Anyone who thinks the financial markets will continue to behave for the next five years the way they have for the last eight certainly enjoys walking on the sunny side of the street.

Some keen observers might divide the current bull market into two phases. The first ran from 2009 through 2012 and was characterized by a risk-on mentality when assets recovered their severely discounted prices after the financial crisis.

During the second phase, different sectors started to diverge; energy and bioscience companies took the lead in 2013 and 2014, only to retreat in 2015 as information technology shares caught investors’ fancy.

With the large-cap S&P 500 up more than 17% since Election Day last year, it’s not surprising that long-short investors are finding their long book is doing a lot better than their short bets. But the immediate question for many advisors is: Exactly how expensive are equities today?

As of early September, valuations stood at the 18th percentile of levels in the 27-year period since 1990, according to the model developed by Gotham Asset Management co-chief investment officer Joel Greenblatt. That period is significant to some investors because many think 1990 marked the real shift to an information economy from an industrial one. Like all models, Gotham’s isn’t perfect, but Greenblatt says that, on average, it’s right about two-thirds of the time.

Greenblatt will be joining Ali Motamed of Invenomic Capital Management and Jim Paulsen of the Leuthold Group for a general session at Financial Advisor’s Inside Alternatives conference on October 24 in Denver. Financial Advisor checked in with the three of them to get a preview of their thoughts.

Gotham’s valuation process ranks stocks on measures of both absolute and relative value, incorporating the firm’s proprietary assessment of a company’s operational cash flow. If the model confirms what everyone knows, namely that equities are pricey, the good news is that they are not as overvalued as some might think.

Greenblatt says it would take a 17% or 18% correction in the Standard & Poor’s 500 to move the index back to the 50th percentile. A correction of that magnitude would keep the bull market alive, but barely so, as it would remain just above the 20% decline that typically defines a bear market. As equities have climbed over the last year, valuations have remained right around the 17th or 18th percentile, meaning that operating cash flow has kept up with rising prices.

In the past when equities have stood at their current level, Greenblatt says the S&P 5000 has returned 4% to 6% during the next 12 months and 8% to 10% over the next two years. Pedestrian to be sure, but better than most bonds are likely to return.

Contrary to what some think, Greenblatt’s model finds the Russell 2000 even more expensive than the S&P 500, ranking it in the 8th percentile. When the Russell has been at this level in the past, the index has averaged 0% to 2% over the next year and 4% to 6% over the following 24 months.

Despite the current price levels, Greenblatt maintains that  the short side opportunity lies in the most expensive stocks. “We’d expect them to do worse than the 4% to 6% returns anticipated for the index,” Greenblatt says.

Short opportunities can be found “all over the lot,” he adds. “No sector stands out.” So far this year, Gotham has enjoyed success shorting certain energy and consumer staples stocks.

Historically, Gotham has found technology to be its best sector on both the long and short sides. “Our spreads have been the best in information technology, meaning that our long technology stocks have had the most outperformance relative to our short technology stocks (as compared to long and short picks in other sectors),” Greenblatt says.

If anything distinguishes this current bull market, it is the tilt favoring large-cap growth stocks, in his view. For a value investor, the environment can be challenging.

But Greenblatt doesn’t agree with the assessment of some like Jeremy Grantham, who thinks that the markets have changed radically with stocks priced at or near 1929 levels for most of the last two decades. Grantham’s argument “is based on normalized margins which compares margins of large industrial companies 20 years ago to light-asset business models of today.”

Another long-short manager perhaps more concerned than Greenblatt about valuations is Ali Motamed, co-founder of Invenomic Capital Management. “The next five years will have a lot of bumps,” he predicts.

Some optimistic followers of the Shiller CAPE (cyclically adjusted price-earnings) ratio take solace in the knowledge that, come 2021, the 10-year look-back period will no longer include the 2008-2010 period that saw wild swings in both equity prices and earnings. Motamed isn’t one of them.

“Take out those numbers and the Shiller CAPE ratio will drop about 6%,” he says. “It will go from being the second most expensive market in history to the third most expensive.”

Low interest rates are one of several reasons stock prices remain elevated, and Motamed doesn’t expect that to last very long. If history is any guide, the market will break at some point in the next five years and there will be a correction of more than 20%. The fact that it hasn’t happened in eight years since the Great Recession makes it more, not less, likely.

“There will be a great opportunity,” Motamed says. He expects many investors accustomed to the low volatility of the current bull market to panic and overreact.

Right now, “they are just chasing what has worked since 2013,” he continues. That is mostly momentum stocks.
At that juncture, what will work “won’t be what has been working since 2013.” He predicts that valuations will start to become a lot more important.

Some defensive sectors like health care could hold up initially. Many of these companies have enjoyed a boost from Obamacare moving millions of Americans to the insurance rolls.

However, even if “Obamacare doesn’t go away,” the growth that the sector has experienced will moderate, Motamed says. He cites several medical device companies that were selling at 10 times EBITDA in 2012 and are now selling at 17 or 18 times EBITDA five years after the secular growth spurt from Obamacare has finally run its course. Many of these companies have some “good things going for them,” but the market discovered the tailwinds at their backs years ago.

Finding instances of mispriced securities after an eight-year bull market is easy. Motamed sees it all over the place. “Many names trade at extremes. That’s why it’s an interesting market,” he says.

Another imbalance he discerns is in the semiconductor sector. The current market darling, Nvidia, is beloved because many think it can penetrate some of market dominator Intel’s key markets. It may be able to do that. However, Intel is earning cash flow that is three times the revenue Nvidia generates, he notes.

Wreckage across the retail landscape is also spawning opportunities. Today, the conventional wisdom is that Amazon will put the vast majority of retailers out of business. It wasn’t so long ago that Walmart was the retail terminator.

“Amazon won’t kill all of them,” Motamed says. “Some companies are learning to deal with it.” It’s not very hard to find solid retailers these days priced at distress levels like two times EBITDA.

Accounting issues also are likely to come to the forefront in the next few years. Changes in retailing will have consequences, however, as lease consolidation accounting issues will hit retailers and their landlords alike. In information and technology, the accounting questions are likely to revolve around revenue recognition. As energy and biotech performance proved in 2015 and 2016, short sellers don’t need a full-fledged recession for opportunities to present themselves.

Jim Paulsen, chief investment strategist at the Leuthold Group, believes that the next recession is at least two years away.

The leading cause of recessions, in his view, is overconfidence. “People start doing stupid things,” he says.

Pundits have talked about low equity market volatility for most of the year but few have noticed the remarkable stability of inflation and interest rates. He is watching wage inflation closely to see if it moves above 3% for a sustained period.

Paulsen thinks it could happen next year, and that could prove interesting on many fronts. It’s not clear if the Fed would overreact, as it often does.

Among the sectors Paulsen favors when it’s late in an economic expansion are energy, materials, technology and capital growth.

“Commodities and real estate are likely to do better than other financial assets the rest of the way,” he says.