The Market is Expensive: Should You Care? | The Practical Implications of Market Valuation

[00:00:00] Welcome to Two Quants and a Financial Planner, where we bridge the worlds of investing and

[00:00:03] financial planning to help investors achieve their long-term goals. Join Matt Zeigler,

[00:00:06] Jack Forehand and me, Justin Carbonneau, as we cover a wide range of investing and

[00:00:09] planning topics that impact all of us and discuss how we can apply them in the real

[00:00:12] world to achieve the best outcomes in our financial lives.

[00:00:16] Justin Carbonneau and Jack Forehand are principals at Volidia Capital Management.

[00:00:19] Matt Zeigler is managing director at Sunpoint Investments. The opinions expressed in this

[00:00:22] podcast do not necessarily reflect the opinions of Volidia Capital or Sunpoint Investments.

[00:00:26] No information on this podcast should be construed as investment advice. Securities

[00:00:29] discussed in the podcast may be holdings of clients of Volidia Capital or Sunpoint Investments.

[00:00:33] Matt, today we are talking market valuation. Does it get more exciting than this?

[00:00:37] I mean, market valuation. People love this stuff.

[00:00:41] They absolutely love market valuation.

[00:00:42] And unfortunately, we're going to rain on their parade a little bit as we go

[00:00:45] through the episode because people love to talk about market valuation.

[00:00:48] People love to think that market valuation is this huge driver of a lot of what

[00:00:51] goes on. But unfortunately for many of us, it doesn't work out the way we

[00:00:56] thought it might work.

[00:00:58] Not only does it not work out the way you think it might work, it's a useful ruler

[00:01:03] to be aware of.

[00:01:04] And it really helps in portfolio construction and financial planning and

[00:01:07] expectation setting for longer time horizons.

[00:01:10] I'm a believer in all that stuff.

[00:01:13] But as far as just like even going through some of the prep for recording this,

[00:01:17] you're just mind blowing stuff.

[00:01:19] You're just like this all runs so counter-dow we normally think, which is why it's

[00:01:23] important to do an episode and talk about this stuff.

[00:01:26] Yeah, it's like anything in investing.

[00:01:27] You just have to understand how it works, why it works and what it's for.

[00:01:31] And a lot of times that's what people get wrong about market valuation.

[00:01:34] It's not that it has no impact or it doesn't matter.

[00:01:36] I mean, obviously a world where market valuation is irrelevant to an infinite

[00:01:40] time frame is not a great place we want to be in.

[00:01:43] I mean, we want people to care about the fundamentals of individual companies

[00:01:46] and the fundamentals of the market.

[00:01:47] It's just sometimes that time frame that it works over gets, you know,

[00:01:50] people can get that crossed up and we'll get into that later.

[00:01:53] But first, obviously now that we've told people that market valuation is not

[00:01:56] that useful, the first thing we need to do is go through the market valuation.

[00:01:59] That only makes sense, right?

[00:02:00] Yeah, I think let's do at least a high level overview of some of

[00:02:04] everybody's favorite valuation metrics, adorable as they may be, and at

[00:02:09] least set the table for digging in a little bit.

[00:02:11] So start us off.

[00:02:12] What's current market valuation?

[00:02:14] Let's just pick on the good old S&P 500.

[00:02:17] Where are we at with the numbers we know?

[00:02:20] And I guess, contrast the trailing 12 month PE.

[00:02:24] Where does the S&P sit here on May 30th, 2024 AD?

[00:02:30] So what's interesting about this, you know, it's not necessarily, we'll get

[00:02:33] into what the valuation is, it's not necessarily what the valuation is.

[00:02:36] It's also like how the valuation is calculated because you'll see so many

[00:02:40] different market valuations out there and it's just like inflation numbers.

[00:02:43] It's like anything, you know, anybody who has a case they want to make

[00:02:46] will find a market valuation indicator to help them make that case.

[00:02:49] And it's the same thing, you know, people who think inflation is going

[00:02:51] to reach out of control have numbers.

[00:02:53] They can dice and slice and dice the CPI and get to that.

[00:02:55] If they think inflation is already below 2%, they slice and dice it

[00:02:59] and get there and it's the same thing with valuation.

[00:03:01] You'll see as we go through this, different ways of looking at valuation

[00:03:04] lead to different conclusions.

[00:03:05] And the first thing here is, you know, we're just looking

[00:03:07] at the S&P 500 PE ratio.

[00:03:08] And you know, what you probably will see from this chart is it's

[00:03:11] high relative to history.

[00:03:13] You can see the mean of history is 16% or 16, 16 in general.

[00:03:19] The median is 15 and we're at 27 right now.

[00:03:21] So we are very high relative to history.

[00:03:24] And you can see also in this chart, if you look at the beginning period,

[00:03:27] if you were to cut this chart in half, the average valuation, the

[00:03:30] median, the mean, whatever it is in the first half of the chart is much

[00:03:33] lower than the second half of the chart.

[00:03:35] And that's something we'll see in a lot of these metrics.

[00:03:36] And that's something people debate right now, which is this idea of

[00:03:39] do we deserve a higher valuation?

[00:03:41] So the fact that it's high, maybe it's not as bad as people think

[00:03:44] because, you know, we deserve a higher valuation, technology has changed.

[00:03:47] The market has changed.

[00:03:48] Things are a lot better than they used to be.

[00:03:50] So, so maybe this high valuation is justified, but in general, clearly,

[00:03:54] you know, if you look at a long-term chart of the S&P 500 PE ratio,

[00:03:56] it's high right now relative to history.

[00:03:59] Super, super basic, but I think a super, super important point,

[00:04:03] whenever we talk about this stuff is we're talking about a ratio,

[00:04:07] which means we're talking about fractions.

[00:04:09] And as I can attest, hopefully past the period where it counts, you

[00:04:13] know, I had a misspelled version of my own last name for a fourth grade

[00:04:17] teacher who taught me fractions.

[00:04:19] And this is the first time I ran into like the full brick wall in school

[00:04:24] and have a lifelong fear of things.

[00:04:26] Like actually I just say fear and respect for fractions because of

[00:04:33] this fourth grade math teacher that I had.

[00:04:35] When we look at stuff like this, we have to remember it's a fraction.

[00:04:39] So when we talk about the PE ratio being at twenty seven point three seven

[00:04:44] love taking it out to decimal places, by the way, really, really helps.

[00:04:48] Shows the sense of humor in these things.

[00:04:51] This idea that we're making both an assessment on what's going on

[00:04:55] in that numerator and the denominator.

[00:04:59] I need this for myself.

[00:05:01] I need to anchor back to a reminder that there's an actual difference

[00:05:04] in the numerator, the denominator and the relationship between the two.

[00:05:07] So funny things happen here.

[00:05:10] Walk me through for a second, Jack.

[00:05:12] What's in the numerator?

[00:05:13] What's in the denominator?

[00:05:14] I know this is fourth grade stuff, but let's just say this out loud

[00:05:17] before we work through the rest of these.

[00:05:19] Yeah.

[00:05:20] Well, you know, PE ratio.

[00:05:21] So the numerator is just the price at any given time, which obviously

[00:05:24] changes all the time changes every day.

[00:05:27] And then earnings is the denominator.

[00:05:29] You know, typically, typically, and again, we'll get into this when

[00:05:31] we look at other stuff, typically trailing 12 months earnings, which

[00:05:35] is earnings in the in the previous 12 months.

[00:05:37] But it's really important to keep in mind.

[00:05:38] We could also look at forward earnings for the current fiscal year.

[00:05:41] We could look at forward earnings for the year, the next fiscal year.

[00:05:44] We could do the CAPE or something, which we're going to do in a second

[00:05:46] where we average out a bunch of earnings.

[00:05:47] So really the numerator is very simple.

[00:05:50] The denominator can be all kinds of stuff.

[00:05:53] And as we'll get through this, we'll see as we change that

[00:05:56] denominator and we look at different things, we can get very

[00:05:59] different conclusions or very different numbers.

[00:06:01] That idea that as you swap out the denominator, you get different numbers

[00:06:07] is the heart of understanding the narrative construction and presentation

[00:06:10] of these things when they're used.

[00:06:12] And it's also the idea where every time you see a giant spike on this

[00:06:16] chart, and there's a number of these times where you see these

[00:06:18] giant spikes in every one of those cases, that's because price has

[00:06:23] typically run away from wherever the earnings baseline is in that

[00:06:28] last 12 month window.

[00:06:30] Part of the reason these things tend to suck as a timing tool is

[00:06:34] because of these gaps.

[00:06:36] So seeing that gap in the, I'm assuming that's the financial crisis or right

[00:06:41] before when we got the, we broke through the top of the chart.

[00:06:46] You can see how narrow and peaky that thing is.

[00:06:49] And it's so narrow and peaky because earnings, correct me if I'm wrong

[00:06:53] because I can't see exactly when that thing starts, but that's because

[00:06:56] basically earnings fall off a cliff before price or price goes through the race.

[00:07:01] In that case, there was an outlier in terms of earnings went in 2008

[00:07:04] earnings fell off a cliff.

[00:07:06] But what's interesting about that is that was not a sign that you

[00:07:10] should be panicked because the market has a huge valuation.

[00:07:13] It was the opposite of that.

[00:07:15] That huge peak occurs like at the beginning of 2009 when we're getting

[00:07:20] 2008 reported earnings and those 2008 reported earnings are terrible.

[00:07:24] But that was clearly not a time you should be selling because of valuation.

[00:07:29] Yeah, if anything, it's actually giving you the opposite signal, which is why

[00:07:33] I know it's a fourth grade math point, but this idea of it's every

[00:07:37] ratio is a numerator and denominator.

[00:07:40] You should be asking the question about what's in each and what

[00:07:43] it's giving to you right now.

[00:07:45] Distinct memories of that early March 2009 market bottoming period and

[00:07:50] seeing some of the valuation arguments and going like, oh my God, this

[00:07:53] thing is this thing is woefully wrong.

[00:07:55] I'm going to butcher it and maybe you remember it, maybe you don't.

[00:07:58] Is it the Moldovsky effect?

[00:08:00] What's the that?

[00:08:01] I don't know.

[00:08:02] There's some crazy stock research thing.

[00:08:04] I should have looked this up beforehand.

[00:08:05] It's this idea.

[00:08:07] It's and I think it's usually used to describe cyclical companies.

[00:08:10] And it's this concept that basically very cyclical companies with very

[00:08:14] quirky like earning cycles will almost always say you buy them when

[00:08:18] the valuations look high and you sell them when the valuations look low

[00:08:21] because you're allowing for this catch up.

[00:08:23] So S&P 500, congratulations on a trailing 12 month basis.

[00:08:28] You're rich according to history, but that could change really fast.

[00:08:32] If earnings accelerated, that could change really fast.

[00:08:34] If the price went off a cliff, wonderfully useful.

[00:08:38] What do we got next?

[00:08:39] Yeah.

[00:08:39] Well, this next thing is going to kind of get rid of that problem.

[00:08:41] You just talked about, which is this idea that, you know, earnings

[00:08:44] plummeted in 2008, so the valuation went off the charts, like just a

[00:08:47] quick spike and came right back down.

[00:08:49] This is the Schiller P ratio, which is using 10 year average earnings

[00:08:53] in the denominator.

[00:08:54] And the idea is it's smooth things out over time.

[00:08:57] So, you know, when you only have one data point in the denominator,

[00:08:59] you can get some of those weird things going on.

[00:09:01] If this is trying to smooth things out over time and you'll see this

[00:09:05] is, you know, we had, if you look at the peaks on here, obviously

[00:09:08] the dot com bubble is the 45.

[00:09:11] Do you see there?

[00:09:11] Which the previous high had been just north of 30 back in the 1920s.

[00:09:16] And then we broke, we got hit 45 before and now we're at 34.

[00:09:20] So we're not at dot com levels, but we're above anything that

[00:09:24] had happened prior to that.

[00:09:25] Um, so yeah, so it shows the same picture.

[00:09:27] I mean, the S and P 500 is expensive.

[00:09:31] Now it's important to keep in mind when we're talking about the S and

[00:09:33] P 500, we are talking about large companies and we are talking about

[00:09:37] the biggest companies having the biggest impact.

[00:09:40] So the valuation of Microsoft is much more important to this overall

[00:09:45] valuation than the valuation of company 500.

[00:09:48] This is not some equal thing.

[00:09:49] And it shouldn't be some equal thing because Microsoft contributes way more

[00:09:52] earnings to the S and P 500 than that bottom company does.

[00:09:55] So Microsoft's valuation should matter a lot more.

[00:09:58] So that's, it's just important to understand this because when we get

[00:10:01] into these debates people have about like, well, the valuation of

[00:10:04] the biggest stocks relative to the valuation of everything else, like

[00:10:07] this is being driven largely by the valuation of the biggest stocks.

[00:10:11] And this is showing that although there are 500 companies in there,

[00:10:13] this is showing that the biggest stocks are expensive right now.

[00:10:17] Numerator denominator price on top.

[00:10:20] When we talked about the trailing 12 month PE and now the Schiller PE,

[00:10:23] we are talking about market capitalization weighted as the price

[00:10:28] signal because I can't think of another word to use for it.

[00:10:32] That means that not only are we taking the price of the index,

[00:10:36] but we're also taking things like Microsoft and Nvidia and Apple and

[00:10:40] those biggest companies and disproportionately weighting them.

[00:10:43] I mean, proportionate to theoretically the earnings and the denominator here.

[00:10:47] But we are, we are looking at that through the lens of the biggest

[00:10:51] companies having the biggest impact on this stuff, which also gets

[00:10:54] into a little bit of a mind bend when you look at the largest

[00:10:57] portions of the market capitalization weighted index relative to their

[00:11:02] earnings contribution to set index that I think helps explain some of

[00:11:06] the tech bubble bananas that we see in this chart.

[00:11:08] But again, numerators and denominators is just so frigging important

[00:11:13] here and even that point, especially as we get into this.

[00:11:16] So we're rich on a Schiller PE ratio to 10 years.

[00:11:21] So what about if let's zoom back out again, we covered trailing 12,

[00:11:26] we covered Schiller, what about the median stock?

[00:11:29] If we split this down the middle, what's actually going on with

[00:11:32] median stock trailing 12 months earnings per share?

[00:11:37] Yeah, so this is interesting.

[00:11:38] So this is not, again, this is not representative of the market

[00:11:41] because like, like I said before, Microsoft is far more important for

[00:11:44] the market than some random smaller company.

[00:11:46] But for us as an investment manager, we like to look at this because

[00:11:49] we're selecting from a universe of all stocks.

[00:11:52] We are not market cap weighting those positions.

[00:11:54] So for us, we like to see like, what are the valuations out there

[00:11:57] in that universe of stocks we select from?

[00:11:59] And so what this is using is a median.

[00:12:01] So this is basically taking all companies sorting them by their PE

[00:12:05] ratio and then just taking the company that sits in the middle.

[00:12:08] That basically is more representative of kind of your average stock that's out there.

[00:12:13] What does their valuation look like right now?

[00:12:15] It doesn't tell us anything about what the valuation of the S&P 500 is.

[00:12:19] And so you'll see here the current all stock, this is basically,

[00:12:22] it's right in the middle of where it's been, you know, we run our data back to 2005.

[00:12:27] So it's not as far back as the other data point, but since 2005,

[00:12:31] we're kind of right in the middle.

[00:12:31] This is not, the average stock is not crazy cheap.

[00:12:34] The average stock is not crazy expensive.

[00:12:36] You can see like in 2008, this got down to 10.

[00:12:39] So this got very low, but it paints a different picture.

[00:12:41] That other picture was very, very high over valuation.

[00:12:45] This is kind of more middle of the road thing.

[00:12:48] So it just gives us an idea that what it's telling us is not every stock

[00:12:52] is out there is expensive, like those most expensive stocks that

[00:12:56] most keep, you know, are the most weighted in the S&P 500.

[00:12:59] Maybe there's some opportunities out there in some other stocks,

[00:13:02] you know, if I look broader than it.

[00:13:03] Do you want to venture to guess what Microsoft's as basically one of the

[00:13:08] largest holdings here, what, what the trailing 12 PE is relative to this?

[00:13:13] I would, yeah.

[00:13:14] I don't even have a guess.

[00:13:14] I don't think Microsoft has that huge of a PE.

[00:13:16] I mean, some of those big tech stocks aren't that expensive.

[00:13:18] Maybe I'm wrong about that.

[00:13:20] According to a quick search, it looks like it's 37 times as of May 2024.

[00:13:26] Yeah.

[00:13:26] But that's an interesting point when we start to compare and contrast

[00:13:29] point when we start to compare and contrast Microsoft as a substantial

[00:13:33] weight and the S&P 500 has.

[00:13:38] What is this?

[00:13:38] A 20 word at 20 times on this chart trailing 12.

[00:13:41] Correct.

[00:13:42] Yeah.

[00:13:42] So Microsoft is orders of magnitude more expensive and dragging those

[00:13:47] numbers that we saw in the other examples higher to your point, the

[00:13:51] median stock is not nearly as rich as some of the concentrated bigger

[00:13:55] names at the extremes of this one.

[00:13:57] That's right.

[00:13:58] And also you have to keep in mind, I mean, obviously Microsoft is

[00:14:00] expensive to some degree for a reason.

[00:14:02] A Microsoft's business is killing it.

[00:14:04] Like if you look at Nvidia, like Nvidia is very expensive too, but

[00:14:06] Nvidia has like tripled their earnings or something, you know, in just

[00:14:09] a few years, so, or at least doubled.

[00:14:11] So there's always two parts to this equation.

[00:14:14] Valuation is only one part of the equation of how we would look at,

[00:14:17] you know, both the market as a whole and individual companies.

[00:14:20] The other part of the equation is, you know, the growth and the future

[00:14:22] cash flows and like all that stuff that comes with the business.

[00:14:25] So this is only part of it, but these numbers, you know, over certain

[00:14:27] timeframes can have some value.

[00:14:29] So it is interesting just to look at it.

[00:14:31] And the big takeaway here is, you know, just that it is a different

[00:14:34] picture when you look at a broad universe that includes small cap stocks.

[00:14:38] I mean, our universe is probably about 2,700 right now.

[00:14:41] So a broad universe where we're kind of looking at everything equally has

[00:14:45] a very different valuation right now than a mark, a 500 stock large cap

[00:14:49] universe where we're counting the biggest companies the most.

[00:14:52] Yeah, exactly.

[00:14:53] So now why don't you take us to, take us from median stock into median earnings.

[00:14:59] All right.

[00:14:59] And let's look forward, median forward earnings.

[00:15:01] Yeah.

[00:15:02] So we're going to take, we're going to look at the median calculation again.

[00:15:04] But now getting back to your point before of what you said about the

[00:15:09] this is the denominator is really what matters.

[00:15:11] We're going to look at instead of looking at trailing 12 month earnings.

[00:15:14] Now we're going to look at what analysts are expecting for this year.

[00:15:17] So this is basically 2024 earnings, which is partially reported now

[00:15:23] and mostly as an analyst estimate.

[00:15:26] And so what picture does this paint relative to the other picture?

[00:15:30] It paints a little bit, a pretty similar picture.

[00:15:32] You know, stocks are a little bit, you know, I guess they're a

[00:15:35] little bit cheaper here, but it paints a very similar picture.

[00:15:40] Where you get into these pictures being very, very different is when you

[00:15:43] start looking at individual companies.

[00:15:44] So like, if you look at individual companies, valuation of trailing 12

[00:15:48] months versus analyst estimates, you can get some really, really different

[00:15:50] numbers, you know, in general, unless something crazy is going on where

[00:15:54] analysts have totally changed their estimates, you know, you for the

[00:15:58] market as a whole, it's not typically that different.

[00:16:01] And so we're getting a little bit of a different picture, but what's

[00:16:03] interesting is if we move on to my next chart, if we move on to price

[00:16:07] to sales here, now we're going to start to see a little bit of a

[00:16:09] different picture.

[00:16:10] Because what you have right now is you have a situation where margins are

[00:16:15] very high across the market.

[00:16:17] So companies have high profit margins.

[00:16:19] And so what that means is they're going to look better on a valuation

[00:16:23] relative to their earnings than they are relative to their sales.

[00:16:27] So in theory, they're getting rewarded for those higher margins with

[00:16:30] higher valuations based on sales.

[00:16:33] And so you'll see here, you see more overvaluation even in the median

[00:16:37] stock, and you would see this too, if we were looking at the

[00:16:38] market cap weighted indexes like the S&P 500.

[00:16:40] But when you look at sales, you're getting a little bit more of an

[00:16:44] overvaluation here than you were when we looked at it the other way.

[00:16:47] So none of these are, and we'll get into what this is useful for, but

[00:16:50] none of these are telling us, you know, some major conclusion about

[00:16:53] what's going to happen in the next year or anything like that.

[00:16:55] But it is, it's interesting to make the point that as we look at

[00:16:58] different metrics and as we change that denominator, as you said before,

[00:17:01] we're going to get different values no matter what type of

[00:17:04] indicators we're looking at.

[00:17:05] It's also really interesting in these cases, and we'll connect it back

[00:17:09] to some other financial planning topics, I'm sure as we go, but just

[00:17:12] understanding how public, liquid, in many cases, well-capitalized

[00:17:18] with deep access to various parts of the financial markets, just to

[00:17:22] understand how these things are valued, especially back to business

[00:17:26] owners or other people too.

[00:17:27] Because this spread always exists in private markets.

[00:17:31] It feels historically a little extra chaotic in public markets right now.

[00:17:35] And on, even if we just think about on a price to sales basis, the

[00:17:40] idea that the median, the median price, that's median price to

[00:17:44] sales, right?

[00:17:45] On this one?

[00:17:45] Yes.

[00:17:47] Yeah.

[00:17:47] So median price to sales on a trailing 12 month basis right now

[00:17:50] is like we're in the, what, in the twos.

[00:17:53] This is not crazy.

[00:17:55] Companies like Microsoft, I'm not picking on Microsoft as a good or

[00:17:58] bad idea, but just to give you a dispersion idea, a giant company

[00:18:03] in the index is trading at over 13 times sales right now.

[00:18:08] Depending on the quality of the business, depending on the

[00:18:11] confidence in the results of the business, we see a really wide

[00:18:15] margin of the way things are being valued.

[00:18:17] And that's, that's as indicative of the crazy stuff we're filling

[00:18:20] in the times as anything else here.

[00:18:22] Yeah.

[00:18:22] It's interesting to think about or like, are we in different

[00:18:24] times now?

[00:18:24] Because if you ran like as a quant, if I were to go back to

[00:18:27] a strategy of 10 times sales plus companies, it's a catastrophe.

[00:18:31] You know, like the long-term returns of that type of thing, when

[00:18:33] things get above 10 times sales is not good, but you also have

[00:18:36] to argue, we are seeing different types of business models.

[00:18:39] We're seeing technology to enable companies to be more

[00:18:41] profitable.

[00:18:42] Maybe that won't be the case.

[00:18:43] I mean, certainly in the runup of some of these tech

[00:18:45] stocks, there were a bunch of times they were above 10 times

[00:18:48] sales and they ended up doing really well.

[00:18:51] It was not any kind of negative indicator about their future.

[00:18:53] So as we debate all that, that's always a good thing to

[00:18:56] as we debate all that, that's always, it's tough to this whole

[00:18:58] this time is different versus, you know, the rules of the

[00:19:00] past apply.

[00:19:02] It's always an interesting debate to have, and you can

[00:19:04] have it around a lot of different metrics.

[00:19:05] And then that's one you can have right now.

[00:19:08] Especially when you consider like a Microsoft example where

[00:19:13] it looks like the way the numbers are coming in so far,

[00:19:15] you have 15% plus expected full year sales growth, 20% plus

[00:19:23] expected full year earnings growth.

[00:19:26] That probably looks a lot different from the median company

[00:19:30] and the experience right now too.

[00:19:32] Some of these big companies to your point on Nvidia a minute

[00:19:35] ago are growing like gangbusters and that's contributing

[00:19:39] to some of this dispersion we're seeing in the various

[00:19:41] valuation metrics.

[00:19:42] That's right.

[00:19:43] And the question is, can they sustain it?

[00:19:44] And you know, that's for smarter people than you and me

[00:19:46] probably.

[00:19:46] Yeah, probably probably for you.

[00:19:48] I don't know if you've been digging into their their

[00:19:50] revenue to try to figure out if it's sustainable, but I

[00:19:52] mean, typically that kind of growth rate on that kind

[00:19:54] of size company has never happened before, but maybe

[00:19:56] it will be.

[00:19:57] You just don't know.

[00:19:58] Well, you know, nobody knows.

[00:20:01] So what about what is this good for?

[00:20:04] So we're talking about this stuff.

[00:20:05] We're talking about how messy this is, how clunky this

[00:20:08] data is, how convenient it is to take some of this

[00:20:10] data and paint a story around it saying stocks are

[00:20:13] super expensive get out or stocks are kind of cheap

[00:20:16] because of growth get in.

[00:20:18] What's market valuation actually good for Jack?

[00:20:21] That's a good question.

[00:20:22] Before we do that too, I just want to show one more

[00:20:23] chart because I just think this is interesting.

[00:20:25] Like I always liked showing stuff where the behind

[00:20:27] the scenes data matters a lot.

[00:20:29] So looking at this, I just changed this chart

[00:20:31] briefly.

[00:20:32] One of the issues you have with a median.

[00:20:33] So if I'm calculating a median, what I'm doing

[00:20:35] is I'm ranking all the companies from cheapest

[00:20:37] to most expensive and I'm taking the middle.

[00:20:39] Well, here's my problem.

[00:20:40] That what do I do with?

[00:20:42] We have more companies than ever that don't make

[00:20:44] any money right now that I've basically don't have

[00:20:46] a calculable P ratio.

[00:20:48] What do I do with them?

[00:20:49] Um, that becomes a challenge, right?

[00:20:51] What do I, how do I handle them?

[00:20:52] So there's two different ways you see this done.

[00:20:54] One is I just get rid of them.

[00:20:56] I just throw them out and I rank all the stocks

[00:20:58] that actually do have a P ratio.

[00:21:00] The other way you can do it is you can treat

[00:21:01] them as bad.

[00:21:02] You can basically put them at the end as treat

[00:21:05] them as the most expensive stocks because they

[00:21:06] don't have a P ratio.

[00:21:07] So the first way I showed you this chart, we

[00:21:09] were doing it the first way, which is we were

[00:21:11] just throwing out the companies, which is the

[00:21:12] way you most commonly see it done.

[00:21:14] Uh, we're just throwing out the companies that

[00:21:16] don't have a P ratio.

[00:21:16] You know, I'm not ranking companies if they

[00:21:18] don't have the variable I'm ranking on.

[00:21:20] This shows it the other way, which is this is

[00:21:22] taking the companies that don't have a P ratio

[00:21:24] and it's putting them at the end and treating

[00:21:25] them as the most expensive.

[00:21:27] And so what that does is that makes the

[00:21:28] market more expensive in general.

[00:21:30] Um, and it's just interesting to look at

[00:21:32] it this way.

[00:21:33] I just wanted to show this just to not

[00:21:34] that the conclusion, it does show the

[00:21:36] market is more expensive.

[00:21:37] Um, not, not to show, not to draw any

[00:21:38] conclusions based on it, but just to

[00:21:39] show how important it is when you're seeing

[00:21:41] data from people to understand what's going

[00:21:44] on behind the scenes in that data, because

[00:21:46] that decision of what do I do with these

[00:21:48] companies that don't make money can

[00:21:50] completely change these types of

[00:21:52] calculations, depending on how you do it.

[00:21:53] And if I had showed you trail in 12

[00:21:54] months, you would see an even more

[00:21:55] extreme version of this.

[00:21:57] But it's just like that type of stuff

[00:21:58] is really important.

[00:21:59] And with all data is what's happening

[00:22:01] behind the scenes to calculate that data.

[00:22:03] Back to the numerator and denominator

[00:22:05] piece, like, yes, this is a fourth

[00:22:07] grade observation, but how often do we

[00:22:10] see one of these charts and actually

[00:22:11] pause to ask what is in the

[00:22:13] numerator?

[00:22:14] What is in the denominator and why?

[00:22:17] If you want to tell a certain story,

[00:22:19] changing what, which data set you're

[00:22:22] drawing from.

[00:22:23] And if you're including or excluding

[00:22:24] profitable or non-profitable companies,

[00:22:26] including or excluding companies with

[00:22:28] sales without sales or, you know,

[00:22:30] with earnings, without earnings or,

[00:22:32] or even above like a threshold,

[00:22:34] these charts get sliced and diced a

[00:22:37] billion ways by people who want

[00:22:39] to tell a story with them.

[00:22:41] Stopping to ask what is in that

[00:22:43] numerator and denominator and why is

[00:22:46] one of the most important things

[00:22:47] you can do.

[00:22:49] What is in there and what is the

[00:22:50] incentive of the person that's

[00:22:51] putting it in front of me?

[00:22:51] Like those, those are always, if

[00:22:52] you can ask those two questions

[00:22:54] about any piece of data you get,

[00:22:55] you'll be in much better shape

[00:22:56] because usually you'll find that

[00:22:58] the incentive of the person is

[00:22:59] completely tied to what's actually

[00:23:01] in the data because they have,

[00:23:03] they have massaged the data in a

[00:23:04] way to make the point they're

[00:23:05] trying to make.

[00:23:07] And it's just important to keep

[00:23:08] that in mind when you analyze any

[00:23:09] kind of data about anything, not

[00:23:10] just about the P ratio of the

[00:23:12] stock market.

[00:23:13] As our friend Ben Hunt likes to

[00:23:14] say, why am I reading this now?

[00:23:17] Probably one of the most important

[00:23:18] questions we can ask.

[00:23:20] Let's go to this.

[00:23:22] I want to ask about what, what's

[00:23:24] this even good for?

[00:23:25] What's market valuation good for?

[00:23:27] Why do we even care at all if

[00:23:29] this is just such a PR campaign

[00:23:31] of stories that strategists want

[00:23:33] to tell?

[00:23:34] Why does this actually matter?

[00:23:35] And I do believe it actually

[00:23:36] does.

[00:23:37] Yeah, I'm interested to get your

[00:23:38] thoughts on this.

[00:23:38] So I think for your average

[00:23:40] investor in terms of how they

[00:23:41] like adjust their investment

[00:23:42] strategy, the answer is almost

[00:23:44] zero.

[00:23:45] And I think the reason for that

[00:23:46] is like it's important with data

[00:23:47] to understand the time frame,

[00:23:48] the data like has signal over.

[00:23:51] And with market valuation data,

[00:23:53] like if I were to look at, I

[00:23:54] don't have the thing to put in

[00:23:55] front of us, but if I were to

[00:23:56] say how much does the valuation

[00:23:57] impact the forward one year

[00:23:59] return of the S&P 500 or of

[00:24:01] anything, the answer is almost

[00:24:02] none.

[00:24:03] There's almost zero correlation

[00:24:05] between what that valuation is

[00:24:07] and what happens in the next

[00:24:08] year.

[00:24:08] When you get to three years,

[00:24:09] it's a pretty similar picture.

[00:24:11] As you get out further into

[00:24:13] the future, like if I want to

[00:24:14] see what's going to happen in

[00:24:14] the next 10 years, now

[00:24:16] valuation is becoming more of a

[00:24:18] signal to me.

[00:24:18] But the problem with that is

[00:24:20] how does your average person

[00:24:22] judge their investment strategy?

[00:24:23] They judge their investment

[00:24:24] strategy over these one

[00:24:25] three year periods.

[00:24:27] So if I'm making changes to

[00:24:28] my investment strategy based on

[00:24:29] valuation, I'm taking a signal

[00:24:31] that's long term and I'm

[00:24:33] making changes that I'm going

[00:24:34] to judge them over a shorter

[00:24:35] term period.

[00:24:36] And so that misalignment

[00:24:37] causes all kinds of problems

[00:24:39] with using valuation data.

[00:24:40] So I think, and we'll get into

[00:24:41] this later in the podcast, I

[00:24:42] think evaluation data can be

[00:24:43] very interesting from an

[00:24:44] expected return standpoint,

[00:24:46] from a planning standpoint.

[00:24:47] It can be interesting from all

[00:24:48] of those standpoints, but the

[00:24:49] standpoint most people use it

[00:24:51] from, which is look at those

[00:24:52] charts they just showed me

[00:24:53] time to short the market,

[00:24:55] time to reduce my equity

[00:24:56] exposure.

[00:24:56] You know, the P ratio is 37 or

[00:24:58] something or whatever it is.

[00:24:59] If not that useful for that.

[00:25:02] Completely agree.

[00:25:03] I'm going to hold off on

[00:25:04] some of the financial

[00:25:05] planning applications for a

[00:25:06] little bit later on this,

[00:25:08] but it's about the timeframe

[00:25:10] match of the information that

[00:25:11] you're using and what were

[00:25:12] the signal you think is in

[00:25:13] that information.

[00:25:15] There's a, I believe a wealth

[00:25:18] of information and at least

[00:25:19] having a, an approach, a

[00:25:21] philosophy and understanding of

[00:25:23] these things so you can use

[00:25:25] them honestly more than

[00:25:27] anything in portfolio

[00:25:28] construction, in rebalancing

[00:25:29] decisions, in contribution and

[00:25:31] withdrawal decisions.

[00:25:33] And that's the kind of

[00:25:34] stuff we know has an impact

[00:25:36] on your experienced or your

[00:25:38] lived sequence of returns

[00:25:39] over time.

[00:25:40] I think valuation as a tool

[00:25:43] and I'm using valuation in the

[00:25:44] most broadly sense, not that

[00:25:45] there's, there's no one metric

[00:25:48] to rule them all for these

[00:25:49] things.

[00:25:50] But having an understanding of

[00:25:51] what goes into the various

[00:25:52] numerators and denominators

[00:25:54] you're going to use for more

[00:25:55] global decisions can actually

[00:25:57] make a big difference in your

[00:25:58] sequence of returns that you

[00:26:00] actually live and experience

[00:26:01] over time.

[00:26:03] I'll take that one with me

[00:26:05] and this stuff can be

[00:26:05] interesting.

[00:26:06] Like I don't, I don't, I

[00:26:07] don't use it, but I do pay

[00:26:08] attention to it all the

[00:26:09] time.

[00:26:09] Like I look at it, like I'm

[00:26:11] interested to see what the

[00:26:11] valuation of the S&P is

[00:26:13] relative to history.

[00:26:14] But the problem comes in when

[00:26:15] you, when you turn it into

[00:26:16] implementation and that's where

[00:26:18] you've got to be really

[00:26:18] careful is what am I using

[00:26:20] this data for?

[00:26:21] It's great to look at it

[00:26:21] and it's great to enjoy it.

[00:26:22] But if it's going to make

[00:26:23] you, if it's going to make

[00:26:24] you panic because the

[00:26:25] valuation is ultra high and

[00:26:27] you're going to make some

[00:26:28] huge change to your

[00:26:29] investment strategy thinking

[00:26:30] in the next one to three

[00:26:30] years, that change is going to

[00:26:31] benefit me.

[00:26:32] That's where you get yourself

[00:26:33] in trouble.

[00:26:34] Or Mr. Value Investor, what

[00:26:36] about when it's ultra low

[00:26:37] and you think there's a

[00:26:38] screaming opportunity?

[00:26:40] It doesn't always play out the

[00:26:41] way you think it's going to

[00:26:42] even when you see it, right?

[00:26:44] Yeah.

[00:26:44] And it can be, I mean, the

[00:26:45] scream like 2009, like most

[00:26:47] of us at the time felt like

[00:26:49] that our value investors

[00:26:50] that are long-term investors

[00:26:51] felt like we did have a

[00:26:52] screaming opportunity, but we

[00:26:54] didn't, we probably felt that

[00:26:55] in November of 2008 that

[00:26:56] could have gone on for

[00:26:57] three more years before it

[00:26:59] came back.

[00:26:59] So if not that you can't

[00:27:01] benefit from, you know, if

[00:27:02] the market's really cheap,

[00:27:04] you're probably, to be honest,

[00:27:05] you're probably better off on

[00:27:06] that side.

[00:27:07] If you ever were going to

[00:27:08] make any changes based on

[00:27:08] valuation, you're probably

[00:27:09] better off.

[00:27:10] If we have some crazy cheap

[00:27:11] valuation adding a little bit

[00:27:13] of exposure, then you are

[00:27:14] trying to time it on the

[00:27:15] other side.

[00:27:16] Because if I think about

[00:27:17] like, think about like 1995,

[00:27:19] like 1996, the valuation was

[00:27:21] getting pretty crazy 97.

[00:27:22] It got even more crazy 98.

[00:27:24] It was out of control 99.

[00:27:25] It was something we've never

[00:27:26] seen in our lives.

[00:27:27] Like how are you going to

[00:27:28] do anything about that?

[00:27:29] Like it's very hard to,

[00:27:31] you know, if you were

[00:27:31] reducing your exposure all the

[00:27:32] way up, you ended up hurting

[00:27:34] yourself.

[00:27:35] So it's not that helpful in

[00:27:37] any case.

[00:27:37] And I'm not saying you can't

[00:27:38] like 2009 was a buying

[00:27:40] opportunity.

[00:27:41] Most people thought it was

[00:27:42] even Jim O'Shaughnessy, who's

[00:27:44] like the most anti-market

[00:27:45] timing person of all time,

[00:27:46] wrote an article back then

[00:27:47] about like a once in a

[00:27:48] generation or whatever

[00:27:49] buying opportunity.

[00:27:50] So it was kind of clear

[00:27:52] that if I looked forward 10

[00:27:53] years, I was probably going to

[00:27:55] be happy I bought then, but

[00:27:56] it didn't tell me anything

[00:27:57] about, well, March 2009 is

[00:27:59] going to be the bottom.

[00:28:00] This could have gone into

[00:28:01] 2010, 2011 and you could

[00:28:03] have looked like an idiot

[00:28:03] for a while.

[00:28:04] And all this stuff still

[00:28:05] goes back to what?

[00:28:08] These are good gauges to

[00:28:10] give you an awareness.

[00:28:11] So long as you can know

[00:28:11] what's in that numerator

[00:28:13] and denominator, and

[00:28:14] especially on the downside

[00:28:15] when price is screaming

[00:28:17] towards what feels like

[00:28:18] zero, but you still are

[00:28:20] certain in some way that

[00:28:21] denominator, whichever

[00:28:24] composition of denominator

[00:28:26] you choose, that you say

[00:28:27] there's some type of

[00:28:28] durable or at least

[00:28:31] still alive asset here.

[00:28:32] So it's not like you're

[00:28:33] buying a live asset here.

[00:28:34] Price may be screaming

[00:28:36] towards zero, but if the

[00:28:37] value of the companies

[00:28:38] by some other measurement

[00:28:39] is not also screaming

[00:28:41] towards zero, those are

[00:28:42] the times when I agree

[00:28:44] on the on the getting

[00:28:47] cheaper downside,

[00:28:48] especially on like

[00:28:49] catastrophic price moves

[00:28:51] that usually has been

[00:28:52] a lot more of a useful

[00:28:53] indicator than the late

[00:28:55] 90s scenario that you

[00:28:56] just gave, which I was

[00:28:57] not an investor in yet,

[00:28:58] but in the seat of high

[00:29:00] school where I do remember

[00:29:01] a history class with the

[00:29:02] teacher, like talking

[00:29:03] tech stocks, presumably

[00:29:05] to the late 90s.

[00:29:07] I believe he stayed a

[00:29:08] teacher after that, so I

[00:29:09] don't think it worked out

[00:29:10] for him.

[00:29:10] But probably not.

[00:29:12] But but this idea of

[00:29:15] and stuff can just keep

[00:29:16] getting carried away in

[00:29:17] each direction.

[00:29:18] But it's a little bit

[00:29:19] more banded on the

[00:29:20] downside because stuff

[00:29:21] getting carried away to

[00:29:22] the downside means we're

[00:29:23] all dead stuff getting

[00:29:24] carried away to the

[00:29:25] upside just means there's

[00:29:26] a new exciting idea that

[00:29:28] a lot of money is flowing

[00:29:29] into.

[00:29:30] And the other thing we

[00:29:31] should we should mention

[00:29:31] here is there are some

[00:29:32] arguments now that we

[00:29:34] talked about how long

[00:29:35] term the time frame is

[00:29:36] where valuation matters.

[00:29:37] There's arguments now

[00:29:38] that that's getting

[00:29:38] longer.

[00:29:39] There's also arguments

[00:29:40] right now that that

[00:29:40] doesn't exist, that

[00:29:41] doesn't matter at all.

[00:29:43] I'm not a believer in

[00:29:44] that, but it is, you

[00:29:45] know, it's interesting

[00:29:46] to review that kind of

[00:29:46] stuff.

[00:29:46] Like if you look at Mike

[00:29:47] Green's work about the

[00:29:49] idea that is more and

[00:29:49] more people become

[00:29:50] passive, their money

[00:29:52] just goes into the

[00:29:53] market when they when

[00:29:54] they fund their 401Ks

[00:29:55] every month.

[00:29:55] The money goes in the

[00:29:56] market.

[00:29:57] They could care less about

[00:29:57] what the valuation is.

[00:29:59] We have more and more

[00:29:59] money flowing into the

[00:30:00] market that doesn't

[00:30:01] care about valuation.

[00:30:02] That may mean valuation

[00:30:05] based strategies have to

[00:30:06] extend their time frame.

[00:30:07] It also may mean that

[00:30:08] valuation doesn't matter.

[00:30:10] So, you know, and we've

[00:30:11] talked to Ben Hunt about

[00:30:12] narrative and there's

[00:30:13] just a lot of stuff

[00:30:14] to keep in mind that

[00:30:15] there are maybe some

[00:30:15] more reasons to question

[00:30:17] whether valuation will

[00:30:18] work the way it has

[00:30:19] historically right now.

[00:30:21] And that's for a

[00:30:21] different podcast, but I

[00:30:22] think it's at least

[00:30:23] important to bring that

[00:30:24] in because we do see

[00:30:25] these valuations in

[00:30:25] the S&P 500 going up.

[00:30:27] And if Mike Green's

[00:30:28] right, I mean, a lot

[00:30:28] of the driver of that is

[00:30:29] people that are just

[00:30:30] investing in their

[00:30:31] 401ks and are not

[00:30:32] sitting there evaluating

[00:30:33] what is the P E ratio

[00:30:34] of Nvidia.

[00:30:35] They're just saying

[00:30:36] money hit my account.

[00:30:37] I need to invest the

[00:30:38] money.

[00:30:38] Here's my default option.

[00:30:39] The money goes in,

[00:30:40] I'm driving up

[00:30:41] Nvidia more.

[00:30:42] Maybe fundamentals

[00:30:43] are mattering less

[00:30:44] in that scenario.

[00:30:46] Maybe they do,

[00:30:47] maybe they don't.

[00:30:47] Over time, I still

[00:30:49] am a believer that

[00:30:50] it's going to help.

[00:30:51] And people like Mike

[00:30:52] Green and whatever else

[00:30:53] can think about this

[00:30:54] way more artfully

[00:30:55] than I can.

[00:30:57] Do you want to talk

[00:30:58] a little bit more about

[00:30:59] just calculating the

[00:31:00] P E ratio of a portfolio?

[00:31:04] So if you own a bunch

[00:31:05] of stuff, how that works?

[00:31:06] Yeah.

[00:31:06] Well, I'm in the,

[00:31:07] I'm a big fan, as you

[00:31:07] know, of the All In podcast,

[00:31:09] which I admit publicly

[00:31:11] sometimes.

[00:31:12] But anyway, they always

[00:31:13] have the science corner

[00:31:14] in that.

[00:31:15] And so I think

[00:31:16] occasionally with these

[00:31:17] podcasts, we have to

[00:31:17] have like Jack's nerd

[00:31:18] corner because we're

[00:31:20] taking a little bit

[00:31:21] of a U-turn here.

[00:31:22] We're turning maybe

[00:31:22] a little bit to the

[00:31:23] left or the right,

[00:31:24] but I think this is

[00:31:24] important to bring up

[00:31:25] just because people do

[00:31:26] this wrong so much.

[00:31:28] People who, let's say

[00:31:29] Matt has a 10 stock

[00:31:30] portfolio and Matt

[00:31:31] wants to figure out

[00:31:32] what the P E ratio

[00:31:33] of his portfolio is.

[00:31:34] What Matt cannot do

[00:31:35] is take those 10 P E

[00:31:37] ratios, average them

[00:31:38] and say that is the

[00:31:39] P E ratio of my portfolio.

[00:31:40] That is wrong.

[00:31:42] What you have to do-

[00:31:42] Wait, but can I call

[00:31:44] in to a television

[00:31:46] show and ask if

[00:31:47] I'm diversified?

[00:31:47] Is that still okay?

[00:31:48] You can do that.

[00:31:49] Yeah.

[00:31:49] I mean, I don't have it.

[00:31:50] But only if I have five

[00:31:50] stocks.

[00:31:51] I don't have the red

[00:31:51] buzzer, unfortunately.

[00:31:53] Maybe we need to get me

[00:31:54] a buzzer for this.

[00:31:55] I don't know if we've

[00:31:55] got budget with the,

[00:31:56] I don't know if you've

[00:31:57] been following the

[00:31:58] budget of the podcast,

[00:31:58] but the ad revenue

[00:32:00] may not be much enough

[00:32:01] for a buzzer at this point,

[00:32:02] but I would love to have

[00:32:02] one at some point.

[00:32:04] We'll get you that buzzer.

[00:32:06] So sorry.

[00:32:06] Go on.

[00:32:07] If I have a 10 stock

[00:32:08] portfolio, why can't

[00:32:09] I just take the 10 P E's

[00:32:11] out of Yahoo Finance

[00:32:12] on a spreadsheet and just

[00:32:13] put them in Excel

[00:32:15] using Microsoft now

[00:32:16] and using all the good

[00:32:17] companies and hitting

[00:32:18] just average?

[00:32:19] Yeah.

[00:32:19] So what you need to do

[00:32:20] is you need to reverse it.

[00:32:21] And so what you need

[00:32:22] to do is calculate-

[00:32:23] You need to take the

[00:32:24] earnings yield

[00:32:24] of each position.

[00:32:25] And so the earnings

[00:32:26] yield is effectively

[00:32:26] just the inverse

[00:32:28] of the P E ratio.

[00:32:29] So if what you were to do

[00:32:30] is take the earnings yield

[00:32:32] of all of your positions,

[00:32:34] if you were to average those

[00:32:35] or if there are different

[00:32:36] weights, you use the

[00:32:37] weights in there

[00:32:38] and then average that out.

[00:32:40] That gives you the earnings

[00:32:41] yield of your portfolio

[00:32:42] and then you can invert

[00:32:43] that final result back

[00:32:44] into a P E ratio.

[00:32:46] So again, we don't need

[00:32:47] to get into all the

[00:32:47] details about this.

[00:32:48] I mean, it's-

[00:32:48] We're going to-

[00:32:49] People are going to fall asleep,

[00:32:50] but it's just important

[00:32:51] to do that because people

[00:32:52] do that all the time.

[00:32:53] They say like, you know,

[00:32:54] here's my holdings.

[00:32:55] Let's take the average

[00:32:56] of all those positions.

[00:32:57] So therefore there's the P E

[00:32:59] ratio of my portfolio.

[00:33:00] Even you've seen like,

[00:33:01] I've seen professional

[00:33:02] money managers on Twitter

[00:33:03] who do that, who actually

[00:33:04] do that calculation

[00:33:05] with their own portfolio

[00:33:07] and do it incorrectly.

[00:33:07] So I think it's just important

[00:33:09] to have the quick

[00:33:09] Jack's nerds corner

[00:33:10] to say this is not

[00:33:12] the way we do it.

[00:33:12] And then we can transition

[00:33:13] back to the body

[00:33:14] of the podcast.

[00:33:15] No, no, stay, stay

[00:33:16] nerdy for one more second.

[00:33:17] So just explain.

[00:33:20] There's different times-

[00:33:21] This can be way more awry

[00:33:23] in certain circumstances

[00:33:24] than others where it can

[00:33:25] actually kind of at least rhyme.

[00:33:27] Do you want to give an example

[00:33:28] or do you have a story

[00:33:29] about where this-

[00:33:31] Can you show just how bad

[00:33:32] this can get if you don't

[00:33:33] do the inversion again,

[00:33:35] fractions, it's full screen math.

[00:33:36] That is the big problem.

[00:33:38] Right.

[00:33:38] You know, it's about

[00:33:39] our contribution

[00:33:39] to the outliers

[00:33:40] of the big problem.

[00:33:40] So when you end up

[00:33:41] with the stock

[00:33:42] with a 300 P E

[00:33:42] in your portfolio,

[00:33:44] that's where you're going to end up

[00:33:45] being really, really wrong.

[00:33:46] You're right.

[00:33:47] And if they're all very similar,

[00:33:48] you know, you might

[00:33:49] get a similar result.

[00:33:49] I mean, it's still wrong,

[00:33:51] but you might at least

[00:33:52] be in the ballpark of it.

[00:33:53] But if it's the outliers

[00:33:54] can really screw this up.

[00:33:56] So it's just important.

[00:33:57] You can go, you know,

[00:33:58] we won't get into all the details

[00:33:59] and you can go to like,

[00:34:00] I think Jake at economic

[00:34:01] has a really good blog

[00:34:02] about this, where he went through

[00:34:04] the entire explanation

[00:34:05] of why it works

[00:34:05] and why you have to do it this way

[00:34:06] and all that stuff.

[00:34:07] But it's just a really

[00:34:08] interesting thing

[00:34:10] because I think it's one of those things

[00:34:11] that most people do get wrong.

[00:34:13] And even to this day,

[00:34:14] like you'll see people doing this

[00:34:15] and it just ends up

[00:34:16] with a conclusion

[00:34:16] that's just completely wrong.

[00:34:18] Now, if market valuation

[00:34:19] doesn't matter anyway,

[00:34:20] it doesn't matter.

[00:34:21] I mean, if I calculate my P

[00:34:22] ratio, my portfolio 60

[00:34:23] and it really is 30, like.

[00:34:25] Oh, well, I can't really

[00:34:26] do much of that anyway,

[00:34:27] but it's at least

[00:34:27] if you're going to calculate something,

[00:34:29] you at least want to try

[00:34:29] to calculate in the correct way.

[00:34:31] And this is one of those things

[00:34:33] where the person telling you

[00:34:34] the thing and how they're

[00:34:35] calculating it.

[00:34:36] If you have an awareness

[00:34:37] of how this is being

[00:34:37] constructed and done,

[00:34:39] then you can at least spot

[00:34:42] hopefully a little bit better

[00:34:43] if somebody's selling

[00:34:43] you a bill of goods.

[00:34:44] Jack, take us now.

[00:34:46] Look, let's

[00:34:47] let's look at individual

[00:34:48] segments here.

[00:34:49] We don't have to get super,

[00:34:50] super narrow into sectors,

[00:34:52] but let's just let's look at

[00:34:53] valuations by segment,

[00:34:54] because this is another thing

[00:34:55] that I think.

[00:34:57] People who don't look

[00:34:58] at this stuff regularly

[00:34:59] get lost in the weeds

[00:35:00] real fast on this.

[00:35:02] Yeah, so this is interesting.

[00:35:03] So obviously we've looked

[00:35:04] at the overall market valuation,

[00:35:06] but there's also ways

[00:35:07] to look at what is the valuation

[00:35:09] inside of the market.

[00:35:10] And you'll see value

[00:35:11] guys like me do this all the time,

[00:35:12] which is we operate

[00:35:14] like with this this idea of deciles

[00:35:15] or quartiles or whatever

[00:35:16] we want to use, which is

[00:35:17] we segment out

[00:35:19] the most expensive

[00:35:20] stocks in the market

[00:35:20] and we segment out

[00:35:22] the cheapest stocks in the market

[00:35:23] and then we say, how do those

[00:35:24] segments valuations compare

[00:35:26] to what they have been historically?

[00:35:28] So I can look at just

[00:35:30] the cheapest 10%

[00:35:30] or the cheapest 20% of the market

[00:35:32] and I can say,

[00:35:33] what's the median P in there?

[00:35:35] So again, to the point

[00:35:37] before where we said,

[00:35:38] you know, you've got

[00:35:39] the overall market

[00:35:40] a certain valuation.

[00:35:40] You've got your average

[00:35:41] stock at a certain valuation.

[00:35:43] You can also have these segments

[00:35:44] at a very different valuation

[00:35:45] and all of those could paint

[00:35:46] very different pictures.

[00:35:47] And so what this conclusion is

[00:35:49] and you can kind of see

[00:35:50] this in the chart is

[00:35:51] when you start to look at value

[00:35:52] versus growth,

[00:35:53] what you find right now

[00:35:55] is that value is very cheap

[00:35:57] relative to its history

[00:35:58] and growth is very expensive

[00:36:00] relative to its history.

[00:36:01] So you can see here before we saw

[00:36:03] with this median type valuation,

[00:36:04] we saw kind of an average

[00:36:06] number of 20,

[00:36:07] which is sort of

[00:36:07] what it has been since 2005.

[00:36:09] When you get into value,

[00:36:10] you're starting to see

[00:36:11] undervaluation here.

[00:36:12] You're starting to see stocks

[00:36:14] have only been cheaper

[00:36:15] 25% of the time.

[00:36:16] So you're starting

[00:36:17] to see a cheaper thing.

[00:36:18] And we could go

[00:36:18] through different metrics

[00:36:19] and show even

[00:36:20] cheaper things in this.

[00:36:20] Like if I were to add

[00:36:21] small cap to this,

[00:36:23] it would get even cheaper

[00:36:24] small cap value

[00:36:25] because size is cheap now too.

[00:36:26] Small cap values,

[00:36:27] even cheaper relative to history.

[00:36:29] But this is this idea

[00:36:30] of value spreads

[00:36:31] that you see all of us

[00:36:31] talk about all the time,

[00:36:32] which is what is the valuation

[00:36:34] of the cheapest stocks in the market?

[00:36:35] What is the valuation

[00:36:36] of the most expensive

[00:36:37] stocks in the market?

[00:36:38] And how do they compare

[00:36:39] to each other?

[00:36:40] And that becomes the value spread.

[00:36:41] So if I switch this to growth now,

[00:36:43] which are going to see

[00:36:44] is the opposite picture.

[00:36:45] You're going to see

[00:36:46] growth stocks are very expensive.

[00:36:48] So that idea of the spread

[00:36:50] that we talk about all the time

[00:36:51] is what is the valuation

[00:36:52] of growth stocks?

[00:36:53] What is the valuation of value stocks?

[00:36:54] So if you just looked at

[00:36:55] overall market valuation,

[00:36:57] you might miss that

[00:36:58] because you wouldn't see that spread.

[00:36:59] That spread just blends

[00:37:00] into the overall valuation.

[00:37:01] But for those of us

[00:37:02] that are looking for opportunities

[00:37:03] in the market,

[00:37:04] you can look at that

[00:37:05] and you can say, you know,

[00:37:06] what is that opportunity

[00:37:07] relative to what it has been historically?

[00:37:09] And we'll talk again

[00:37:09] about what this actually means.

[00:37:11] But you can see our value

[00:37:13] stocks cheap relative

[00:37:13] to growth stocks

[00:37:14] relative to history.

[00:37:16] It's also fascinating too,

[00:37:18] because in that

[00:37:20] while we split

[00:37:20] into growth and value,

[00:37:22] there's a lot of different

[00:37:23] definitions of growth and value.

[00:37:26] So understanding which companies

[00:37:28] are getting lumped into that thing,

[00:37:30] how they dance back and forth.

[00:37:32] I mean, I know with the Vlidia tool

[00:37:33] you can actually scrub

[00:37:34] through a lot of the ETFs

[00:37:35] and see some of

[00:37:37] at least understand

[00:37:37] some of the holdings that I believe.

[00:37:39] Jack, you want to just comment on

[00:37:41] all the different valuation

[00:37:43] and methodologies

[00:37:44] of constructing these indices?

[00:37:47] That's really interesting as well.

[00:37:48] You know, when you when you think about

[00:37:50] I mean, I think it's S&P

[00:37:50] and Russell are the two, right?

[00:37:51] That have the big

[00:37:52] growth and value indices,

[00:37:53] if I've got it right.

[00:37:54] Those are the biggest two,

[00:37:55] I think.

[00:37:56] Yeah.

[00:37:56] Yeah.

[00:37:56] And when you look at that,

[00:37:58] like how those are constructed

[00:37:59] can be very, very different.

[00:38:00] Like some of sometimes

[00:38:02] a stock is either a growth

[00:38:03] or a value stock.

[00:38:04] Like they segment them out

[00:38:06] to one or the other.

[00:38:07] Sometimes they can be in both.

[00:38:08] They use completely

[00:38:09] different calculations

[00:38:10] in terms of what are the ratios?

[00:38:12] Going back to your point

[00:38:13] about the denominator before.

[00:38:14] What are the ratios that determine

[00:38:16] whether a stock is value or growth?

[00:38:17] Because one of the interesting things,

[00:38:19] if you go to just pure

[00:38:20] academic data

[00:38:21] that a lot of people get wrong is,

[00:38:23] well, what's the difference

[00:38:23] between value and growth

[00:38:25] in pure economic

[00:38:26] pure like academic data?

[00:38:27] It's valuation.

[00:38:28] It's not growth.

[00:38:30] It's not what the earnings

[00:38:31] are growing at

[00:38:32] or what the sales are growing at.

[00:38:33] When an academic tells you

[00:38:34] about the growth decile,

[00:38:35] they're talking about expensive stocks.

[00:38:37] Now, in general,

[00:38:38] you would expect expensive stocks

[00:38:40] probably are growing

[00:38:41] faster than cheap stocks,

[00:38:42] but it's not done that way directly.

[00:38:44] And you can kind of see

[00:38:45] the same thing in the indexes.

[00:38:46] Like there are some growth metrics

[00:38:48] in there, but a lot of times

[00:38:49] a big driver of it

[00:38:50] is the stock expensive

[00:38:51] or is the stock cheap?

[00:38:52] So again, going back to the devils

[00:38:53] and the details,

[00:38:54] just always important to look at

[00:38:55] what's going on in terms of

[00:38:56] how these things are constructed

[00:38:58] because the conclusion

[00:38:59] can be very, very different.

[00:39:01] And not only that stuff moves,

[00:39:03] so like Apple

[00:39:05] is a value stock

[00:39:07] a handful of years ago

[00:39:08] and a growth stock again now.

[00:39:09] Microsoft, a value stock

[00:39:10] a handful of years ago

[00:39:11] by many of the classification,

[00:39:13] a growth stock again now

[00:39:15] as these things shift

[00:39:16] and especially because price

[00:39:17] can often shift a lot faster

[00:39:19] than especially trailing

[00:39:20] 12 month data.

[00:39:22] These names can flip where they are,

[00:39:25] depending on what you're doing

[00:39:26] at a broader level

[00:39:27] and constructing your portfolios.

[00:39:29] You're thinking about this stuff

[00:39:31] that can be a little bit of a headspin.

[00:39:33] So for those who choose

[00:39:35] to slice and dice

[00:39:36] and think about things

[00:39:37] on these terms,

[00:39:38] understanding again

[00:39:40] the composition of those numerators

[00:39:41] and denominators

[00:39:42] can go a really, really long way.

[00:39:45] And it's also as

[00:39:46] companies mature, they change.

[00:39:48] So a lot of people

[00:39:49] like associate technology, growth, expensive.

[00:39:51] But a lot of these technology companies

[00:39:53] now there's cutting edge

[00:39:54] technology companies

[00:39:55] that are way on the growth spectrum.

[00:39:57] But a lot of these big names,

[00:39:58] the medas of the world

[00:39:59] that we've gotten to know

[00:40:00] have over time

[00:40:01] and not maybe not as much

[00:40:02] because they've had big runs recently,

[00:40:03] but have over time

[00:40:04] shifted more towards the value area

[00:40:06] because those are big

[00:40:07] and mature companies

[00:40:08] that are growing at more normal rates now

[00:40:10] and they're going to trade

[00:40:11] at more reasonable valuation.

[00:40:13] So it's whenever you see a company

[00:40:15] that you've kind of grown up knowing

[00:40:17] like meta or something like that.

[00:40:19] You want to refer to it.

[00:40:20] You want to think of it

[00:40:21] as a certain type of company,

[00:40:22] like meta is a growth company.

[00:40:23] But all the growth companies

[00:40:25] over time typically will migrate

[00:40:27] towards value because just

[00:40:29] as they get bigger and bigger,

[00:40:30] it just becomes hard to grow

[00:40:31] at those kind of rates.

[00:40:33] And again, the point you just made

[00:40:36] two points ago about

[00:40:38] a growth company

[00:40:39] has a growth valuation.

[00:40:41] It doesn't actually mean

[00:40:42] it's just growing.

[00:40:43] So as companies get bigger,

[00:40:45] the ability to grow

[00:40:47] an increasingly larger ship

[00:40:48] is just definitionally harder.

[00:40:49] Just simple as that doesn't mean

[00:40:52] they can still have big price swings

[00:40:54] when they crack a new market

[00:40:57] or they crack a new idea

[00:40:58] or something that rewards them.

[00:41:00] The other one of the place

[00:41:02] you can really use this

[00:41:03] and learn from this

[00:41:04] is when you compare countries.

[00:41:06] So for instance,

[00:41:07] we'll all talk about

[00:41:08] how emerging market stocks are cheap

[00:41:10] and they are cheap.

[00:41:11] But the one thing

[00:41:12] you have to keep in mind is

[00:41:12] you have to think

[00:41:13] about sector composition.

[00:41:14] And this is again

[00:41:15] the devil's in the details

[00:41:17] the US market has a lot of technology,

[00:41:20] like rapidly growing

[00:41:21] technology companies.

[00:41:22] Emerging markets are much more resource

[00:41:24] and cheaper type stocks heavy.

[00:41:27] So if I don't correct

[00:41:28] for difference,

[00:41:29] they're going to seem way cheaper

[00:41:30] than they actually are

[00:41:31] relative to the US.

[00:41:33] So now even when you correct

[00:41:34] for the difference,

[00:41:34] they're still cheap.

[00:41:35] But the point is

[00:41:36] you'll see these crazy things

[00:41:37] talking about how the US

[00:41:38] is the most of the one percent

[00:41:40] most expensive it's ever been

[00:41:41] relative to emerging markets.

[00:41:43] That might be true,

[00:41:44] but you want to make

[00:41:45] those adjustments first.

[00:41:46] You want to say

[00:41:47] what type of sector

[00:41:48] composition am I looking at

[00:41:49] in emerging markets?

[00:41:50] What type of sector

[00:41:51] composition am I looking

[00:41:52] at the United States?

[00:41:53] Let's normalize that

[00:41:54] and then let's do a comparison

[00:41:55] and say, are they really still cheap?

[00:41:57] Yeah, if you start saying

[00:41:59] this is cheap relative to that,

[00:42:00] but forget to say, well,

[00:42:02] these are a bunch of poorly run

[00:42:04] banks and energy companies.

[00:42:06] Try you're never going to make

[00:42:08] apples to apples comparisons here,

[00:42:10] but just making sure

[00:42:11] you're at least doing like

[00:42:12] apples to oranges

[00:42:13] and understanding your comparisons,

[00:42:14] especially when using

[00:42:16] valuation across stocks.

[00:42:18] Very, very much worth

[00:42:20] the step to understanding

[00:42:21] what you're buying.

[00:42:22] Otherwise, you could find yourself

[00:42:24] on a purely valuation

[00:42:25] driven argument saying,

[00:42:26] well, why isn't everything in

[00:42:28] this other part of the world

[00:42:29] that's so attractively valued?

[00:42:30] And if the reality is

[00:42:31] because it's a bunch of really

[00:42:32] crappy mining companies or something.

[00:42:36] You can find those

[00:42:37] in your home country sometimes too.

[00:42:38] Or even you should have a reason

[00:42:40] where you want to go

[00:42:41] or even like the state

[00:42:41] owned enterprises,

[00:42:42] like those things are always messy.

[00:42:43] Like I mean, Russia

[00:42:44] was very, very cheap.

[00:42:45] Russia was like dirt cheap

[00:42:47] before the entire thing collapsed.

[00:42:49] So it's just important

[00:42:50] to understand what you're getting

[00:42:52] inside of that valuation.

[00:42:53] It's not like you can just take

[00:42:55] Russia's valuation

[00:42:55] and compare it to the US

[00:42:56] and be like it trades

[00:42:57] at five times earnings

[00:42:58] in the US trades at 30.

[00:43:00] So therefore,

[00:43:00] Russia is a very attractive.

[00:43:02] There's there's a lot of more

[00:43:03] details that go in there,

[00:43:04] both in terms of the risks

[00:43:05] in the countries,

[00:43:05] but also the composition

[00:43:06] of the index and what

[00:43:07] what you're actually getting

[00:43:09] in terms of the companies.

[00:43:10] Like another interesting

[00:43:11] example is like Korea.

[00:43:13] It's like Samsung is a

[00:43:14] massive part.

[00:43:15] I don't know

[00:43:16] what the actual number is now,

[00:43:17] but like of those Korean indexes,

[00:43:18] like Samsung is a huge, huge part.

[00:43:21] So that's another example

[00:43:22] of what you've got to look at.

[00:43:22] Like one company

[00:43:23] and we've got concentration

[00:43:24] in the US,

[00:43:25] like if nothing compared

[00:43:26] to what some other places have.

[00:43:27] So you just got to be looking

[00:43:29] at what you're getting

[00:43:30] and understanding that

[00:43:31] when you evaluate

[00:43:32] any kind of valuation data.

[00:43:34] What happens when we step back

[00:43:35] and we don't just look at stocks,

[00:43:37] but we look at stocks

[00:43:38] relative to bonds, for example,

[00:43:40] and apply valuations.

[00:43:41] How do you think about that

[00:43:42] as a quant?

[00:43:42] It's just always important

[00:43:43] to think about there.

[00:43:44] There is a trade off there

[00:43:45] between stocks and bonds

[00:43:46] like Bob Elliott had a really

[00:43:47] interesting tweet the other day

[00:43:48] where it was like stocks

[00:43:49] went down slightly,

[00:43:50] but they got more expensive.

[00:43:51] And the reason they got more expensive

[00:43:53] because bond valuations

[00:43:54] or bond yields had gone up.

[00:43:56] So it's just always important

[00:43:57] to think there is a trade off

[00:43:58] like between long term bonds,

[00:44:00] short term bonds, stocks,

[00:44:02] all of that stuff.

[00:44:02] There's a trade off that exists.

[00:44:03] And when you're

[00:44:04] when you're investing in stocks,

[00:44:06] you have to consider

[00:44:07] that trade off.

[00:44:08] Obviously, if I could get 15%

[00:44:10] on a short term bond,

[00:44:11] which I can't right now,

[00:44:12] but let's say I could

[00:44:13] that changes my view

[00:44:15] of whether I should be

[00:44:16] investing in stocks.

[00:44:17] And so that, again,

[00:44:18] is another point to keep in mind.

[00:44:19] Like all these charts

[00:44:20] we've shown so far,

[00:44:22] they don't consider bonds

[00:44:23] as an alternative to stocks.

[00:44:24] But it is important

[00:44:25] to at least keep that in mind

[00:44:27] and to at least understand

[00:44:28] that that that's out there.

[00:44:29] And, you know,

[00:44:30] the earnings yield of stocks

[00:44:31] relative to the yields of bonds,

[00:44:33] you can show some charts around that.

[00:44:34] And that's always

[00:44:34] interesting to compare.

[00:44:36] And sometimes when you see something

[00:44:37] in the types of valuation

[00:44:38] data we showed first,

[00:44:40] like the valuation of stocks,

[00:44:41] when you put that bond data

[00:44:43] in there as well,

[00:44:44] it helps to explain it

[00:44:45] a little bit more than maybe

[00:44:46] just having the stock

[00:44:47] date on its own.

[00:44:49] Cross asset class valuations are.

[00:44:54] I'll make myself save it

[00:44:55] for just another topic

[00:44:57] we'll get to,

[00:44:58] I'm sure, in a minute.

[00:44:59] They're they're useful

[00:45:01] to understand what valuation metrics,

[00:45:03] which numerators and denominators

[00:45:05] you're going to use

[00:45:06] both within an asset class

[00:45:08] or within a sector

[00:45:09] or within a portfolio

[00:45:10] or whatever it is

[00:45:11] where you know

[00:45:12] I'm comparing businesses

[00:45:13] to other businesses in some way.

[00:45:15] You want to know

[00:45:16] what's in the numerator

[00:45:17] denominators there.

[00:45:19] Same thing when you're looking at bonds.

[00:45:21] Bob Elliott example stands

[00:45:22] like you can look at stuff

[00:45:23] relative to other bonds

[00:45:25] relative to itself

[00:45:26] to make sense

[00:45:27] inside of that asset class.

[00:45:28] As soon as you start to compare

[00:45:30] across asset classes,

[00:45:31] you're going to need

[00:45:32] some extra math.

[00:45:33] You're going to need

[00:45:33] some extra thought

[00:45:34] to understand how these things act together

[00:45:36] and then what you're even going

[00:45:38] to do with this information.

[00:45:39] Because if you think one thing is rich

[00:45:41] and one thing is cheap,

[00:45:42] it doesn't necessarily mean

[00:45:44] that it's cheap and rich

[00:45:45] relative to each other

[00:45:47] or just cheap and rich inside

[00:45:48] rich inside of that silo

[00:45:50] or if you should rebalance

[00:45:51] or if you should hold off

[00:45:53] because this historically

[00:45:53] happens every so often.

[00:45:55] There's a lot of nuance there.

[00:45:57] Useful to understand how to do it.

[00:46:00] But what you're going to do

[00:46:01] with that information becomes,

[00:46:02] I think, even more critical

[00:46:04] in that perspective.

[00:46:05] That's kind of become

[00:46:06] the theme of this episode,

[00:46:07] which is all of this stuff.

[00:46:08] You know, it's all interesting

[00:46:09] to look at.

[00:46:10] But like what you do with it

[00:46:11] is so important.

[00:46:12] And if you try to do

[00:46:13] short term things with it,

[00:46:15] typically it's going to go against you.

[00:46:17] Or if it goes for you,

[00:46:18] you're going to be lucky.

[00:46:19] And that's again the idea

[00:46:20] of you just have to know

[00:46:21] what is like the time frame

[00:46:22] of this signal

[00:46:23] and then what is the time frame

[00:46:24] of what I'm trying to do

[00:46:25] with changes to my portfolio

[00:46:26] and do they match up?

[00:46:28] That's an important question

[00:46:28] to ask no matter what I think.

[00:46:31] So we're getting closer

[00:46:32] to the financial

[00:46:33] planning aspects of this

[00:46:34] that I'll weigh in on some of.

[00:46:35] But let's talk about

[00:46:37] the link between valuation

[00:46:39] and expected returns,

[00:46:40] because I think this wraps us back around

[00:46:42] to that time horizon

[00:46:43] bet you mentioned a couple of times so far.

[00:46:45] What's what's the link

[00:46:47] between valuations

[00:46:48] and expected returns?

[00:46:49] Yeah, so there's other components

[00:46:50] of expected returns.

[00:46:50] But one of the components

[00:46:51] when you see, you know,

[00:46:52] research affiliates

[00:46:53] has a good site

[00:46:53] that does other places do it.

[00:46:55] When people calculate

[00:46:56] these expected returns,

[00:46:57] they typically one of the components

[00:46:59] of that is valuation.

[00:47:00] And what they're assuming is

[00:47:02] basically the market has had

[00:47:03] some sort of valuation over time

[00:47:05] when the market is expensive

[00:47:07] relative to that evaluation.

[00:47:08] They're assuming it's going to come back

[00:47:10] towards that when it's cheap.

[00:47:12] They're assuming it's going to come

[00:47:13] back up towards it, too.

[00:47:14] So when the market is expensive,

[00:47:16] you're assuming value

[00:47:17] expected returns are going to fall

[00:47:19] because that's going to be a drag

[00:47:20] and moving back to sort of

[00:47:21] a more normal valuation

[00:47:22] is going to be a drag.

[00:47:23] And when it's cheap,

[00:47:24] it works in the opposite direction.

[00:47:25] And so you'll typically see

[00:47:27] like I think research affiliates,

[00:47:28] I think it's like seven to 10 years.

[00:47:29] I think that's around

[00:47:30] where they do expected returns.

[00:47:32] So again, going back

[00:47:33] to what we talked before,

[00:47:34] like this is this is useless

[00:47:35] for one year, two years, three years.

[00:47:37] But over seven to ten years,

[00:47:38] they decide that how is that

[00:47:41] valuation going to impact

[00:47:42] the expected return of

[00:47:43] not just the market,

[00:47:44] but they'll do it, you know,

[00:47:45] in all kinds of emerging

[00:47:46] market stocks, value stocks,

[00:47:48] all kinds of different things,

[00:47:49] different asset classes.

[00:47:50] And so in stocks specifically,

[00:47:52] it's just important

[00:47:52] to keep that in mind

[00:47:53] because what happens is

[00:47:55] valuation is a component

[00:47:56] of those expected returns

[00:47:58] and it can lead to like right now

[00:47:59] I think they're showing

[00:48:00] like for U.S. stocks,

[00:48:01] a very poor expected return.

[00:48:04] Now for value stocks,

[00:48:05] they're showing a better return

[00:48:06] back to the point we talked about before

[00:48:07] where value stocks are cheap

[00:48:09] for emerging market stocks.

[00:48:10] They're showing an even better return

[00:48:11] back to the point we talked about

[00:48:12] before emerging market stocks are cheap.

[00:48:14] But so these can be a valuable tool

[00:48:16] in terms of just thinking

[00:48:17] about how the future might play out.

[00:48:20] But it's also important

[00:48:21] to keep in mind,

[00:48:21] these are wrong

[00:48:22] a lot of times as well.

[00:48:24] Even at seven to ten years,

[00:48:25] a lot of times this valuation

[00:48:26] does not revert

[00:48:27] in the way you think it's going to revert.

[00:48:29] I mean, if you think about

[00:48:29] that first chart I showed you

[00:48:31] where we were talking

[00:48:31] about the market valuation,

[00:48:32] like for the first entire half,

[00:48:34] I don't know what that

[00:48:34] that was back to almost like

[00:48:35] almost 1900, I think.

[00:48:37] Like the first half of that chart

[00:48:38] had a certain average valuation.

[00:48:40] The second half of that chart

[00:48:41] had a certain valuation

[00:48:42] that's much higher than the first half.

[00:48:43] If we had sat there expecting

[00:48:45] that to revert for over seven

[00:48:47] to ten years over and over

[00:48:49] and over again,

[00:48:49] we would have been wrong

[00:48:50] over and over and over again.

[00:48:52] So then this is a big issue

[00:48:53] these guys deal with.

[00:48:54] And we talked about to Rob Arnott

[00:48:55] about this when we interviewed him

[00:48:57] is like, what do you expect

[00:48:58] it to revert back to?

[00:49:00] Well, we've got this valuation

[00:49:02] that's the long term valuation.

[00:49:03] We've got this valuation

[00:49:04] of the past 30, 40 years.

[00:49:06] What do you do?

[00:49:07] And what a lot of people do

[00:49:08] is they kind of split

[00:49:09] the difference.

[00:49:10] They say, well, we're not sure,

[00:49:11] you know, evaluations

[00:49:12] are going to stay at this higher level

[00:49:14] that they've been in

[00:49:14] the past 30 or 40 years

[00:49:15] or if they're going to go back

[00:49:16] to this lower level.

[00:49:16] So let's kind of assume

[00:49:18] they're going to have,

[00:49:19] you know, they're going to revert

[00:49:19] to somewhere in the middle.

[00:49:20] But all of that plays a big role

[00:49:22] in these expected return calculations.

[00:49:23] So that was kind of a long answer.

[00:49:24] But expected returns

[00:49:26] can be interesting in terms of

[00:49:27] if I'm trying to figure out

[00:49:28] like what might happen

[00:49:29] in the next seven to ten years

[00:49:31] with stocks and if I'm

[00:49:32] an extreme situation

[00:49:33] where they're very cheap

[00:49:34] or they're very expensive,

[00:49:35] that can go into what you do.

[00:49:37] That can impact my financial plan.

[00:49:39] That can impact how I think about

[00:49:40] what the market might deliver me

[00:49:42] over the next decade.

[00:49:43] Tools like the research

[00:49:44] affiliates tool, tools like others

[00:49:46] and just understanding the math.

[00:49:48] It's a funny thing,

[00:49:50] but like 10 plus years ago,

[00:49:51] I think John Hussman was the one

[00:49:53] who actually wrote a series of posts

[00:49:55] walking through the expected returns

[00:49:57] based on assumptions, math.

[00:49:59] And it was an incredibly

[00:50:01] informative experience for me

[00:50:02] to like work through all the math.

[00:50:04] And build some spreadsheets

[00:50:05] that did this stuff because, yeah,

[00:50:07] it is a maybe I'm misusing the word.

[00:50:10] It's a mean reverting set.

[00:50:11] It's one of those things

[00:50:12] where it's like valuations

[00:50:14] do tend to have some impact

[00:50:16] on if you're average above average

[00:50:18] or below average in the years

[00:50:19] that go forward, usually

[00:50:21] somewhere between probably

[00:50:22] like five and 12 years.

[00:50:23] I think it's seven to ten

[00:50:24] on the research affiliate stuff.

[00:50:27] Where it gets really interesting

[00:50:29] is when you start

[00:50:30] to scale these things.

[00:50:31] And this is the

[00:50:32] financial planning aspect.

[00:50:33] We want to know what those forward

[00:50:35] return assumptions are

[00:50:38] looking forward in time

[00:50:39] with some type of valuation

[00:50:40] adjustment to the point

[00:50:41] you just made.

[00:50:42] We want to know our US

[00:50:45] large cap stocks,

[00:50:46] rich or cheap relative to history.

[00:50:48] And what's that assumption

[00:50:49] look like going forward

[00:50:51] so that we can make a comparison

[00:50:52] against US smaller

[00:50:54] mid-cap stocks,

[00:50:56] the real estate stocks,

[00:50:57] infrastructure companies

[00:50:59] inside the US,

[00:51:00] outside the US,

[00:51:01] big and small inside the US,

[00:51:03] outside the US,

[00:51:04] across the fixed income complex,

[00:51:06] across various types of

[00:51:08] adjusted further

[00:51:09] valuation metrics,

[00:51:10] private equity,

[00:51:11] private credit,

[00:51:12] private real estate,

[00:51:13] things like this too.

[00:51:15] The assumptions when we start

[00:51:17] to stack them up

[00:51:17] next to each other,

[00:51:19] then we start to think

[00:51:20] how can I rebalance

[00:51:21] between one or another

[00:51:22] if somebody is adding

[00:51:24] or taking money out?

[00:51:25] Because that's definitively

[00:51:26] a rebalancing scenario,

[00:51:28] not just like

[00:51:29] the portfolio exists

[00:51:30] and I'm rebalancing.

[00:51:31] But contributions

[00:51:32] and withdrawals,

[00:51:33] what's attractive,

[00:51:33] what's not and why

[00:51:35] over the horizon

[00:51:36] the person may need it

[00:51:37] for consumption or gifts.

[00:51:39] And especially as we start

[00:51:40] to look over longer time horizons,

[00:51:43] we want to be thinking about

[00:51:44] how does this play into

[00:51:46] everything from like

[00:51:47] estate planning

[00:51:48] to future consumption needs

[00:51:49] for years and years down the road.

[00:51:51] So when we think about that,

[00:51:52] are stocks rich right now?

[00:51:55] So if you're 25 years old

[00:51:56] and you're not even

[00:51:57] thinking about retirement,

[00:51:58] should you have money

[00:51:59] in stocks just because they're rich?

[00:52:03] If you're contributing money

[00:52:04] to your 401K,

[00:52:05] like, yeah, you

[00:52:06] you probably want that variance.

[00:52:08] You want to be on the right

[00:52:09] side of this thing,

[00:52:10] even though your current

[00:52:11] expected returns are low.

[00:52:13] You're trying to build up

[00:52:13] that nest egg in this category

[00:52:15] and you might overlook

[00:52:16] a bunch of these things.

[00:52:18] If you're 65

[00:52:19] and you're trying

[00:52:19] to plan for something,

[00:52:20] if you're the 70

[00:52:22] something year old client

[00:52:23] I was talking to this morning

[00:52:25] where we're paying for

[00:52:26] in-home health care

[00:52:28] and stuff like that,

[00:52:29] we have to approach

[00:52:30] these assumptions

[00:52:31] with a lot of granularity.

[00:52:33] We have to think, OK,

[00:52:35] mom still has these stock accounts.

[00:52:38] Equity valuations are up.

[00:52:40] We need this money for consumption.

[00:52:42] This is probably a good time

[00:52:44] to take certain things off the table.

[00:52:45] We just have to calculate taxes

[00:52:46] and all the other stuff

[00:52:47] that goes into the mix.

[00:52:49] Always pay your taxes, folks.

[00:52:51] This idea of understanding

[00:52:53] how to look cross asset classes

[00:52:55] and having a methodology

[00:52:57] for money as it's added

[00:52:59] or taken out

[00:52:59] or let to ride.

[00:53:02] That's a hugely, hugely important aspect

[00:53:04] of the financial planning process

[00:53:06] and it's hugely personal

[00:53:07] for anybody in their portfolio.

[00:53:09] How do you think about this

[00:53:10] like in terms of the overall market?

[00:53:11] Because it's interesting.

[00:53:12] Like if I if I

[00:53:13] let's say I've just got somebody

[00:53:14] who just invested in the S&P 500

[00:53:16] and I have to figure out

[00:53:17] like what are my return

[00:53:18] assumptions going forward?

[00:53:19] Like I could go about that

[00:53:20] in different ways.

[00:53:20] I could say, you know,

[00:53:21] the S&P 500 has delivered 10 percent

[00:53:23] or whatever it is

[00:53:25] over the long term

[00:53:25] and that's my return assumption.

[00:53:27] Or I could say

[00:53:27] I could go to a research affiliate site

[00:53:29] and I could say, you know,

[00:53:30] well, they're expecting two percent returns.

[00:53:32] So I need to make some adjustment.

[00:53:33] I mean, I would assume

[00:53:34] one thing that

[00:53:35] I think is important

[00:53:36] to keep in mind is like

[00:53:37] research affiliates

[00:53:37] is doing a seven to ten year assumption.

[00:53:40] As you lengthen that time frame,

[00:53:42] you probably get closer

[00:53:43] to the market average return.

[00:53:45] So that 30 years

[00:53:46] I'm going to be a lot closer

[00:53:47] to the market return.

[00:53:48] And a lot of people

[00:53:49] probably are planning

[00:53:50] for a 30 year retirement.

[00:53:52] So they probably don't want to get

[00:53:53] too wrapped up in this two percent

[00:53:55] seven to 10 year projection

[00:53:56] because over time

[00:53:57] that's going to at least blend

[00:53:58] in a little bit.

[00:53:59] But how do you think about that?

[00:54:02] So there's an interesting

[00:54:03] background component to this for me.

[00:54:06] And that's having done

[00:54:07] a lot of work in like building

[00:54:08] pension type portfolios,

[00:54:10] so liability driven investing mainly

[00:54:12] where you're looking at

[00:54:14] these shorter time horizons.

[00:54:15] So if you're looking at a three

[00:54:18] to five year or a three

[00:54:19] to seven year window

[00:54:21] in many cases doing like

[00:54:22] liability driven investing,

[00:54:24] getting ready for money

[00:54:25] that will be needed

[00:54:26] to be paid out to pensioners

[00:54:27] or whatever else.

[00:54:29] Those tools like what research affiliates

[00:54:31] and people that are building

[00:54:33] are actually really useful

[00:54:34] for those circumstances

[00:54:36] because you're trying to figure out

[00:54:37] how do I get to my four percent bogey

[00:54:39] or my five percent bogey

[00:54:40] or whatever it is,

[00:54:41] my hurdle rate for this pension

[00:54:42] that I got to hit

[00:54:43] over this finite period

[00:54:45] for most people who have like

[00:54:46] a 10 plus year time horizon

[00:54:48] on this stuff.

[00:54:49] It's a different approach.

[00:54:50] So separate this

[00:54:52] to be ultra clear about it.

[00:54:55] If you are doing

[00:54:56] liability driven investing

[00:54:57] and trying to fund some very specific

[00:54:59] goal on a sub 10 year period,

[00:55:01] you might want to think about it

[00:55:02] through the lens that

[00:55:03] research affiliates describes.

[00:55:05] Five, an extreme overvaluation.

[00:55:07] I might actually look

[00:55:08] at that forward return

[00:55:09] at two percent on stocks.

[00:55:11] Say I can instead lock that in

[00:55:12] in fixed income

[00:55:14] for my five year period

[00:55:15] that I need.

[00:55:16] And that might be the decision

[00:55:17] and all the math that I need to go

[00:55:19] don't need to own stocks in this.

[00:55:20] I can accomplish this thing

[00:55:22] with bonds

[00:55:23] based on the valuation assessment.

[00:55:24] It's just really not

[00:55:25] worth the risk at all.

[00:55:27] From a pure shorter term

[00:55:29] sub 10 year liability driven

[00:55:31] investing standpoint,

[00:55:32] that's really useful to know

[00:55:34] the math in those ways.

[00:55:35] Now, if I'm doing

[00:55:37] planning for a regular client

[00:55:39] or especially in when we get

[00:55:40] into the multi generational

[00:55:41] conversations,

[00:55:42] we have to do what you just said.

[00:55:43] We have to actually say

[00:55:45] the long term

[00:55:46] assumptions for stocks

[00:55:47] making the number up.

[00:55:48] If it's 10 percent,

[00:55:49] but I know stocks

[00:55:51] US large cap growth stocks

[00:55:53] or US large cap stocks

[00:55:54] are now a few shades

[00:55:56] above average

[00:55:58] and how they're valued.

[00:55:59] I might not want to use 10 percent

[00:56:01] anymore for that number.

[00:56:03] And we have a bunch of people

[00:56:04] who do a bunch of math

[00:56:04] about this and go

[00:56:06] we are in an overvalued

[00:56:07] historically environment.

[00:56:09] So instead of using

[00:56:10] the 10 percent number,

[00:56:11] maybe we're going to duck

[00:56:12] that down to 8 percent

[00:56:13] or 7 percent

[00:56:14] on the look forward

[00:56:15] for 10 plus year horizons.

[00:56:17] And we want that

[00:56:18] because now we can start

[00:56:19] to compare it to

[00:56:20] other asset classes.

[00:56:22] The expected correlation

[00:56:23] between those asset classes

[00:56:25] and the timing of future

[00:56:26] potential liabilities

[00:56:28] in that individual's plan.

[00:56:30] So shorter term

[00:56:31] liability driven investing,

[00:56:33] just trying to make sure

[00:56:34] we match up assets.

[00:56:35] These valuation tools

[00:56:36] can be really useful

[00:56:37] and what to hold

[00:56:38] and what to avoid

[00:56:39] over a longer term.

[00:56:40] You can usually use

[00:56:41] the long term assumptions,

[00:56:42] but you're going to duck tilt,

[00:56:44] whatever word you want to use

[00:56:45] in the direction informed somewhat

[00:56:47] by the valuations

[00:56:48] where they stand against history.

[00:56:50] And if you want to raise

[00:56:50] a little bit of caution,

[00:56:52] usually for new money

[00:56:53] coming in, new money coming out.

[00:56:55] So I have a 20 year time horizon.

[00:56:57] I'm not so worried about money

[00:56:59] coming into stocks

[00:57:00] relative to bonds

[00:57:00] because of that time horizon,

[00:57:01] I can take the variance.

[00:57:03] If I have a shorter time horizon,

[00:57:04] I might be going, OK,

[00:57:05] with that new money coming in

[00:57:07] because stocks are so richly valued,

[00:57:09] I might be looking at another

[00:57:11] piece of fixed income

[00:57:12] or making sure I invest more

[00:57:13] in small caps or something else

[00:57:15] because that manner

[00:57:16] marries itself better

[00:57:18] to the time horizon

[00:57:19] and the goal profile that I have.

[00:57:22] Did that make sense?

[00:57:23] Yes, it did.

[00:57:23] That's great

[00:57:24] because it kind of gets

[00:57:24] at the point we've been talking

[00:57:25] about the whole time is like

[00:57:26] all these tools.

[00:57:28] The tool is great.

[00:57:29] The information is great.

[00:57:30] What I do with it

[00:57:30] is the most important thing.

[00:57:31] You just gave a great example

[00:57:32] of how these expected returns,

[00:57:34] there's not one way to use

[00:57:35] these expected returns.

[00:57:36] They may or may not be relevant

[00:57:38] depending on what you're doing.

[00:57:39] They may be a lot more relevant.

[00:57:40] Like you said,

[00:57:41] if you have a shorter term time frame

[00:57:42] and you have given

[00:57:43] liabilities you have to meet,

[00:57:44] they may be a lot less relevant.

[00:57:46] If you're retiring tomorrow

[00:57:47] and you have a life expectancy

[00:57:48] of 30 years,

[00:57:49] they're going to be a lot less relevant.

[00:57:50] You shouldn't be like

[00:57:51] completely panicked

[00:57:52] about the 2 percent return.

[00:57:53] I don't know

[00:57:53] if it actually has 2 percent.

[00:57:54] I just made that up.

[00:57:55] I know it's a significantly lower

[00:57:57] than what the...

[00:57:57] It's like 4 percent or less though.

[00:57:59] Whatever it is.

[00:57:59] It's not good.

[00:58:01] Yeah, so it's just interesting

[00:58:02] like a different person

[00:58:03] with a different time frame

[00:58:05] with different liabilities

[00:58:06] in the future is going to think

[00:58:07] about these things

[00:58:08] in different ways.

[00:58:08] And I think that's probably

[00:58:09] the most important thing

[00:58:10] to take away from this is

[00:58:11] you look at the data,

[00:58:13] but also understand

[00:58:14] how is it relevant to me

[00:58:15] and how is it relevant

[00:58:16] to what I'm doing?

[00:58:17] And that might be very different

[00:58:18] than how it's relevant

[00:58:18] to someone else

[00:58:19] and what they're doing.

[00:58:21] And in many cases

[00:58:22] in the real world

[00:58:23] financial planning cases

[00:58:24] around this stuff,

[00:58:26] most people have a mix too.

[00:58:28] So you have a mix

[00:58:29] and you're going to go

[00:58:30] through different periods.

[00:58:31] So post financial crisis,

[00:58:34] you had all this

[00:58:34] pension reform happened.

[00:58:36] You had a giant movement

[00:58:37] for business owners.

[00:58:39] And this is pretty like

[00:58:42] if I just think about

[00:58:42] the last call it

[00:58:45] 12, 15 years here on this stuff.

[00:58:47] You have this giant

[00:58:48] pension reform

[00:58:49] post financial crisis,

[00:58:50] a bunch of business owners.

[00:58:51] All of a sudden it makes sense

[00:58:52] to not just have the 401k

[00:58:54] set up with the full profit sharing,

[00:58:56] but to bolt on these

[00:58:57] cash balance pension plans

[00:58:58] for extra tax deferral,

[00:59:00] depending on their time horizon.

[00:59:02] You were in a 0% world

[00:59:04] with like a 4% hurdle rate

[00:59:06] on these cash balance

[00:59:07] pension plans.

[00:59:08] So you had to do this

[00:59:09] liability driven investing thing

[00:59:11] inside of a place

[00:59:12] where you couldn't really use

[00:59:13] fixed income to get to your bogies

[00:59:15] that started to shift

[00:59:16] as interest rates shift.

[00:59:17] Now, as those things shift,

[00:59:18] then we have the tax cuts

[00:59:19] and jobs act,

[00:59:20] which now all of a sudden

[00:59:21] a lot of those same business owners

[00:59:22] are doing the consideration.

[00:59:24] Do I keep this in place

[00:59:25] and do I convert myself

[00:59:26] to an S corporation?

[00:59:27] Again, all the tax planning

[00:59:28] around what gets consumed,

[00:59:30] what doesn't,

[00:59:30] what gets deferred,

[00:59:31] what gets paid out later?

[00:59:32] How are we going to treat these things?

[00:59:34] Then we have COVID

[00:59:35] and small business valuations

[00:59:36] go through the roof.

[00:59:38] My point is you can have

[00:59:39] a business owner that's lived through

[00:59:41] like 16 different eras

[00:59:44] with 16 different asset classes

[00:59:45] and 16 different crazy assumptions

[00:59:48] that have changed wildly

[00:59:49] in this period of time.

[00:59:51] And that's just like

[00:59:52] in one client's life,

[00:59:53] they might have experienced

[00:59:54] all those things.

[00:59:56] These tools are useful

[00:59:58] and I'll go so far as to say like

[01:00:00] having a approach

[01:00:02] is actually essential.

[01:00:03] You want an advisor

[01:00:04] who can walk you through

[01:00:05] the different approaches

[01:00:06] that apply what,

[01:00:07] where, when and how.

[01:00:08] But then that why

[01:00:10] taking it back

[01:00:11] to what you're trying to achieve

[01:00:12] and how you want to do it,

[01:00:13] like that's all that's

[01:00:14] actually going to matter here.

[01:00:16] You have some logic

[01:00:17] to steer all this stuff through

[01:00:18] because it matters

[01:00:19] a heck of a lot more

[01:00:20] than the gap between

[01:00:21] US large cap growth

[01:00:23] value at the index level.

[01:00:25] That, I think, is the

[01:00:26] that's the ultimate concept

[01:00:28] behind this whole conversation.

[01:00:29] Yeah, I think that's great.

[01:00:30] And that's what you do

[01:00:30] a great job of these.

[01:00:31] Like again, we ended up

[01:00:33] connecting this to like

[01:00:34] a certain person's why

[01:00:35] in terms of what they're

[01:00:36] trying to do.

[01:00:37] And it's so we've looked

[01:00:38] at so many charts

[01:00:39] and valuations and stuff.

[01:00:40] But bringing it back

[01:00:41] to that is important

[01:00:42] because that's ultimately

[01:00:43] what matters.

[01:00:44] You know, for every person,

[01:00:45] how do I use this

[01:00:46] in terms of trying to achieve

[01:00:47] what I'm actually trying to achieve?

[01:00:49] And when you do that,

[01:00:50] you'll find most of this stuff

[01:00:52] we've talked about today.

[01:00:53] Most of this valuation data

[01:00:55] doesn't have that much impact,

[01:00:57] but it can be important

[01:00:58] to understand it.

[01:00:59] And especially when we got

[01:00:59] to the expected returns

[01:01:00] part at the end,

[01:01:01] like it does tell me

[01:01:03] a little bit about where we are

[01:01:04] as the market with the market

[01:01:05] and what I might expect,

[01:01:07] you know, coming forward

[01:01:08] in the next seven to 10 years.

[01:01:09] And that can be valuable

[01:01:10] for people just just

[01:01:12] to understand that,

[01:01:12] even if I'm not going

[01:01:13] to make changes to my portfolio

[01:01:14] tomorrow because of it.

[01:01:17] These are snapshots

[01:01:17] for points in time.

[01:01:18] They're worth understanding.

[01:01:20] I'm thinking about

[01:01:22] I'm thinking about like

[01:01:23] movie soundtracks,

[01:01:24] 90s movie soundtracks,

[01:01:25] lots of great 90s

[01:01:26] movie soundtracks.

[01:01:27] The Long Road,

[01:01:28] the excellent,

[01:01:29] excellent Eddie Vedder song

[01:01:30] that appears on Dead Man Walking.

[01:01:32] Crazy, crazy soundtrack,

[01:01:34] crazy movie.

[01:01:34] Susan Sarandon,

[01:01:35] who would have known it?

[01:01:36] You know, Rocky Horror

[01:01:37] to Dead Man Walking

[01:01:38] and all that stuff.

[01:01:39] Sean Penn, same thing.

[01:01:40] Sean Penn in prison.

[01:01:42] Lots of great Sean Penn prison movies.

[01:01:43] But here we have

[01:01:45] I think it was like

[01:01:45] you had Tom Waits.

[01:01:47] You had,

[01:01:48] you know, you have Eddie Vedder

[01:01:49] breaking out for Pearl Jam

[01:01:50] on the solo career.

[01:01:51] You have this fascinating stuff

[01:01:53] that happens for a brief moment in time.

[01:01:55] Valuations

[01:01:56] kind of like 90s

[01:01:57] movie soundtracks.

[01:01:58] And if there are even

[01:01:59] movie soundtracks anymore today,

[01:02:00] I don't even think I know.

[01:02:01] I think TV shows

[01:02:02] have more soundtracks than movies

[01:02:03] or at least playlists.

[01:02:04] But it's just

[01:02:05] they give you a measurement

[01:02:07] of a point in time.

[01:02:08] You got to figure out

[01:02:08] what you're going to do with it.

[01:02:09] Beyond that,

[01:02:10] it's entertainment.

[01:02:12] Well, I'm happy

[01:02:12] you brought in

[01:02:12] the pop culture reference

[01:02:13] because I can't wrap up

[01:02:14] the episode, as you know,

[01:02:15] until you did.

[01:02:16] So I could have rambled on

[01:02:17] for another hour.

[01:02:17] I would feel morally wrong

[01:02:19] if I didn't at least

[01:02:20] try to tie this back into,

[01:02:22] you know, our Lord and Savior

[01:02:23] Eddie Vedder.

[01:02:23] The viewers thank you

[01:02:24] because I was about to

[01:02:25] break up some more charts.

[01:02:26] So

[01:02:28] you prevented them

[01:02:28] having to do that.

[01:02:29] So

[01:02:30] but thank you, everybody,

[01:02:31] for joining us

[01:02:31] and we'll see you next time.

[01:02:49] Please subscribe

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[01:02:52] or leave a review

[01:02:53] or a comment.

[01:02:54] Also, if you have any ideas

[01:02:55] for topics you'd like us

[01:02:56] to cover in the future,

[01:02:57] please email us at

[01:02:58] excessreturnspodatgmail.com

[01:03:01] We would like this to be

[01:03:02] a listener driven podcast

[01:03:04] and would appreciate

[01:03:04] any suggestions.

[01:03:05] Thank you.