The S&P is up 8% since the election. Volatility has been squashed. 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 omniscient forward 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.
Snapchat IPO
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
Mish Comments
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
Valuation Reality
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
Eight years obama ZIRP/QE/bailouts/TARP/HARP/helicopter cheap money
Eight years of obama adding more to the debt than all other administration COMBINED and accounting for inflation
Eight years of not ONE banker going to jail to include Jon Corzine
All that money HAS to go somewhere.
And now investors think this is the new NORMAL…
To be fair to O’B the fed was the maestro for much of this stuff. Deficit spending for a great recession is understandable but not deficits in good times with record low financing costs for the nat dept.
What the heck will happen if interest rates spike, trump is building infrastructure and military and there’s a recession? Good night Irene!
Yes, the money has to go somewhere.
The value though could just get eaten up by inflation. So the equity prices could remain high while the P/E slowly drifts back to reality. I don’t have anything to base this on other than gut, but that’s what the 70’s felt like
The 1970s had 15% interest rates…
“All that money HAS to go somewhere”
In the “Everything Bubble” the value of most assets are priced at the margins (the last sale)… All that money can go Puff and just vanish into thin air (from whence it came).
From a risk stand-point I often think back to Benoit Mandelbrot’s book. Don’t be lulled.
Investing is getting too much like gambling.
Casinos have to follow pretty strict laws and regulations. Arrest and jail will follow if they don’t.
Wall Street? They just pay a “fine” and keep their massive bonuses.
There is a reason why not ONE BANKER went to jail under obama.
And why Holder got his corner officer back.
“Investing” in things one has no insider information about, has never been anything other than either 1) gambling, and 2) benefiting from Fed and regulatory theft. Most often a combination. The whole idea that grown men should sit around and waste their lives wanking about with stocks and bonds they know nothing about, is nothing more than a way for the well connected to use the asset pumping mechanism to enrich themselves on the back of others.
If we still lived in a civilized country with an economy not explicitly manipulated for the benefit of the elites, meaning $19.39/oz of gold, no Fed and no possibility of getting “bailed out”, there would be exactly zero of the utterly nonproductive waste of time that CNBC, 90% of stock brokerages, “day trading”, “high frequency trading” and the rest of the nonsense that has become part and parcel of “investing culture” since the West went down the drain once and for all. Such that people would instead have to do something at least potentially useful for a living. Not just leech of those few who still do, while collecting Fed welfare paid for by debasement of those few.
investing in stocks is really no different than becoming a junior partner in the neighborhood grocery store, pizzeria or bagel place. it only looks like gambling when you invest for a short time and don’t bother reading the financial reports. The longer one holds a stock the more the performance of the stock and underlying business move in the same direction.
No one here wants to hear things like that.
“it only looks like gambling when you invest for a short time and don’t bother reading the financial reports.”
Beat expectations by a penny. GAAP earnings vs. non GAAP. Repeating one time charges. Mark to model.
The banking stocks took off in 2009, when FASB was told by congress to allow banks to lie about the value of their assets.
Companies have been massively borrowing to buy back stock to artificially goose the stock price.
It isn’t investing.
The difference, and this makes all the difference i the world, is that you know Tony down at the Pizzeria. You know your neighborhoods dietary customs, preferences and financial wherewithal. IOW, you have inside knowledge, not available to the entire rest of the world and more.
“Reading Financial Statements” give you no such inside track on what the correct price for a stock should be. After all, everyone on the planet, plus another 8 to 10 billion algorithms, already finished reading them. And bid the price up to all it’s worth based on said financial statements. Long before you even got around to adjust your reading glasses.
The only, as in really one and only, reason this obviousness hasn’t seemed so obvious over the past century, is that central banks have actively confiscated wealth from their constituents, and handed it back out via asset appreciation to “investors,” for the entirety of that time period. Full and well knowing that, while this may have benefited the occasional small fry retail investor (there’s a lot of random involved, as in even a Casino loses to someone sometimes), the correlation between “asset owner” and “well connected” is so overwhelmingly strong, that nominally favoring the former, is really nothing but a slightly obfuscated mechanism for transferring wealth to the latter. Which was the whole point of central banking all along.
Yes, I have no idea what Proctor and Gamble is doing, it’s a complete mystery.
Exxon, I hear they have gas stations, but they refuse to tell us where.
The relevant question is not what you know about what Proctor and Gamble does. But rather what you know about what Proctor and Gamble does that noone else knows. After all, what everyone else also knows, is already priced in to the stock, such that no economic profit is left for you.
not a relevant question at all for an investor, possibly relevant only for short term trader foolish enough to be seeking advantage by investigating fundamental valuation.
As a practical matter, you are, or at least have been for a century or so, certainly correct. In the longer term, the only thing investors have needed to know, is that the Fed and regulatory structures will rob others in order to pay them. As that is where all financial asset appreciation have come from.
Excellent work from Jason Leach, again.
He completely avoided the elephant in the room: political risk, or in this case, political opportunity for corporations to order right off the Trump menu of tax cuts and reduced regulation.
The risk is not whether the benefit package will come soon or not at all, the risk is whether the world-wide resistance to his efforts will end up in some kind of chaos.
The robot trading going on is not able to factor in this particular risk and only focuses on the perceived benefit of a business friendly administration like it was 1982.
There has never been a time in the last 65 years when the old order has been overturned.
No one can even begin to imagine what the consequences will be.
High valuations in this environment are teed up to fall, but let us gaze upon this stupendous island of optimism one last time and admire the beauty of the stupid, crazy hope it represents. We may never see anything like it again for a long time to come.
“Then, credit dried up and even viable companies had trouble rolling over debt.”
Why will credit not dry up (and thus companies will not be able to roll over debt) not happen in a rising rate environment. Unless you expect the central bankers to go for QE for ever or start buying equities.
“Unless you expect the central bankers to go for QE for ever or start buying equities.”
Both. They have no other politically acceptable choice.
Countdown for the Trump bashers to blame DJT for the bubble…..
3….2….1…..
…and don’t forget the Russians (not the DNC’s own IT staff) hacked the super bowl score board and prevented voters from getting the truth about possibly deflated footballs.
Tonight the Trump bashers rioting in New Haven CT managed to prevent an ambulance from getting to Yale-New Haven hospital. EMTs had to perform hospital procedures in the ambulance to try to save the patient (who’s status is being withheld).
Evidently, allowing criminals from those 7 countries into the USA is way more important than allowing an ambulance to get a US citizen to an emergency room.
Tom Brady is friends with Trump. He must have cheated tonight to pull off that comeback win against Atlanta. Jill Stein and the DNC should ask the Federal District Court in Seattle to issue a stay on an official win pending further investigation.
Any chance the parient can sue those willfully blocking the passage of the ambulance – the organisers?
I’ve been generally pleased with Trump’s actions so far. I couldn’t be happier with his cabinet picks. The immigration policy roll out was clumsy at best, but the premise is sound. It’s nice to finally have a Republican president who has a pair….
….but if you think he’s not going to go full-Keynesian when this bubble pops I’ve got a resort in Mar-a-Lago to sell you.
“Countdown for the Trump bashers to blame DJT for the bubble”
More like blame him for the INEVITABLE crash or major downturn and they can easily get away with that, too, because, yes, Virginia, people are that clueless.
There is a difference this time – the rise of the passive fund blindly following market weight and re-balancing on some known schedule, not very often – to keep costs down. The passive market element is now substantially higher than 1999-2001.
There will be substantial mispricing on any rapid indexes change. There’s money to be made there, I think they will add to market inefficiency when change happens quickly. Inefficiency that could be exploitable.
Passive is great in a sensibly valued medium volatility environment, not when extremes are prevelant.
Ammunition for Trump etc. Also shows economists don’t have much of a clue.
“German factory orders, released this morning, have smashed forecasts by growing by a whopping 5.2% in December. That’s the best result since July 2014, and crushing the 0.5% expected by economists.”
Euro drops a lot and german factory orders increase.
Seems an obvious thing to happen.
We are in a stock market value bubble that is based on consumer debt bubble and government debt bubble and that are causing a demand bubble.
There will be a crash.
.
Keep cash handy and create a list of great companies you will buy when they reach discount valuations.
The problem is that so much of the consumer demand is FAKE (aka financed by debt levels that are unsustainable) so once the crash comes consumer demand will most likely stay depressed for a long time.
.
When well paying jobs disappear the debt levels should be going down but instead the debt levels are going up.
When well paying jobs disappear the consumer demand should be going down but instead it is going up.
I used to love when people would go on four hours, just like this guy did. Then I would just respond. “But it keeps going up”, then back to whatever I was doing.
That said… I have had this weird thing with 2,400 for a few years now. Think I might let some fly there.
…and VIX has NOTHING to do with FEAR. Why must people keep repeating that stupidity?
If you have owned volatility since December you have been ass raped.
ERP is decisive. When it went negative in 1929 we all know what happened. If interest rates keep rising and the profit outlook dims causing ERP to go negative, watch out. Hussman’s graph on median P/E is one of the most interesting graphs I have seen recently. Shows that all shares are vulnerable.
Well, let see what Trump did or did not do so far:
Did not exactly kick Golden Sacks to the curb.
Loosened financial regulation, and other regulations without prosecution for misdemeanor.
Did not address the issue of FED.
Promised to repeal Obama care, i.e. profits to health insurance companies.
Lower corporate taxes without addressing loopholes, i.e. higher profits.
Spend money for infrastructure and the military. Obviously, by increasing deficits.
Building the wall, onshoring manufacturing, and tighten H1B visa program would decrease profits, but those are still just promises.
ECB questioned by MEPs today and stated Trumps deregulation is the last thing needed.
They will look to pin anything on anyone.
What I don’t quite get – why can’t the ECB organiuse their own regulation if they are so concerned with changes Trump will bring in?
Presumably, because banks are so interconnected that one rogue system can blow up the whole system. In this case, kettle calling the pot black. Still, could be a good, politically expedient fodder for the MEPs.