The VIX is near record lows. Jason Leach at Fusion Capital credits “Policy Trumpacho“.
This is a guest post by Jason Leach with minor editing and a few new subtitles.
Policy Trumpacho: It’s Digital
There has been much talk on the TV these last few months: (i) how valuations don’t matter, (ii) how it is about sector rotation, and (iii) how making America great again is going to unleash financials, industrials, materials, energy, etc.
I’ve read fundamental and technical research and attended conferences with virtually no mention of potential downside. How could there be when everything is “breaking out” (healthcare be danged) and a cursory glance at the omniscientforward multiple on the S&P 500 is barely above the historical 16.5x mean, at a warm porridge just right 18x.
Furthermore, it is argued, that since we have moved from dirty to digital, from smokestacks to server racks, margins have expanded and rendered useless any historical comparison of today’s valuation multiples to the 1980s or aghast, the dirty 1960s-1970s – pre-steroid era…pre-concussion protocol…hide yo kids, hide yo wife…they’re canceling CFA Level II study courses around here…
In the mid-60s, at the height of “dirty”, U.S. profit margin from current production hit 14% (with a trailing P/E of 18x). It declined to a low of 7% in the late ‘80s (P/E of 18x), rose to 14% in 2006 (P/E of 18x), declined substantially during the crisis, and is 14% as of 3Q16 (but with a P/E of 22x). The profit margin trend has no doubt been up since computerization in the 1990s, but cyclicality remains. So, “digital” profit margins today are the same as they were 10 years ago, before the iPhone, and the same as 50 years ago, before Apollo 11 landed a man on the moon with processing power less than an iPhone. The difference is the price paid today for those margins is 20% higher. I get it, this time is different because it’s not different.
So, let’s hold on to the CFA study courses and assume there is still merit to fundamentals, throw in some charts (sacrilege), and look at where we are. We’ll start with the macro (equity risk premium) and move to some micro examples of what happens when reality bites.
In Pulling Awesome Forward, I discussed PE10 (cyclically adjusted PE multiple over 10 years). The measure now stands at 27.9x vs. 8.6x at Reagan’s inauguration. A 50% decline in interest rates provided six years of PE expansion and a 200% rise in the S&P 500 from 1982-1988. We face the opposite scenario now from the 1980s – today we are in a rising rate environment potentially compressing PE and thus equity markets.
Let’s add a look at chart of Equity Risk Premiums by colleague Arun Chopra, CFA CMT.
I summarize the chart here:
- The equity risk premium (ERP) is the amount equity investors can expect to earn over the risk free rate (i.e. 10-year Treasury). This is thought of as the excess return received for the risk of holding stocks vs bonds.
- It can be computed by subtracting the yield on the 10-Yr from the earnings yield (E/P).
- Note the crush in ERP from 4.37% in 2010 (high earnings yield) to 1.2% today (low earnings yield and rising 10-Yr yields).
- Also note that at a 10-Yr yield above 3.0%, the ERP goes below 1.0% – said again, the amount investors can expect to earn over the “risk free” 10-Yr Treasury is below 1% when the 10-year goes above 3% (glad they brought back the long bond eh? Or no?)
Using ERP as a guide, we see what Dow 20k and the spike in yields really mean – valuation extremes and low return for risk.
Remember James Glassman’s infamous “Dow 36K” book written right after the peak in 2000?
DOW 36,000 Launch, November 2000 “New Strategy”
TINA to the Rescue
The prevailing logic to explain the low ERP today is similar to Glassman’s – “there is no alternative (TINA)” equities carry little if any risk relative to bonds and that is the reason for the low equity risk premium. The reality is ERP is telling us there is little long term reward for risk in the broad U.S. market at current valuations. Since the last breakout in yields, we have been pointing out to clients that many are mischaracterizing the equity breakout as another ‘great rotation’ out of bonds and into stocks as we saw in the mid-80’s. But, as discussed, today we are in a Fed divergent rising rate environment punishing bonds and potentially compressing PE and equity markets.
GoPro and Twitter
Getting micro, what does this really mean for individual stocks? Extreme price to sales stocks (in this case GoPro and Twitter but examples abound) face a lose/lose scenario, eventually giving up and falling much further than most expect.
And now we have SNAP [Snapchat IPO] on the way.
Behavioral finance is often most important input in our process (both micro and macro). Arun notes four important behavioral fallacies that slip past the mainstream lines.
- New user metrics such as number of eyeballs.
- Benchmarking against other overvalued models
- Authors with limited experience in the field (increasingly the case with old and numerous new outlets etc. – something we saw consistently with GPRO etc.)
- Challenging to justify absolute valuations
Are the pundits on the TV, never mind the over the wall analysts, institutions, financial journalists and retail even aware of the 1990s metrics (eyeballs) they are using and accounting fallacies in Snap or are they just willfully blind?
Lastly, and to the larger point of this writing, the Snap valuation rationalization is not relegated to extreme price to sales valuation new new thing stocks. Here are two household names everyone is crowded in creating a similar limited upside max downside capture scenario. Just 9 months ago, valuations didn’t matter either on these digital era stalwarts which are underperforming the S&P by 15% and 13%, respectively since (when they traded at 3x-4x times sales…very high ratios for them).
Starbucks and Nike
When valuations reach extremes, despite what the masses say, even greater fools run out.
The TV, research analysts, and conferences say the Trump trade is on, the 18x forward multiple is just right porridge (ignoring the dubious history of forward earnings estimate accuracy, bowl size and porridge thermodynamics that would dictate otherwise), that it’s just sector rotation, and financials, industrials, materials, energy, and discretionary are going to rip as stimulus and tax money comes pouring in. And, of course this time is different because margins are digitally dirty…err…different.
Yet, we have increasing uncertainty around Policy Trumpacho, the same operating margin level as 10 and 50 years ago with a 20% premium paid, PE10 at its third highest level ever, a rising rate environment, ERP indicating there’s just 1% of excess return over Treasuries, and numerous recent examples that fundamentals, in the end have a way of rearing up and bucking bad hombres off when they get too heady.
But, that’s not how this works. That’s not how any of this works. It’s digital.
Jason B. Leach, CFA
I did not think we would see a bubble of this magnitude, this fast. But here we are. Once again investors chase IPOs of companies that may never make a dime.
Worse yet, the current environment is unlike that of 1999-2000. In the dot-com bubble, there were plenty of excellent stocks with low P/Es that investors shunned. The energy sector is a prime example.
Today, the median P/E is at record levels. Nearly all stocks participate in the bubble.
Courtesy of John Hussman, please consider …
The Everything Bubble
I do not know when this massive bubble will pop, but insanity has gone so far for so long, the carnage is likely to last for many years. The equity market might not even “crash”. Why?
Conditions are much different than 2007-2009. Then, credit dried up and even viable companies had trouble rolling over debt. Unless we see similar conditions, we may just see valuations drift lower for years.
Losing 5-10% a year for 5-7 years will not constitute a “crash”, but the result will be worse, especially for pension plans.
Mike “Mish” Shedlock