At the Strategic Investment Conference 2018, Steve Blumenthal of CMG Capital Management Group looked at valuation metrics from a probability standpoint. He noted that in the long run probabilities govern market direction.
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Right now most metrics, from P/E ratio to dividend yield, are extremely overvalued. And it’s just a matter of time before they bounce back to fair levels. But the correction is not the only thing investors have to worry about.
High Valuations Are Followed by Low Returns
Blumenthal looked at Ned David’s research showing earnings from periods with valuations like today’s. The median 5-year return from those periods with a Shiller P/E of 25 or higher was 1.23% annualized. The range was -6.66% up to +19.68% annualized.
Steve Blumenthal then showed a series of charts pointing to subdued returns over the next decade and beyond after period of high valuations.
He warned that the correlation between expected forward returns and actual forward returns is high. This holds trued across most asset classes, including bonds.
Valuations and Risk at Record Highs
Blumenthal noted that when we break today’s valuations into quintiles, we’re in the highest quintile. As such, forward returns look ugly. On top of that, high valuations come with high risk. And that means the level of probable drawdowns is high.
He thinks keeping an eye on the bond market is key, as most assets are priced based on a risk-free rate. And when interest rates move up, markets typically do not do well.
In this environment, risk management is critical. Blumenthal remains bullish but increasingly cautious. He advised investors to be more defensive and prepare for great buying opportunities when a correction arrives. Gold is one of the hedges that investors turn to in times of volatility (check the gold price).
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