Using Valuations to Navigate the Cycle

The concepts and application of valuation signals + practitioner perspectives...

Learning Goals

• Understand the concepts of using valuation indicators in market cycle analysis.

• Interpret & apply valuation signals in investment strategy and decision making.

• Be able to use valuations to reduce risk, and see/seize opportunities.

Concepts

Valuation signals are perhaps one of the most important methods of understanding the stage and progression of the market cycle for investors. Valuation signals are useful for identifying opportunities and setting future risk vs return expectations. 

The purpose of a valuation signal is to inform your underlying directional bias: if the signal says the asset is cheap, you should be bullish all else equal, and if the signal says the asset is expensive, you should be ready for downside risk.  But it doesn’t stop there.

When we talk about valuations in the market cycle analysis context, we are not talking about what is the specific right or fair price at a moment in time as such, but rather we are most interested in whether the valuation signal today is high (expensive) or low (cheap) vs its historical context.

The reason is that valuations go through cycles where they typically peak at expensive levels, and trough at cheap levels.  This is driven by the various repeating underlying cycles in crowd psychology, monetary policy, and asset specific fundamentals.

It is the progression of these cycles — especially to extremes — where the forward-looking opportunities and risks are generated. 

Conceptually, the best time to buy is when valuations are driven to extreme cheap levels due to investor panic, pessimistic sentiment, slumping expectations about the macro/fundamental outlook.  Typically this phase is at least initially grounded in very real deterioration in the fundamentals and macro backdrop.  Overall, the downshift and cyclical trough in valuations is an (over)reaction to negative developments.

On the other hand, conceptually the riskiest time to own an asset is when valuations are driven to extreme expensive levels due to investor euphoria, optimistic sentiment, overconfident expectations about the future and over-extrapolation of favorable conditions.  These conditions are likewise grounded-in or at least start from very real improvement in the fundamentals and normally start from a supportive macro backdrop.  Likewise, it is an (over)reaction to positive developments.

Indeed, while there are usually clear and compelling macro/fundamental cycles underlying the evolution of valuations — valuation indicators can basically be thought of as a confidence barometer.  High/expensive valuations indicate bullish investor confidence, while low/cheap valuations indicate bearish investor confidence.  This is particularly true at extremes.

Ultimately, the key concept and operation of valuation signals is to support the efforts towards the ideal of “buy low, sell high” (and/or “sell high, buy low”) — through the cycle.  Ideally they are grounded in some objective fundamental metric, and provide an objective source of information, with logical (make sense fundamentally) and consistent signals (send the right signal at the right time, over time).

Although valuation signals tend to be most powerful and useful in informing longer-term risk vs return expectations (based on the actual data, and based on how long cycles tend to run), they can also have important tactical/short-term insights at extremes. 

Meanwhile, between the extremes valuations also have their limitations as the informational content drops as valuation signals approach neutral.  But one subtlety to grasp is that while level is clearly important, direction is also an important piece of context.  As with most things, application is more nuanced than the high-level concept — the nuanced conceptual model below adds further color.

Thinking about this visual it really emphasis the cyclical context and nuance.  For example, cheap valuations can get cheaper (as you move through the cycle) and potentially stay cheap (value traps, longer-running cycles).  Likewise, expensive valuations can go further and stay higher than you expect (structural shifts, market bubbles). 

Valuations are a key piece of the puzzle, but it is only one piece of the puzzle – and cycle-aware investors will want to bring in further cyclical context to raise conviction and confidence.  So, once you have established an underlying directional bias based on the valuation signal, you can then build out the rest of the picture with other factors to raise conviction and fine-tune timing. 

In this sense, valuations can be thought of as a foundational signal for active investors.

Data and Application

This section takes it from concepts and theory to data and application to make the concepts more concrete and show you how to use them with real world application.

The first example looks at my valuation indicator for US equities. I will get into specific methods on indicator design in a later post, but the key point to note when using a valuation indicator is conceptually it should be giving an expensive/elevated signal around market peaks, and it should be giving a cheap/low signal around market bottoms. 

The valuation indicator in the chart below is based on PE ratios, and in that sense is anchored in fundamentals, and hence provides an objective and economically logical signal.  It also looks the way it should and gives the right signal over time (signal consistency). 

The statistics (scatter plot) also confirm its merits (higher subsequent long-term returns are more common when valuations are lower, and vice versa).

And that highlights an important point.  Valuation signals generally provide the most useful information for longer-term investment horizons — this is useful for long-term investors, but also for those with shorter timeframes looking for an underlying directional bias.  Beyond that though, if you eyeball the chart, there are clear instances where extremes in the indicator provided useful tactical insights – especially around market bottoms.

When it comes to practical application, as noted, there are nuances — if we look at some of the specific examples for US equities:

• 1987 – the crash was flagged by the extreme expensive reading, but you did not get time to wait for the indicator to turn down.  In that instance, high valuations were an important risk signal, but you had to act quick.

• 1997-2000 – in this instance expensive valuations did forewarn of the downturn and long period to reclaim the all-time high, but in contrast the signal remained in extreme expensive territory for 4 years.  In that example, it was necessary to wait for the cycle to turn, and lean heavier on other factors.

• 2021 – expensive valuations flagged the peak in advance, but understanding the macro/policy backdrop was key to identifying the catalyst and fine-tuning exact timing.

• Major Bottoms (2002/03, 2008/09, 2020) – in these three instances, the indicator sounded a loud buying signal, which was highly useful from a tactical standpoint, and interestingly enough gave longer-term investors only a relatively brief window to act.

So clearly, there is useful information here, but there is nuance to it, and although we can get highly useful risk management information from valuation signals it can be risky to rely on just one signal.

The second example looks at bonds (US treasuries, focused on the 10-year Treasury), and helps illustrate the concept and application of valuation signals for a different asset class.  As with stocks, the bond valuation indicator also does more or less what it’s supposed to in terms of flagging downside risk at the peaks, and signaling cheap valuations at market troughs. The scatter plot also adds statistical evidence to the intuition, with lower valuation scores being consistent with higher 10-year subsequent returns, and vice versa.

Indeed, from an active asset allocation or multi-asset investing standpoint, it is critical to develop valuation indicators for each asset class in order to identify moments of extreme risk both in absolute terms for each individual asset, but also as a whole, and on a relative/ranked basis (n.b. I will cover cross-asset applications in greater detail in a future post).

Indeed, one useful aspect of having valuation indicators for both stocks and bonds was the rare moment in 2022 where both stocks and bonds fell materially: shattering at least temporarily the 60/40 investing paradigm.

This was preceded by *both* stocks and bonds showing up as extreme expensive in 2021 – something that has not happened before, and something that conceptually should be very rare given the differing drivers for each asset.  In that instance, you could have effectively considered cash as cheap by comparison, especially given the combined 60/40 portfolio view of valuations rising to one of the most extreme expensive readings on record (indicating elevated risk of adverse future returns).

As it turned out, given the lack of offset from bonds (which are typically expected to be a diversifying asset), the following year was the second worst total return for the 60/40 portfolio in over 150 years. And if you think about it — if your bond valuation signal is saying extreme expensive, you can’t look at that asset to perform its usual capital preservation role when it itself is at risk.

In this way, valuation signals can provide advance warning to even seemingly novel and far tail risk scenarios, and present important information on the risk vs opportunity set at both the individual asset level as well as at the portfolio/asset allocation level.

Practitioner Perspectives

In this section I turn to my mostly institutional investor following on social media to add some practitioner perspectives on the matter and as a prompt to consider some of the other practical issues in application.

Importance of Valuations

When it comes to how people look at valuations, most (50%) said it was a “very important” part of their investment process, while few said that it was either the most important thing (mostly fundamental value investors) or not at all important (mostly market technicians and quants).  Personally, I would agree, it’s a very important and useful input, but given the benefit of also incorporating other inputs and limitations of valuations – I wouldn’t call it the single most important thing.

Source: Callum Thomas (LinkedIn), Topdown Charts

Why Use Valuations

In terms of why people use valuations, the overwhelming consensus is because valuation signals provide objective/quantitative info – and this is important, it’s one of the key strengths of valuations and what they are supposed to do.  They’re supposed to provide a cool, clear, logical signal… and often times the most important signal comes when crowd psychology is at its most extreme, when grand narratives have taken over, and your will to do the right thing (as suggested by the valuation signal) is at an all-time low, because it’s typically a contrarian position.  So in those times, the value of an objective signal is critical.

Indeed, at the major market bottoms identified in the charts above, most people would have talked themselves out of buying as the prototypical fear, uncertainty, doubt/doom messages and emotions pervaded vs evidence and logic.

But let’s also give passing reference to the last option in the survey – perception. This is vital for those acting as custodians of other people’s money.  You need to not only have a good process that performs, but you need to be able to communicate that process and instill confidence in your stakeholders/clients (especially relevant for when things don’t work… and you never get it right 100% of the time!). 

This is about appearing sensible, but also being sensible by having a process that is not just based on the fear of underperforming vs peers, not just chasing the latest hot trend and being overrun by recency bias.  A repeatable evidence-based process is key to survival and long-term success.  Important and interesting points to ponder.

Source: Topdown Charts (LinkedIn)

The Challenge with Valuations

As noted, there are a number of limitations and short-comings when it comes to using valuation signals for investment decision making and market cycle analysis.  Most people noted that getting the timing right is the biggest issue – and this was quite clear in the data & application section earlier. 

It’s why you need to be as much of a historian as a statistician when applying these signals, but also why you need to build up the bigger picture with puzzle pieces (for example, bringing in additional information from monetary policy settings, economic cycle data, and technical analysis are typically what it takes to improve the timing and conviction-level).

But interestingly, there were also quite a number of respondents citing lack of patience (alluding to the point that valuations have their strongest reliability in influencing longer-term returns).

Figuring out the right metric to use also featured highly — which indeed is an issue, as there are many different options when it comes to valuation indicators, and each with their own strengths/weaknesses, and then also as with all indicators: maximizing signal vs noise. Structural changes meanwhile were also front of mind (which refers to situations where the typical range and level of e.g. a PE ratio may move to a semi-permanent new higher or lower range). 

Source: Callum Thomas (LinkedIn), Topdown Charts

So it’s clear, even among practitioners that despite the usefulness and importance of valuations, there are challenges and nuance in their application that need to be well-understood by those who would use them.

Reflections

Tying it all together, I tend to think of valuations as one of the most important pieces of the puzzle, it helps set your directional bias and should guide your longer-term expectations around risk vs return -- as well as reminding you not to get too carried away in the short-term gyrations of greed and fear.

I often see criticisms levelled at valuations (usually by those with a vested interest or existing bias; which they are attempting to confirm) — that because they are most useful for longer-term horizons, most investors can’t use them and/or should ignore them.  As you might guess if you’ve read this far, I would say that’s wrong from a number of standpoints.

Firstly, equipped with the nuanced conceptual model, the statistical evidence, and the right indicators, investors can not only draw important tactical insights at the extremes (at either end of the cycle) – but even use valuations as a compass and torchlight for navigating through the cycle.

Yet I would also say a pure valuation-driven approach could conceptually work, provided you have the patience and risk tolerance.  For example by underweighting/selling the most expensive assets, overweighting/buying the cheapest, and letting mean-reversion sort things out over time.

Hidden in that thought is also the importance of knowing your objectives, constraints, and your own psychology… and ensuring that your information sources align with that.  One of the biggest sources of disagreement and confusion in markets is when a short-term trader attempts to convince a long-term investor of their viewpoint or what they should do – it’s almost never productive as the two individuals are playing different games, with different objectives, different parameters, and differing strengths/edge.  So: know yourself; and know the game you are playing.

Back onto the utility of valuations though, another approach could involve only taking action on the most extreme readings in valuations. Taking relatively few positions, and perhaps only acting once every few years as the strongest signals typically only come that often (or even less frequently), but then taking sizeable positions when they do come.

So there are a number of ways to incorporate and utilize valuation signals, but practically speaking, I still think of it as just one piece of the puzzle.  The below table shows how it fits in with how I run multi-asset investment strategy at Topdown Charts.

Based on my experience in the funds management industry and as an independent investment strategist serving a wide range of institutional investors – I would say “best practice” for active investment strategy (particularly in the asset allocation space) is being grounded in valuation and building the puzzle picture up from there.  

Focusing on that metaphor, typically you need multiple puzzle pieces in order to get the full picture.

When it comes to investment strategy, having a fuller picture helps you raise conviction levels (which determines your threshold to action – whether you actually take a position, and how significant the position would be), and aids in finessing timing *through the cycle* -- because it’s not just about reacting to the extremes, but navigating the often long and large spaces between.

Indeed, as noted in the concepts section, valuation signals take on a different meaning and weighting at different stages of the cycle. 

So overall, I would say that valuations are the best place to start for cycle-aware investors in forming the risk vs return picture. And again, valuations are one of the purest measures of where we are in the cycle, from a fundamental, monetary, and crowd psychology perspective.

Key points

• Valuations provide an objective source of information that can generate important insight into the stage of the cycle and the risk vs opportunity outlook.

• In concept, valuations help investors “buy low (cheap), and sell high (expensive)”.

• In practice, valuations provide useful evidence-based information across asset classes and cycles, but care needs to be taken in their use given limitations/nuance.

• Limitations and challenges include first and foremost getting the timing right (the nuanced model), getting the timeframe right (they have a greater influence on longer-term returns), and then getting the indicator and wider context right.

• Best practice when it comes to using valuation signals is to be aware of the cycle, be aware of past scenarios, let valuations guide your underlying directional bias – but after all as just one of a number of puzzle pieces for building up the larger picture (and conviction level).

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Best regards
Callum Thomas

Head of Research and Founder of Topdown Charts

Twitter: https://twitter.com/Callum_Thomas
LinkedIn: https://www.linkedin.com/in/callum-thomas-4990063/

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