What a year it has been in the markets. Neither the vengeance of Mother Nature, North Korea’s threats of nuclear retaliation, an increasingly fractious political environment both at home and abroad, the first year of Donald Trump, a rising terrorism threat, nor the prospects for coordinated monetary tightening by central banks in the US, the UK, and Europe were enough to shake investor conviction over the past year . Global equity markets have roared over the past year and continued their advance unabated. Investors who were waiting for a chance to ‘buy the dip’ have been left on the sidelines still awaiting an opportunity to do so. Such has been the enduring strength of what is now the second-longest bull market in modern financial history.
While my portfolio has been a significant beneficiary of this extended bull market, the relentless press of “animal spirits” in our capital markets has elevated equity market valuations to levels that will be hard to sustain without increasing underlying fundamental support. In short, valuations across markets look stretched and I do not expect returns going forward to be as good as they have been over the past decade. Having said this, I have been proved wrong before!
You have probably heard the common remark of Wall Street taking a good thing to a bad place. In this instance, central bankers around the world have been complicit. Unfortunately, their experiment with extreme, and what some consider to be radical, monetary policy over the last many years (however well-intentioned) has been accompanied by some unintended consequences that in my opinion may have led to some of the extremes that we have seen of late in our markets and in our politics – extremes which could threaten the sustainability of this long expansion.
Few would doubt that monetary stimulus was required to “get the patient off the ground” immediately following the financial crisis, and clearly central banks played the pivotal role in that successful resuscitation. However, their subsequent inability to pull the palliative needle from the arm of the recovering economy has led in part to extended asset valuations, rather tepid economic growth, the increasing absence of price discovery in our capital markets, and compromised capital allocation. In addition, excessive monetary stimulus has contributed indirectly to disparities in income and wealth that, together with increasing globalization and technological disruption, have led to a populist awakening manifested in the election of President Trump in the United States and nationalist movements across Europe,with the most significant being Brexit.
These unintended consequences have been masked, at least to date, by strong returns in virtually all asset categories, and a virtually unprecedented level of calm in our financial markets as measured by the VIX (the Chicago Board Options Exchange Volatility Index). It is no wonder that investors have begun to throw caution to the wind when it comes to risk taking.
As Brett Ryder recently pointed out in an article in the Economist:
Yet rarely have so many asset classes – from stocks to bonds to property to bitcoins – exhibited such a sense of invulnerability … rarely have creditors demanded so little insurance against default, even on the riskiest “junk” bonds. And rarely have property prices around the world towered so high … add to this the craze for exotica, such as cryptocurrencies, and the world is in the throes of a bull market in everything.
With short-term interest rates still hovering near zero or even negative in many parts of the world, money has been very cheap, if not essentially free, and that can theoretically translate into nearly limitless valuations for financial assets.
Given their extraordinarily low yields, ten-year government bonds the US, the U.K, Germany, and Japan traded at implied P/E ratios of approximately 43X, 73X, 216X, and 1,667X their respective annual rates of interest. For the twelve months ending September 30, 2017, the S&P 500, MSCI World and MSCI European indexes all traded north of 21X trailing earnings. These multiples imply an earnings yield of approximately 5%, and, if your view is that interest rates will remain at these extremely low levels for years to come, these valuations may not appear to be extreme. However, if you believe that these low rates will not always be in vogue, then today’s valuations are stretched. In addition, the Shiller Cyclically Adjusted Price Earnings (CAPE) ratio of the S&P 500 is approximately 31X, compared to its historical average of 17X, and according to industry sources, the “Buffett Indicator,” which measures the ratio of total US equity market capitalisation to gross domestic product (GDP), is today at approximately 138%, or nearly double its long term average, and approaching its all-time high recorded during the tech bubble in early 2000. These high valuations have been accompanied by record high levels of margin debt which is currently higher than it was in July of 2007, its last peak before the financial crisis began. (Margin debt is money borrowed from brokers by investors to purchase securities.)
According to The Washington Service, a leading provider of insider trading data, news, and analytics, the ratio of companies with insiders purchasing to companies with insiders selling in the month of October dipped to an all-time low since they began collecting data on insider rading in 1988.
It has been reported that Facebook, Amazon, Apple, Netflix and Google (the FAANGs), which are perhaps the poster children of this extended bull market, have added nearly $2.2 trillion to their combined market capitalisations since the financial crisis. As present, these companies are trading at P/E of 32X, 289X, 18X, 186X and 34X. With respect to Amazon and Netflix, it would take nearly two centuries’ worth or more of current earnings to recoup one’s investment in these companies. When contemplating the sustainability of valuation multiples such as these, we are reminded of Cisco, the darling of the tech, media and telecommunications bubble of the late 1990s. In early 2000, Cisco became the most valuable company in the world, trading at over 230X earnings at its peak. We should not forget that in the succeeding 10 years Cisco’s multiple fell to approximately 10X earnings, which allowed even value investors the chance to establish a position.
These companies may very well grow into their lofty valuations, but their technological future, while bright, is fraught with uncertainty and assured change. When valuations become untethered in the near term from underlying fundamentals, as we believe they have for FAANGs such as Amazon and Netflix, the risk of potential permanent capital loss increases significantly. When such untethering occurs across virtually all asset categories, our capital markets become more fragile. More about Amazon later in this report.
While the so-called FAANG stocks have been growing at a rapid rate, the same cannot be said about the global economy as a whole. The economic recovery since the financial crisis has been rather anemic up until only very recently. According to information from The World Bank and the World Economic Forum, GDP in the United States has grown ever so modestly over the last eight to nine years, on average between 1% and 2% per year. Europe’s overall growth has been only marginally positive during this period, and growth in China has slowed dramatically from the high growth rates it enjoyed prior to the financial crisis.
Returns in equity markets since the financial crisis have largely been due to significant increases in the prices investors have been willing to pay for a dollar of earnings, and not so much due to growth in those earnings. In fact, organic growth has been tough to come by for most companies. Much of the growth in corporate earnings has instead come about due to restructurings, stock buybacks and accretive merger and acquisition activity. While most market observers today feel that economic growth is on an uptick and near-term chances
for a global recession are remote, it is always best to caution against such complacency, particularly in light of the prospect of coordinated tightening by central banks around the world.
A worrisome by-product of central bankers’ monetary largesse over the last few years has been the increasing absence of price discovery in our bond and equity markets. What exactly does this mean? Interest rates are essentially prices to which the value of financial assets are directly or indirectly tied. A decline in interest rates lowers the discount rate applied to the future earnings streams of a bond or an equity security, and correlates to higher valuations for each. A rise in rates has the opposite effect. What valuation should one apply to a security whose future earnings are being discounted by near zero to negative interest rates? Discovering a fair value for such an asset can be a daunting proposition. And yet investment capital continues to flow aggressively into higher risk and increasingly lower yielding assets. In equity markets, this has
translated into massive flows of new capital into low cost, passively managed index funds and ETFs, which have received over a trillion dollars worth of new investment over the last five years.
This torrent of money into passively managed products has for the most part been indiscriminately invested in index constituents based on their proportional market capitalisation, without regard to fundamental financial analysis. Other things being equal, as more and more money proportionally and mindlessly flows into many of the larger, better performing index constituents, their valuations often continue to climb resulting in many of the most highly valued companies in the index being priced ever higher. This goes on and on until it doesn’t.
According to the May 5, 2017 Grant’s Interest Rate Observer, “$21 trillion or so of today’s invested capital…. belongs to value-indifferent stewards.” Think central bank bond purchases, index funds and ETFs. As Jim Grant has repeatedly warned, “Prices convey information. Distorted prices convey misinformation.” Without rational price discovery, asset bubbles can percolate, and scarce financial resources are likely to be allocated irrationally. If the proverbial black swan appears at some point, price agnostic investors in index funds and ETFs will be without a fundamental anchor in the ensuing storm, and the money could leave these assets faster than it came to them.
All of the above information might paint a gloomy picture but this doesn’t mean stock markets will crash tomorrow. For all we know, markets can have another record breaking run next year. But unfortunately we do not have crystal balls and thus must assess markets based on the information at hand. So what implications does all of this have for you as an investor? As perfectly summed up by Howard Marks, “We are living in a low return, high risk world.” We agree. While I, along with many readers of this site, have been significant beneficiaries of our strong equity markets over the last many years, the inexorable rise in valuations has created “trying times” for disciplined, price-conscious value investors. The available opportunity set has shrunk dramatically. New bargains, which plant the seeds for future returns, have been increasingly hard to uncover, and residual cash reserves in my portfolio has been growing. Whilst markets are still at record highs, it is wise to prune the investment portfolio carefully so that you are comfortable with the composition of your portfolio. That way, if the inevitable bear market does strike, you will be well prepped and ready.