Not surprisingly, the question most frequently posed by our shareholders, investors and other stakeholders concerns the relative valuation of equity markets. U.S. indexes set new all-time price highs recently and references to the late 90’s are starting to pop up with greater frequency. So, are we in a “bubble?” and, more specifically, do today’s markets look anything like the late 90’s?
Summary
- U.S. stocks are not in a bubble, and 2017 is nothing like 1999 – valuations, leverage and behavior don’t compare at all.
- Main Street participation in this bull market remains apathetic. When was the last time your cab driver, or, since this is 2017, your college-educated Uber driver, recommended a stock?
- Pockets of soaring valuations exist, including an odd twist where some venture-backed companies’ valuations today are far higher than publicly traded companies. So, Silicon Valley sure is “bubbly.” Uber is valued at fifty times revenue in the private market, but Apple is ten times EPS in the boring old stock market. We believe this is unprecedented.
Economic bubbles share common characteristics, whether tulip bulbs, real estate, internet stocks or college tuition. First, a rapid rise in asset prices occurs that vastly exceeds the asset’s intrinsic value. Then fantastic “stories” and narratives are concocted to justify price levels. Finally credit standards decline and debt is readily issued to fund asset purchases. Bubbles ‘pop’ when prices stall and debt is called in.
Today, risks in the equity markets abound to be sure, but anyone comparing 2017 to 1999 simply hasn’t done the math. For those too young to remember, silliness was everywhere in the 1990’s. RedHat Software was trading for 300x revenue in 1999 and analysts justified such prices as “cheaper than the comps.” DoubleClick, it was said, should be valued on “clicks.” The madness wasn’t limited to small caps. Cisco Systems’ valuation back then (100x revenue) meant that it needed to sell three routers to every man, woman and child on the planet to justify its enterprise value.
David Einhorn of ThirdPoint Capital made an excellent point in his latest investor letter, not to be overlooked. “There was no catalyst that we know of that burst the dot-com bubble in March 2000,” Einhorn wrote, “and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen. . . In due time, we expect these bubbles to pop.”
He’s 100% correct. The Tech Unwind of the early 2000’s began slowly and picked up momentum over a multi-year period, mostly because valuations were insane relative to business models, and too many concepts were chasing too little revenue, usually financed from a bloated and unstable balance sheet. There were many tech and telecom bankruptcies in 1998 and 1999, but they were mostly shrugged off as anomalies, and the high-profile filings didn’t begin until two years after Nasdaq peaked in March, 2000. People forget that Worldcom was one of the last of its breed to file Chapter 11.
Today, in contrast, market darling Apple Computer makes up 4.7% of the S&P 500’s total value, but still only trades at ten times earnings, generates more than a billion dollars per month in free cash flow and maintains a $250 billion cash hoard that’s larger than the entire Mexican stock market. Outrageous public company valuations like Tesla Motors (five times sales) or Exxon-Mobile (43 times EPS) are the anomalies. If 2017 were 1999, Tesla would have dozens of comparables valued similarly, but instead peers Ford and GM trade for single-digit P/E’s and 5% dividend yields. There may be a valuation bubble in Tesla, but it is not the norm.
Our trusted advisor Don Luskin of TrendMacro tracks equity risk premia across global markets, and has data in the U.S. back to 1900. The chart below plots the risks priced into U.S. equities measuring forward earnings yield less 10-year treasury yield. The current reading of 2.73% is just below the Crisis-era mean of 3.72% which itself it just above the Post-1900 moving average of 3.60%.
As far as bubble markets go, the data clearly points to 1999 and 1987, each with negative -2% equity risk premium, which is not even remotely close to today’s seemingly tamer prices. What differentiates an overbought bull market from a bubble is Expensive vs. Insane. At worst, today’s S&P 500 is “mildly expensive.” We very well could get to Insane levels again, but we aren’t there yet.
To be clear, we see caution flags for U.S. stocks, and our hedge funds are well-stocked with short positions in buggy-whip vendors with high debt loads, and companies in secular decline, but few elevate to Bubble Watch status due to valuations.
More broadly, our concerns include unwinding the Great Quantitative Easing Experiment, and the frightening position concentrations in many widely-owned ETF’s, which we believe will lead to serious liquidity problems during periods of market volatility, especially during drawdowns.
Another significant risk to equities is that debt leveraged to the stock market is rising dramatically. Recall the third shared characteristic of bubble from our page one definition: That “credit standards decline and debt is readily issued to fund wildly overvalued assets. Bubbles ‘pop’ when prices stall and debt is called in.” The chart below clearly indicates U.S. brokerage accounts’ securities held on margin has been an instructive, albeit coincident indicator for U.S. equity index prices.
Which brings us to Einhorn’s second excellent point. “The bulls explain that traditional valuation metrics no longer apply to certain stocks,” he writes. “The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.”
Again, Einhorn is 100% correct. Nine years into this bull market, we are certainly susceptible to short-term “crashes.” Sharp drawdowns caused by elections, Brexits, Grexits, war, and Flash Crashes are not only possible but likely more frequent.
Which is why paying too much for growth has long been a fool’s errand. Investors often forget that for a 30-year period through 2009, the S&P Utilities Index actually outperformed the Nasdaq. Valuation has always provided investors with a margin for error.