My valuation model still says 5800 is the best guess of the current fair value of the S&P 500.

It is necessary to square the recent week economic news and sharp sell offs in worldwide stocksand interest rates with corporate earnings that are being reported every day. All these data

are being collected in the same time frame, and history tells us that earnings and dividend growth

have more predictive power in the long run than do changes in GDP and interest rates.

In my judgment, the billions of dollars that corporate America is investing in AI have not had nearly

enough time to find gold. We are in the “picks and shovels,” or early stages of the gold rush where

the miners are assembling the people and tools, and identifying where to mine. In short, nowthe big winners are the chip companies that manufacture the AI chips. The products

and services that will be forthcoming in the years ahead are still concepts. Yet, when giant sums

of capital are being placed in the hands and minds of the smartest tech people in the world,

life-changing products and services are assured.    

I believe an AI gold rush is underway. AI gold will be found and lead to huge stock gains in many existing, as well as start-up companies. My calling it a gold rush is not a total disparagement. The operative questions are: How much gold is there to be found, and who will find it? Almost certainly, too much money will ultimately join the gold rush, but it is far too early to declare AI dead. That being the case, the huge selloff in tech stocks is way overdone and offers a buying opportunity in the coming weeks and months.

Warren Buffett selling a huge chunk of Apple is probably the best news I have seen to assure us that AI has real merit. I am a great fan of Mr. Buffett, but he is anything but a gold rush player. He is strictly a “picks and shovels” guy. He did not sell out entirely. He just took some profits.   

In an earlier post, I said we are traversing a gold rush in AI, and almost all gold rushes end poorly for the average investor. However, for the recent sell off in AI and the stock market to be anywhere near correct, AI would have to be a complete bust. My bottom line is all gold rushes  are driven by periods of reality and illusion. AI has been called the driver of a new industrial revolution. That is big talk, but to say that AI is a bust is just as big an exaggeration.

Stay tuned.

It's Official: The AI Goldrush Is Underway

 

1. Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.

2. Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . .  . not by a mile.

3. A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.

4. We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries. 

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended. 

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com  

Dividends and Earnings Say, The S&P's Current Price is About Right

The question I have been asked most in recent months is, "Is the current bull market in tech stocks signaling another dot-com massacre, or is it justified in light of the promise of AI?" 

1. Most of my questioners lived through the dot-com bubble of the 1990s and its subsequent crash in early 2000. In the late 1990s, the notion that computer and internet stocks could only go higher took hold, which proved dead wrong and devastating to many investors when some tech stocks fell by 90%. 

2. Nvidia and its artificial intelligence computer chips are skyrocketing in much the same way that Cisco and Intel did in the late 1990s, before crashing back to earth in 2000.

3. The Fed gives the impression that their rate hikes are finished, but inflation is still running near 3.5% and shows little signs of slowing on a month over month basis. 

3. If the Fed does not have inflation under control, a spike in long-term interest rates could cause another sell off in tech stocks just as it did in 2022. 

    One of the most disappointing aspects of modern day investing is we seem to have all become momentum investors. Find a winning stock, jump on board, and hope to sell out before it turns lower. Ben Graham's famous quote about how stocks operate is in full bloom today. He said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The point being, stock prices can be driven to ridiculous levels by short-term projections of how high is the sky, but ultimately, stock prices find their correct value. 

    Over the years, I have developed two stock market valuation tools. One looks back and is primarly earnings driven. The other looks forward and is dividend and interest rate driven. Dividends would seem to be a very pedestrian way to value a gold rush, but over the years, I have found the growth of S&P 500 dividends in combination with changes in long-term interest rates have been the best risk-adjusted predictor of S&P 500 prices. At present, my dividend discount model predicts that the fair value of the S&P 500 is approximately 5800. At 5300, that would mean stocks are modestly undervalued. However, one has to realize that the forward dividends and earnings estimates are heavily influenced by Wall Street's 3-5 year forward estimates for tech stocks. 

    My answer to the questions I have been receiving about the risks in the markets is a familiar one: "It depends." It depends on whether the AI and other high-flying tech stocks can deliver the dividends and earning growth Wall Street is now projecting. If the overall S&P 500 can deliver numbers reasonably close to the current estimates, the market is modestly undervalued and vice versa. I'll keep you posted in the weeks and months ahead how the estimates are holding up and measuring up, as well report on how interest rates are impacting my model.    

  

The Great P/E Debate: The End Is Not Near, Stocks Are Going Higher

The cacophony of “the end is near” cries from the doom and gloomers is much with us as stocks have marched unrelentingly higher over the last few years.  The doom and gloomers do a lot of talking and shouting, but they don’t seem to do much actual research.  For if they did, they would have discovered a relationship between earnings yields (the inverse of P/E) and inflation that suggests that at a P/E of 21.7x stocks are selling just about where they should be.

The picture below is a screenshot from my Bloomberg terminal showing the historical spreads of the S&P 500’s earnings yield and the personal consumption deflator, the measure of inflation that the Federal Reserve says is most accurate.  Earnings yield, which I define as S&P 500 operating earnings divided by price, or the inverse of P/E, is quoted as a percentage, as is inflation. This produces a visual representation between the two data series that is easy to analyze.

I have written about this relationship as the most important driver of the S&P 500 and Dow Jones 30 price-to-earnings ratios for many years.  I first discovered the relationship between earnings yield and inflation in the 1990s via some data that Value-Line provided their subscribers.  I was surprised that of all the data that I studied, inflation was the most highly correlated with earnings yield.  I would have bet almost anything that interest rates would have proven to have had the best correlation. (I will show the current picture of earnings yield and interest rates later.).   

 

In the upper left-hand side of the picture, you can see the movements of inflation versus earnings yield charted on a quarterly basis going back to 1973.  The difference between the two data series is shown in green.  During this time, you will note that the two lines have moved almost on a tit for tat basis and now stand at about 4.6% for earnings yield and 1.4% for inflation.  The data box at the top right of the picture shows that the average difference between earnings yield and inflation during this 43- year period has been about 3.4%.  Right above that data-point is the current difference of about 3.3%.  There is a lot of other data on this picture, but let me direct your attention to two other important indicators.  I have drawn a red arrow (lower right) pointing at R^2 (Correlation).  You can see that the R^2 between the two data series is very high at .705.  R^2 is a statistical measure of fit between two or more data series and calculates that quarterly movements in inflation have been able to predict just over 70% of the movements of earnings yield and thus P/E.  At our firm, we have more complex models using a wide range of other data series that can raise the R^2 up as high as 95%.

The second important indicator to consider is contained in the red circle I have drawn around a faint red asterisk on the lower left-hand side of the picture.  The red asterisk shows the current differential between earnings yield and inflation, and it is sitting just about where we would hope it would be -- on the fair value line.

In summary, trading at 21.7 times operating earnings, stocks are not wildly overvalued, using inflation as the measure of value, and there is no other single data series that I know of that is able to pinpoint P/E with such statistical accuracy.  I think the doom and gloomers are howling in the wind and their doom and gloom will continue to build as stocks go higher. In my judgement, if the current earnings growth continues, inflation would have to rise nearly one percent to roughly 2.5% before stocks would begin to feel headwinds.

Below I have copied a picture of the relationship between earnings yield and interest rates.  You will note the fit between the two data series is much less convincing than that of earnings yield and inflation.  Indeed, the two data series flip flopped positions in the late 1970s and thus have an R^2 of only about .42.