Yankee Baseball By John M Robards CFA VP-Wealth Management International Client Advisor April 18, 2017 With April comes the start of the Baseball season, and this year, it can’t come fast enough. While the winter in New York started out mild, it ended on a brutal note, including a midMarch blizzard that dumped 20 inches on my yard just north of the city. Turning on the television to see baseball warms my bones, because it means spring is finally here, late as it is. I was raised as a Yankee fan since birth, having been taken by my father to my first baseball game at the original Yankee Stadium when Mickey Mantle was playing. The Yankees are the most successful franchise in the history of professional sports, having won 27 world championships in their history, more than any team in any sport. For most of my life, that status enabled them to exploit the momentum it created. Being the most popular team, they generated more revenue, which enabled them to pay for the most talented players, which in turn gave them greater success, which engendered greater popularity among fans. Their success also made them an attractive place for players to play. This virtuous cycle existed from the 1920s, with Ruth and Gehrig, through the 1990s and 2000s with Derek Jeter and Mariano Rivera. The last championship the Yankees won was in 2009, eight seasons ago. Between 1994 and 2009, they finished first in their division 12 times, and finished second three out of the other four years, making the playoffs fourteen times in that time period. They have only made the playoffs in two of the last five years, and one of those was the one game Wild Card play-in in 2015, which they lost to the Astros. How has the most successful franchise in the history of sports gone from a track record of such incredible success to one of mediocrity, seemingly overnight? In short, it happened because the rules were changed and the Yankees did not adapt. Beginning in the 1990s, Major League Baseball began to implement various revenue- sharing and luxury tax measures that completely changed the economics of baseball. For the first time, teams could actually outbid the Yankees, and they also began to lock up their homegrown rising stars with longer term contracts at younger ages. By last summer, the Yankees found themselves stuck with a roster full of aging has-beens, the most glaring example being Alex Rodriguez. So finally, realizing that the old ways of doing business were no longer working, the Yankees finally decided to radically change their approach. They traded away their established stars for young prospects a year or two away from making the major leagues. They cleared space on the roster for young players ready to make the move up, including waiving Rodriguez despite owing him over $30mm for last season and this. So far, the results seem favorable, with the Yankees having one of the best records in baseball after the first couple of weeks, although the season is still young, and we will not know the true success of this approach for months, if not years. The point here is that their world changed, and the Yankees were forced into the realization that they had to adapt to their new reality. Investors often are forced to confront changes to their own reality as well, and to acknowledge that the old way of doing things does not always work in new investing environments. I have had some conversations with clients recently that reflect their refusal to accept that the world has changed. More than one client has asserted that the market, still trading close to its all-time highs, is overvalued. “What is the p/e of the market now?” one valued client asked me recently, referring to the price-to-earnings multiple of the S&P500. That question has more than one answer, and depending on which measure you use, the market can seem more or less highly valued. If you use the simple trailing earnings, in other words the multiple of the S&P500 as of March 31 to the earnings of the index for the year ending that date, the answer is 19.4x earnings. If you compare that with the average over the last fifteen years of 16x earnings, that appears slightly high. If you use the estimate of forward one-year’s earnings of $135 for the index, the P/E ratio is lower, 17.4x based upon the next four quarters’ earnings estimates by the collective group of individual company analysts. This reflects a market that is a little less expensive, but still higher than average. The argument for using this measure is that future earnings are more appropriate to use, since the entire stock market can be seen as a mechanism for discounting future earnings. Finally, the bears point to the multiple of earnings based upon the Shiller cyclicallyadjusted p/e, or CAPE ratio. Named after Yale University professor Robert Shiller, this measure takes the average of the last ten years’ earnings estimates, based on the theory that earnings go in cycles, so taking the average gives a more appropriate number. According to the Shiller CAPE ratio, the S&P500 is trading at a more expensive 29x earnings, as of March 31, 2017. Here’s a chart from Morgan Stanley’s Global Investment Committee that lists those and some other valuation measures: The problems with using the p/e ratio as a method for gauging the valuation of the stock market, and using that information to make buy and sell decisions, are threefold: 1) Using the p/e ratio on a stand-alone basis ignores the reality that the world is constantly changing, and using historical data on this one valuation measure ignores the multitude of other variables that affect valuations. It’s like the Yankees saying, “We won championships in years past by awarding huge contracts to established superstars, so we will use that approach again in the future.” Chief among the other variables that matter are interest rates, or what other competitive investments are going to pay you. The bottom chart on that previous page is a depiction of the “Equity Risk Premium,” which compares the earnings yield of the S&P500 (Earnings/Price, or the inverse of P/E) to the yield of the US 10-year Treasury Note. In business schools all around the world, future stock analysts are taught the concept of the Capital Asset Pricing Model (CAPM) as a valuation tool, which is more complicated than that simple relationship, but the Equity Risk Premium is at the heart of it. When the 10-year Treasury was yielding double digits in the 1970s and early 1980s, this ERP argued for single digit P/E ratios, because if you could earn 10% in US government-guaranteed treasuries, why would you take the risk of equities at anything other than rock bottom valuations. Today, with the 10-year Treasury yielding below 2.5%, and the earnings yield on the S&P500 at about 5.75%, stocks actually look cheap by comparison. 2) In addition to interest rates, the CAPM used predominantly by stock analysts also factors in other variables, chief among them earnings growth. When investors believe that earnings are growing at a higher rate than they have in the past, they are willing to pay a higher multiple. The highest rate of growth in earnings occurs when the economy is emerging from a recessionary or low growth environment, when earnings growth is accelerating. Morgan Stanley’s GIC believes that we are in such an environment now, as indicated by the following chart: 3) Bull markets depend on more than just valuation to maintain their health. Looking back throughout history, it is not uncommon for Bull markets to go from undervalued to fairly-valued to overvalued to dramatically overvalued before they end. In late 1999-early 2000, the S&P500 traded at a P/E ratio of over 30x, giving us an earnings yield of 3.3%, at a time when the 10-year Treasury Note was yielding significantly higher. None of this is to say that there is no risk in the US stock market at the current time and at these levels. As we know from history, exogenous events can knock prices down and cause losses and investor anxiety (see the Technology Bubble of 1998-2000, 9/11/2001, and the rampant fraud of the 2007-2009 financial crisis for recent examples). More often than not, though, markets are most vulnerable when investors are not paying enough attention to those risks, and today does not appear to be one of those times. Here’s a link to the American Association of Individual Investors’ website: http://www.aaii.com/sentimentsurvey . That organization polls its members each week, and in the latest week, the number of bullish investors had fallen well below the long-term average while the number of bearish investors had increased to well above its long term average. If those numbers dramatically reverse themselves, then it might be a time to get more cautious. A few years ago, the Yankees lost their key to success by using the faulty methods that had brought them success in the past, and ignoring the fact that their world had changed. Now they may have regained that key. The world has certainly changed for investors as well; the last time the 10-year Treasury Note yielded higher than 4% was over seven years ago, in 2010. The world can change again, but there are those who argue that the global demand for yield will keep rates low for the foreseeable future. There is an old saying that “Money goes where it is treated best,” and with such paltry competition from other investments, there is an argument that equities are undervalued in the current environment. Investors would be well-served to look beyond the host of distractions that are detriments to their success. Paying close attention to the fundamentals, patience and discipline are the keys to winning in the long term for both investors, and baseball teams. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. Dow Jones Industrial Average is a price-weighted index of the 30 “blue-chip” stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. An investment cannot be made directly in a market index.
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