Veteran Wall Street strategist Stovall says market close to overvalued, but certain stocks are still cheap

Published Tue, Feb 7 20174:36 PM ESTUpdated Tue, Feb 7 20174:42 PM EST

Sam Stovall, a veteran Wall Street strategist known for his study of market patterns, sat down with CNBC's Mike Santoli for an in-depth interview on the various principles he uses to predict market returns and evaluate stocks. Stovall explains why he believes the S & P 500 should be trading at around 2,340, or only about 2 percent higher from here. "The reason we haven't stumbled with a P/E so high at this point is, we've had inflation in the low 2 percent area. So as a result, we can stand higher valuations when inflation itself is lower," he said. In this exclusive conversation, Stovall, who first joined Standard & Poor's in 1989 and now serves as chief investment strategist at CFRA, defends his market-timing methods against the passive investing onslaught. "The reason why history works is because one element has been consistent throughout the beginning of time and that is human reaction," Stovall said. Other topics include: His 'Rule of 20' method for evaluating stocks. The best way to determine sector allocations. Whether emerging markets could outperform developed markets this year. Active versus passive investing and how to choose a management style. The various ways retail investors can stay ahead of the curve by using history as a guide. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Sam Stovall is chief investment strategist of CFRA, an independent equity research firm which acquired Standard and Poor's equity and fund research business in October 2016. Widely followed veteran of Wall Street, Sam first joined Standard & Poor's in 1989. His work focuses on market history and valuations as well as industry momentum strategies. Sam is the author of The Seven Rules of Wall Street as well as two other investment books and writes a weekly investment piece on CFRA's Market Scope advisor platform. He joins us now here at the NASDAQ to share his favorite investment ideas, market approach and long-term outlook. Sam, good to see you. Thanks for being here. SAM STOVALL: Thanks for inviting me. MIKE SANTOLI: So let's just start kind of big picture. You've obviously been in the business a while, have seen a lot of different ways. Obviously there's many different ways of deciphering and interpreting what the markets are doing and trying to figure out what they might do. How have you settled upon your approach? How would you characterize what your approach is to those things? SAM STOVALL: I would say that the best bit of investment advice I ever got came from Clint Eastwood when he was playing Dirty Harry in the movie Magnum Force. He kept mumbling through grit teeth, "A man's got to know his limitations." And so I think it's very important while job seekers should focus their strengths, investors should acknowledge their weaknesses and try to work around them. Most investors find that their emotions get in the way and become their portfolio's worst enemy. So what I've done is acknowledge that I too can be very emotional if left to my own devices. Also I got a history degree from Muhlenberg College in Allentown, Pennsylvania. So I like to look to stock market history. It's a great way to get started. Obviously there's no guarantee that what worked in the past will work again in the future. But a lot of times if history doesn't repeat, it certainly rhymes. And so I look to history then also try to embrace rules-based approach. And that has worked pretty well. MIKE SANTOLI: When you say looking toward history, I gather you mean looking at previous investment cycles, previous periods of time that seem to play out in a way that seems like it's somewhat similar through the decades. SAM STOVALL: Exactly. Now, the first thing that people will say is, "But, Sam, today is so different from any other time. How can you even consider looking at history?" And my answer is, "Well, you have to look at history somehow." Because if I said to you, "Oh, this stock is a bargain. It's trading at 60 times trailing earnings," you wouldn't know if that's good or bad if you didn't have history. But at the same time, it gives you sort of a framework. For instance, I like to say that bull markets don't die of old age, they die of fright. And what are they most afraid of? Recession. A lot of cynics will way, "Yeah, but no economist has ever correctly forecast a recession." Don't look at the economists. What I do is I look to the yield curve, I look to housing starts, I look to consumer confidence. And traditionally those have been very good indicators. A year-over-year percent change in housing starts, minus 30% is usually accompanying or preceding a recession. 20% decline in consumer confidence usually precedes or accompanies recessions. Even a rolling six month percent change in leading economic indicators, if it turns negative, that has accompanied every recession since LEI got started. MIKE SANTOLI: So you have this virtual checklist I guess of things to sort of verify whether in fact we are late in the cycle, whether in fact a recession is on the horizon. I'm going to guess at least that right now really we're not seeing many imminent signs of vulnerability to recession in the U.S. SAM STOVALL: You're absolutely right. Housing starts most recently were up 6% year-on-year. Consumer confidence is also in positive territory as is leading economic indicators. Last year at around this time, the reason that the market was down 10.5% through February 11th is because most on Wall Street thought we were headed for a recession. We had earnings down almost 7% in the first quarter. And in 13 of the last 11 recessions, we've basically been preceded by an earnings recession ahead of time. It didn't work this time primarily because the culprit for the earnings recession this time around was energy. Take out energy, earnings would have been up 7% in 2015, up 4% 2016. Leave them in, now they're a tailwind for 2017. So it's like peeling the leaves of an artichoke. You got to find out if the heart itself is still good. MIKE SANTOLI: So if we can say with some degree of confidence that perhaps a recession is some ways off, what does that mean in terms of where markets sit right now in terms of valuation? In terms of what reward they might be able to deliver, because it's not always the case that just because a bear market is not in the offing right away that returns are gonna be wonderful or you're gonna be without volatility. SAM STOVALL: Absolutely. In one month we will be celebrating the eighth year of this bull market. It will be the second longest bull market since World War II. If this bull market ended with the most recent top, it would also be the second most expensive on a trailing 12-month as reported earnings basis. Twenty-six times, trailing earnings, that's expensive. So investors are a little bit nervous as they should be. But I also like to look to interest rates. I like to look at inflation. And I also like to look at comparative dividend yields on the S & P 500. Right now we're only about 2% on the S & P 500 division yield. You might think, "Oh, that's awfully low. And maybe that's an indication that we should get worried." What I have found is that since 1953 whenever the yield on the ten-year note exceeded the dividend but by one percentage point or less, we were up 11% on average in the coming 12-month period. So there is still upside potential. Obviously not a guarantee. MIKE SANTOLI: 'Cause right now that is the situation, right? You have the ten-year treasury note-- SAM STOVALL: Exactly. MIKE SANTOLI: --at about 2.5%, not nearly one percentage point higher than the dividend yield. SAM STOVALL: Exactly. So we do have upside potential. But you're right about volatility. What's interesting is that the average bull market lasts about five years. So once we get beyond that average, the number of days in which the market is up or down by 1% rises to 65 times in year seven, 85 times in the year that we're in now, 95 times if we're lucky to get into year nine. So I like to say that bull markets are like humans. The older they get, the more unstable they become. MIKE SANTOLI: Which actually makes it somewhat more fascinating that we've been, at least in this recent phase, so steady. The market has been unusually calm. And we're talking about for the last several months. Not-- SAM STOVALL: Right, right. MIKE SANTOLI: Not before that. SAM STOVALL: There's an old adage, "You never short a dull market." And we've been given the answer to that time and time again. We're up 12% since the presidential election which everyone thought was gonna end up with a rout. We've been up fairly sharply since inauguration day, again thinking that we would be selling off after that. So the first 100 days is usually a pretty good time period for the new president. Even though history says that the market does not do all that well with a first-term Republican president. MIKE SANTOLI: That's right. Yeah, that is what the almanac will tell you, right? And how do you filter into your outlook whatever specific policy hopes or fears or proposals are out there? 'Cause they don't seem to conform directly to anything that would be, as you would describe it, rules-based. SAM STOVALL: That's true. You do have to sort of make a guesstimate. One of the things I like to use is called the Rule of 20 when anticipating where will the market likely close at the end of 2017. It's very simple methodology. It's 20 minus inflation times earnings. That's it. Which right now says we should be trading around 2,340 on the S & P 500 with earnings expected to be up about 11%. Now, typically investors, analysts are pretty optimistic in the beginning of the year when it comes to forecasting earnings. By the end of the year, they're usually trimmed by about five to six percentage points. So history would say we probably should be expecting something more like 6.5% rather than the 11% to 12%. Because President Trump is likely to pass some sort of a tax reduction program, maybe that will be beneficial. So maybe we leave the earnings estimate exactly where it is. And even so then we have that 2,340 level which really implies only about a 4% year-on-year price gain for the S & P 500. If we end up with a much stronger earnings advance, say 20%, then yeah, we could get up to 2,500 on the S & P 500. MIKE SANTOLI: But in either case obviously the Rule of 20 as it stands right now is telling you the market is in the zone of what would be considered fair by long-term standards. SAM STOVALL: Exactly. Because what it does is it looks at the P/E ratio for the market and puts it into context with inflation. We have had two times since World War II that the market peaked at a P/E of ten or lower. And that's because inflation was near 15%. Most other times you had a P/E top of about 19 times because of where we were relative to inflation. The reason we haven't stumbled with a P/E so high at this point is, we've had inflation in the low 2% area. So as a result, we can stand higher valuations when inflation itself is lower. MIKE SANTOLI: What is the action within the market in terms of sectors telling you anything about either the economic outlook or where the opportunities are? SAM STOVALL: First off it's telling us that it likes what it thinks it's going to hear from President Trump. We've had the cyclical sectors do very well in general, financials, industrials, materials, in particular are. But I like to add that this is what typically happens in the seasonally favorable or cyclical of November through April period. The Stock Trader's Almanac likes to remind us that "Sell in May" usually is a time when you wanna be defensive. You don't wanna retreat. You wanna rotate usually into the more defensive sectors. But November through April, the market is up on average about 7% since World War II. Not surprisingly therefore consumer discretionary, industrials, materials, and technology have been very strong performers in this time period. So they're really sort of following the old dance steps. Add financials because the expectation of lifting of regulations combined with the potential of a steepening yield curve which would assist the bank profits. MIKE SANTOLI: One point that I find interesting you've been looking at is the relative opportunities around the world in terms of non-U.S. markets. The U.S. has been such a leader in terms of equity performance for a while right now. And people feel like that makes sense, right? The narrative always tends to fit what's been going on. And I wonder if you think that perhaps it seems as if the rest of the world in terms of the equity markets seem under-appreciated right now? SAM STOVALL: Yes, I think so. There was an old baseball player named Wee Willie Keeler who used to say, "Hit 'em where they ain't." And right now most people ain't overseas because they're just worried about the volatility. They're worried about economic growth, et cetera. But when you look at a rolling ten-year compound rate of growth for the MSCI EAFE which is the developed international index, it is now rivaling the all-time low set back in February of 2009. So if you're an investor who has exposure overseas, this chart would probably be surprising and remind you maybe now is not the time to be selling. And if you have the nerve, maybe you can actually be adding to your position. When looking on a rolling five-year relative strength, between developed international or even emerging markets, versus the S & P 500, they are also at extreme lows at this point and in a sense would be begging to be added to. Finally look at valuations. P/E ratios for developed international emerging markets are anywhere from three percentage points to five percentage points below that of the S & P 500. Whereas you're looking at dividend yields that are substantially higher overseas. So in a sense you are getting paid for that additional uncertainty. So what you do is buy, hold, and close your eyes. And for the long term international exposure could work out nicely. MIKE SANTOLI: And if you're somebody who as a matter of routine kind of rebalances among different parts of the world in different asset classes, you'd probably be essentially reallocating into those cheaper markets, right? SAM STOVALL: Exactly. In seven of the last nine years the S & P 500 has outperformed the MSCI EAFE. And in the other two it basically missed by a small amount. So really the developed international equities have been underdogs for quite some time. And reversion to the mean is the mantra that I'm not issuing. MIKE SANTOLI: You mentioned before when you talk about having a regard for history and people always push back and say, "This time is different. Or at least we've never in this particular place before." And of course at every point in history, it was different and more advanced than every time-- SAM STOVALL: Right, right. MIKE SANTOLI: before, right? But I do wonder about one element which people do wonder if it's going to come through this bull market, which is a broader public participation or enthusiasm for stocks. I think you could play this either way. People say, "Look, many individual investors have sat out the bull market or at least not really thrown their money behind it in a very optimistic way." On the other hand, people say, "Demographically we're in a different country right now." And if you've owned any stocks at all, the market itself has kinda carried equity weightings higher. Is it something we should be waiting for, that phase of a bull market when you do have kind of broader public excitement? SAM STOVALL: I think so. What made me feel good on July 11th was we hit a new all-time high, confirming that we had celebrated our seventh birthday of this bull market. The reason I was happy is because the market was down more 4% from March of 2015 through March of 2016. Now I'm happy that it's down because typically bull markets go out with a bang. They don't go out with a whimper. They're like an incandescent light bulb that glows brightest just before it goes out. So I think we still have a little more to go in this bull market. Of course as you had mentioned before, there's gonna be a lot of volatility. We'll probably have some sort of digestion of recent gains, et cetera. But this bull market itself will likely continue until we go into what I call the FOMO stage, Fear Of Missing Out, where investors will actually start putting money that they've kept on the sidelines waiting for that correction that never really has come. They start to put that money to work. Essentially every bull market since World War II that lasted three years or longer ended up with a final year performance that was anywhere from 16% to 36%. And we're not there yet. MIKE SANTOLI: I wonder how that bears on this other big debate that's going on right now which is of course the general tilt toward passive index fund investing as opposed to trying to outperform. On the one hand, people's willingness to just own the index means obviously that they're happy to have the market just sort of do their work for them. On the other hand, it does seem in that fear of missing out phase people wanna own the hottest thing. They wanna chase those IPOs or those stocks that seem like they have the best shot. SAM STOVALL: Right. The interesting thing is that I've seen this before where toward the latter part of a bull market, everyone talks about passive investing and how you're much better off owning the overall index. Mainly because the index doesn't look at indicators to say, "We're getting a little bit expensive. I'm worried about this or that or whatever." The reason why history works is because one element has been consistent throughout the beginning of time. And that is human reaction. So typically in the latter part of a bull market, it ends up moving further and farther than most people would expect mainly because we're waiting for something to kick us off to the downside. So therapy passive investing does well toward the latter part of a bull market. But it's more the active investing that does better toward the latter part of a bear market, beginning of a bull market, mainly because people have found religion by then and says, "Oh, next time I will maintain a balanced approach, et cetera." Interesting stat is that every year the again high/low is 27%. So if you're a passive investor, you miss out on being able to buy low and sell high later on. I typically tell investors, "You're much better off buying than you are bailing. But look for those opportunities." Also 85% of all years have experienced a year-to-date decline. So 85% of all up years go into the tank at some point in time. So it's a natural thing. So you look for that opportunity to actually add money which you would not be able to do too much if you were simply a buy, hold, and forget it kind of an investor. MIKE SANTOLI: Certainly have not seen that yet this year. So we'll see-- SAM STOVALL: Not at all. MIKE SANTOLI: if this is one of the minority of years or whether you're gonna get that opportunity. Finally, there's one other element much longer term that I wonder if you have a view on. I'm not sure it really matters in here now for most investors. But you hear talk of a secular bull market, a new one, that may have been kicked off once the stock market, the S & P 500, went above its prior high. So that's just a few years old. That's not the eight years going back to 2009. What was it? 2014 or so, I think, maybe we finally got above that level. But anyway, does it really matter in terms of trying to scale what the longer term opportunity is, if in fact we're in another one of these very prolonged phases when the market has an upward bias? SAM STOVALL: Not really. Because looking at the S & P 500 since we got back to break even in 1954 from the all-time high back in September of 1929, every new bull market whether it's cyclical or secular ended up exceeding the prior bull market's level. So it's really a matter of semantics. Secular means long term. Cyclical means shorter term. The '87 crash was a cyclical bear market within the secular bull market of 1980 or even '73 up to 2007 or even the tech bubble bursting. So but that still hurt. That scared investors an awful lot. So whether it's a cyclical or a secular, it Hurst just as badly and it doesn't really matter. MIKE SANTOLI: Exactly. Sam, thanks very much. Appreciate it. SAM STOVALL: My pleasure, Michael. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

Stovall explains why he believes the should be trading at around 2,340, or only about 2 percent higher from here.

"The reason we haven't stumbled with a P/E so high at this point is, we've had inflation in the low 2 percent area. So as a result, we can stand higher valuations when inflation itself is lower," he said.

In this exclusive conversation, Stovall, who first joined Standard & Poor's in 1989 and now serves as chief investment strategist at CFRA, defends his market-timing methods against the passive investing onslaught.

"The reason why history works is because one element has been consistent throughout the beginning of time and that is human reaction," Stovall said.