As regular readers know, the
market-wide valuation measure that OM pays the most attention to is Professor
Shiller’s Cyclically Adjusted Price to Earnings (“CAPE”) ratio. Like all measures of valuation it unquestionably
has flaws – as some kind folks point out here,
here and here
– so bear that in mind as you read on!
Source: multpl.com
First off, the headline CAPE
numbers are pretty scary; valuations were only higher during the 1999/2000
Technology bubble, eek! Wait, but OM’s
just spent some blog posts telling you he owns a bunch of risky distressed
and/or emerging markets stuff like Brazil, Argentina, Uranium and Greece, and
that everything’s awesome – this makes no sense! Worry not kind reader, OM has not taken
(complete) leave of his senses; yes, this chart does look horrific. But…it is a data point, not a fait accompli,
and like many good data points the value is in the context and nuance.
OM is a fan of CAPE, but he
accepts it for what it is; a fine measure of long-term value that’s a good
guide to long-term (10-year) returns. Crazy,
I know, that a measure that uses 10-years of adjusted data is best used at
predicting things over a similar long-term span. What CAPE is not, and the same holds true for
every other valuation measure, is a good indicator if markets are about to
crash (or rally). So the next time you
read an article saying “CAPE = X therefore Markets = Y”, or your favorite
pundit is filling his 60 second slot on TV with “CAPE didn’t predict (or peaked
after) X or Y, and is thus flawed” then for your own sake ignore them. Sadly, we’re in age where common sense
requires data to be believed so OM won’t just ask you to trust him on
this. Fortunately, we’re also in an age
where the answers are available if you’re willing to look. In this case, Vanguard comes to OM’s
data-rescue with this most helpful chart from 2012 that shows CAPE is a pretty
good guide on long-term returns and everything sucks at predicting next year's.
Source: Vanguard
So, onto the nuance. It’s January 2018, so (the most updated) CAPE
calculations are based upon data from Q4-2007 through Q3-2017. As Q4-2017 earnings are announced in the
coming weeks, they will replace the inflation-adjusted Q4-2007 numbers and as
2018 progresses the 2008 numbers will drop out of the 10-year look back. Well, pre-crisis earnings peaked in Q2-2007
and during the Great Financial Crisis they fell 90% to trough in Q1-2009. As the data from the Financial Crisis drops
out and is replaced by today’s earnings, the Earnings part of the CAPE is going
to look a whole lot stronger. Folks have
tried to model/show
the specifics but what matters is that CAPE is going to fall over 2018 (and
into 2019) unless either (i) the stock market is up a lot (the P in CAPE), or
(ii) something happens to decimate Earnings immediately (i.e. think more
nuclear attack, rather an economic recession which needs time to impact
things).
What intrigues OM is the
potential change in sentiment (dare he say narrative) from a “CAPE is crazy
high” to a “CAPE is high but falling” world.
While fundamentals (and value) provide underpinnings for great returns,
it is sentiment and especially sharp changes in sentiment that create the
necessary conditions for those returns. Distressed
situations – including Brazil, Argentina Greece, and Uranium – are plays on
people’s fear, and it is the depressed valuations coupled with the shift from
“this is abysmal” to “there’s challenges, but this is not too bad” that creates
the returns. Today, for the broader
markets that are fairly (to expensively valued) it’s the move from “things are
pretty good” to “everything’s awesome” as investors’ greed sees them
extrapolate out all the trends and find ‘good’ reasons to ignore the warning
signs. While we are still some way from
speculative excess, OM thinks he has started to see increasing signs of people wanting
and starting to believe…Here are some signs that have piqued OM’s interest.
- Global Economic Growth: As the first post noted, it’s the first time in a LONG time that everything’s looking pretty rosy globally. Don’t underestimate what not hearing about economic strife does to people’s risk appetites. The longer it continues, the more likely people are to extrapolate and expect the good times to roll.
- Length of the recovery: This has been a long recovery, and a key argument against it has been that it has been very uneven with metropolitan areas doing well, while the rest of the country failing to keep up. The sheer length of the economic rebound coupled with the demographic trends (people leaving the NE/Midwest for the South and West) means this will naturally change. Conor Sen wrote a timely piece on this, and it plays neatly into the next point.
- President Trump: Whatever one’s opinion of the President, I think we can all agree that (i) he likes to be flattered, and (ii) that he enjoys taking credit for anything that goes well. Hence, good economic facts and rises in the stock market are worth Twitter victory laps. Under President Trump, EVERYTHING IS AWESOME and if it’s not its (pick a group)’s fault and only he can fix it. It doesn’t matter whether it’s true, if the data keeps rolling in then he will keep saying it. If you say it long enough, then people might even start to believe it – the signs are that they already do!
- 2008 (and especially 2000) fades from memory: The further we get from 2000/2008, the easier is to forget the lessons and attribute the events to foolish other people or our naive younger selves. There’s a reason why there’s a popular misquote about history rhyming.
- Corporate Margins & Tax Cuts: Corporate margins are near all-time highs, and Congress has just passed a healthy tax cut designed to benefit corporations yet more. This will be good for corporate earnings, and Our Man suspects that (in the short-term at least) a little of it might even find its way into wages. Not too much, of course – since wage rises are regarded as bad for corporations and by the Federal Reserve – but enough to make the wage earners feel a little happier and more optimistic.
- Deals: We’ve started to see mega-mergers and IPOs reappearing, the bigger and more publicized these get the nearer we’ll be to the end of the road.
- Big Tech: In Things From My Newsreader, Our Man mentioned the pushback that bit tech was starting to get. These firms continue to receive every increasing amounts of media coverage (both positive and negative), and while the companies are starting to get some pushback, the stocks (and those of international peers, e.g. Tencent) continue to rise inexorably. If Our Man is right, these trends will continue so expect to hear a lot more about Amazon, Apple, Google, Facebook, Netflix, Tesla, etc and how they’re going to change the world, how they’re ruining the world, and how much their stocks keep rising.
- Cryptocurrencies: Our Man suspects that we’ll look back at cryptocurrencies as the tinder that helped fully unleash the animal spirits. The blockchain is a great concept but early in its lifecycle (like the Internet in the late 90s) and much is still to be proven and determined. Thus at this stage it’s a better narrative than product/tool and like all good ideas, it’s ripe to be extrapolated to beyond its current limits. While the claims of grandeur may come true, it’s already at the stage where it has true believers insisting that it will change the world (Everything will be AWESOME!). The world we inhabit means their $ profits validate these opinions, and just in the last couple of months we’ve seen a broadening out as people’s greed and FOMO see them join the party. After all, Coinbase now has more accounts that Charles Schwab.
Final Thoughts
So in summation, get
ready!! OM’s working theory* is that if
2017 was the slow and steady chug to top of the rollercoaster, 2018 (into
perhaps 2019) is going to be the insane part, with much more volatility and the
possibility of much much higher prices.
It goes without saying, that Sod’s Law dictated that
while OM put-off completing this piece over the holidays, someone far smarter
and more productive came out with a better (and more aggressive) version of
it. Read
value investor and bubble historian Jeremy Grantham’s piece – it’s great
and OM hopes he’s right.
* As a ‘sensei’ of OM would
say; have a working theory you believe in and then project, monitor and
adjust. In that vein, expect a future post
with a list of things that OM is going to be keeping his eye on to help him
work out if he’s wrong.
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