In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John discusses why he thinks the talk of a bubble in the stock market just isn’t supported by the facts.
Excerpted from the Nov. 22, 2013 issue of the Validea Hot List newsletter
“Only by learning to live in harmony with your contradictions can you keep it all afloat. You know how fighting fish do it? They blow bubbles and in each one of those bubbles is an egg and they float the egg up to the surface. They keep this whole heavy nest of eggs floating, and they’re constantly repairing it. It’s as if they live in both elements.”
– Poet Audre Lorde
For more than five years now, the Federal Reserve has been pumping billions upon billions of dollars of liquidity into the U.S. financial system. Other central banks have followed suit with billions upon billions of their own. It’s no secret that one of the Fed’s intentions with its ultra-low-interest-rate, ultra-high-liquidity policy was to drive investors into riskier assets — like stocks — thereby creating a “wealth effect” scenario in which stocks rise, Americans feel wealthier, Americans spend more, and the economy grows at a strong pace.
The growth-generation part of the plan hasn’t been too successful. With banks hoarding much of the liquidity provided by the Fed, growth has been average to subpar for most of the last five years. But more and more pundits and analysts are saying that the wealth effect part of the Fed’s plan has been working all too well, pushing stocks higher and higher and far beyond what their fundamentals merit. Could stocks, like the fighting fish eggs to which the poet Audre Lorde referred, be supported by little more than bubbles — in this case dangerous, precarious, bubbles blown by central bankers who want desperately to live in two elements (that is, one world of feel-good, rising markets, the other of harsh economic realities)?
A growing crowd seems to think that’s the case. I’m not among them.
To understand why, let’s first look at some measures of the broader market’s valuation. The S&P 500’s price/earnings ratio based on trailing 12-month operating earnings is 17.6; its forward P/E (using projected operating earnings) is 15.4. Those figures have been climbing, yes, but neither is indicative of major overvaluation. In fact, According to Charles Schwab’s Liz Ann Sonders, those are both still shy of the 18.7 and 18.1 averages, respectively, for the past ten bull market peaks.
But by some metrics, valuations do seem high. The 10-year cyclically-adjusted P/E ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 24.9, using Yale Economist Robert Shiller’s earnings data. That’s up from 20.9 a year ago, and well above the historical average of about 18.3 since World War II. But it’s still below the 27.5 level seen in mid-2007, and far below the 44.2 seen at the height of the tech bubble. (For what it’s worth, Shiller — one of the few to recognize both the tech bubble and the housing bubble before they burst — told The Wall Street Journal last week that he doesn’t think a stock market bubble exists today.)
Other metrics show a reasonably priced market. The S&P trades for about 2.2 times book value, according to Morningstar, for example. That’s below the 1978-early 2011 average of about 2.4, according to data from Ned Davis Research and Comstock Partners. The S&P’s current price/sales ratio of 1.46, also according to Morningstar, is higher than the historical average cited by Comstock and Ned Davis. But it doesn’t seem astronomical — my James O’Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.
Now, I suppose one could say that they just don’t trust the earnings and sales data these days, and that the bubble is less like the ultra-high-valuation tech bubble and more like the stealth 2007-08 bubble, in which huge amounts of leverage propped up earnings and sales to make valuations look deceivingly reasonable. And to be sure there’s a bit of that going on, with historically low interest rates helping corporations borrow money on the cheap, and letting homebuyers get very low mortgage rates. But in some cases, the low rates hurt businesses and consumers. PIMCO bond guru Bill Gross has noted several times that the low rates make for low yield spreads, which can actually hurt bank profits. And for consumers, well, just check your bank statement to see what kind of returns your cash is earning. (And, with a personal savings rate of 4.9% in October — nearly twice what it was before the Great Recession — Americans do indeed still have a lot of their money in the bank.)
As for the sea of liquidity central banks have pumped into the economy, it’s pretty well documented that banks haven’t passed a whole lot of that through to Main Street. To say that liquidity itself is artificially supporting the economy and markets, to the point that a bubble exists, thus seems a stretch. In fact, it seems many of the same people who say the Fed’s policies are creating a bubble are also the same ones who have argued that the liquidity provided by quantitative easing has been failing to make it’s way into the economy. You can’t have it both ways. I don’t think you can’t say the liquidity isn’t making it through the system and then say that things like earnings and sales and book values are being propped up by QE — not to the point that a bubble exists.
Then there’s the issue of sentiment. Back during past bubbles, investors have poured into stocks at incredible paces for extended periods. In the four years leading up to the tech bubble peak, investors pumped more than $470 billion into U.S. equity funds, according to The Wall Street Journal (citing Morningstar data). This year, investors through October had put a net of $111 billion into U.S. stock mutual and exchange traded funds — a big number, yes, but not big enough to even make up for the $134 billion they’d taken from those funds since 2009.
To me, the bubble talk seems to be more of a reflection of investors’ psyches than a reflection of reality. For most of their lives, today’s investors knew of stock market bubbles only through history books. Then, within an eight-year span, their portfolios were rocked by two traumatizing bursting bubbles, the latter of which came along with a global financial crisis that threatened to decimate the entire financial system and lead to another Great Depression. The fear that those events caused isn’t something that disappears overnight, or even over a couple years. Wells Capital Management’s James Paulsen has said, in fact, that the scars have led to a “post traumatic-Armageddon-hypochondria” among investors — just as a medical hypochondriac’s mind immediately goes to the worst-case scenario when they get a minor ache or cough, so too do many investors’ minds now go to disastrous scenarios at the slightest sign of trouble.
With the economy having weathered so many storms and appearing to be on decent footing for the moment, I think many people’s market hypochondria has shifted away from economic ailments and toward valuation. And there’s no doubt, valuations have been rising. Around this time last year, the S&P 500’s trailing 12 month operating P/E ratio was 14.2, and its forward operating P/E was 12.7. Its price/sales ratio was 1.3, while its price/book ratio was 2.0. All of those figures have increased over the past year, some by fairly significant margins. But taken in their totality, these measures just don’t paint a picture of a bubble, or anything close to it.
Confirmation bias also may be at play here. During the 2008 market crash, many pundits and prognosticators said that the U.S. economy was headed for oblivion, along with U.S. stocks. The Federal Reserve, they said, could keep things afloat for a little while, but soon things would fall apart. Well, we are now five years past the financial crisis, and the economy, while far from spectacular, continues its slow, steady improvement. And stocks have been a great investment over the past several years. Those who had been calling for doom and chaos don’t want to admit that they were wrong, so they dig their heels in deeper and deeper and look for any data that will confirm their gloomy predictions, regardless of new data that shows that the economy is hanging in there and stocks are decently valued.
It’s hard not to cling to your beliefs, even in the face of changing information. We try hard not to do that. We try to stick to the facts and figures, and right now, in my opinion, the totality of the data seems to show that the market is somewhere on the higher side of the fair value range. You might even say that it’s gotten a bit ahead of itself. But guess what? That’s what happens in bull markets. Valuations go up. They pass their historical averages — by definition, you’re sometimes going to be on the high side of an average. But “a bit ahead of itself” is not the stuff of which bubbles are made. Perhaps because they by and large missed the last two bubbles, however, the media seems to be fearful of getting blindsided a third time. The slightest hint of overvaluation thus leads to the “B” word getting thrown around.
The reality is that, while some stocks and areas of the market are looking pricey, we’re still finding plenty of individual companies whose shares are trading at very reasonable values. Take Hot List newcomer Chevron. This well-established energy giant trades for just 10 times earnings and just over 1.0 times sales, despite having grown earnings at a 26% pace over the long haul, having a debt/equity ratio of about 13%, and having a 17% return on equity.
Chevron is far, far from the only strong business with cheap shares out there. That doesn’t mean the broader market is going to continue higher without any hiccups, of course. As I always say, predicting the market is incredibly hard, particularly in the short term. Could a correction be just around the corner? Perhaps. But given all of the evidence, I feel comfortable as a long-term investor owning the types of stocks that are in the Hot List today.