Are stock markets over valued or is there more upside from here?
In my last email I highlighted the fact that lots of market commentators are suggesting that stock markets are heavily over valued at the moment and it might be time to get out and move your investments into something more defensive.
As I have said reasonably frequently in the past, I do not claim to have a crystal ball or the ability to predict where markets are going. That said – I do think that the whole question of whether stock markets are about to endure a massive crash or not is quite an interesting one and wanted to put some thoughts down on the matter.
So let’s look at some of the arguments currently doing the rounds about why a crash is very likely. In what follows – I will use the US S&P 500 index as a proxy for shares generally. Clearly individual country indices such as the FTSE in the UK, CAC in France, DAX in Germany or Nikkei in Japan are affected by various country-specific factors but – given “when America sneezes, the world catches a cold”, looking at the S&P 500 is broadly relevant to stock market investment the world over – it will also make the article easier to read seeing as I won’t have to talk about half a dozen indices the whole way through ;-) .
How long has this been going on?
The first argument is about the length of the current bull market. After the last stock market crash of 2007-2009, the S&P 500 bottomed at the rather spooky and biblical number of 666 in March 2009. This means that the current bull run is now eight years and two months long – in its 98th month. This is second only to the run from October 1990 to March 2000, which lasted 113 months. Various folk point to this as bearish (negative) – but I suppose the counter argument is that, if this bull market can match or even surpass the length of the longest one, then we’ve still got over a year left to go. As such, I’m not sure that this analysis is particularly helpful. The market could have another 20 months to run for all we know – which means that selling now could leave a great deal of money on the table if it does.
It’s too expensive
The next argument concerns valuation. Below is a chart of something known as the Schiller or Cyclically Adjusted P/E ratio (“CAPE” ratio) for the S&P 500 going back to 1880. The CAPE ratio is a long run measure of valuation for the stock market – essentially the average P/E ratio of the last ten years.
Shiller PE Ratio
Market bears highlight the fact that this chart must surely evidence that we are at or very near a crash. As you can see in the chart, the market valuation is around the level of the 1929 crash and above the level of the 2007 one (but not yet as ridiculous as it was in the dot.com boom of the late 90s).
But does this actually tell us much? First – I’ve heard more than one sensible market commentator say: “If you used the CAPE ratio to decide when to invest, you’d never invest in the stock market at all.” This is a fair point, given the ratio has been higher than many ‘purist’ investors would like essentially the whole time that the S&P has bounced by more than 200%. That is a great deal to miss out on just because you happened to fixate on one measure of stock market value.
People I know in financial markets started wondering if the S&P 500 was a sell from about the 1,000 level – seeing as it was up about 50% from the 666 bottom and various ratios (the CAPE included) suggested the market was already “expensive”. If you felt that way – and sold out of equity markets at that level – you’d have missed out on more than another 140% of upside since then.
The counter argument from the bears at this point, of course, would be that that’s all very well and good but the valuation now is just too much. Enough is enough. They would argue that the rubber band was stretched then and is just insanely stretched now. A snap back must be coming.
Buy backs and corporate profitability
Other points flagged by the bears to suggest we are due a big correction, include:
- The "worrying" proportion of earnings that have been driven by companies buying back their own shares – usually by borrowing money. This, they say, is ‘fake’ growth and can’t go on for ever.
- The fact that total corporate profitability for S&P companies is the same today as it was five years ago – yet the market is up as much as 100% since then as we’ve seen. This is the valuation point again, just made a different way. If earnings are static but the market continues to rise, this just means that investors are willing to pay more for those earnings – hence why the CAPE ratio is close to 30x today vs. the 20x or so that it was ten years ago.
- The fact that corporate profit margins are at or near all-time highs. On average, S&P 500 companies currently make a higher percentage profit on each dollar of sales they make than ever before in history. The bears would argue that this is unsustainable. When profit margins ‘mean revert’ (i.e fall) this will bring earnings down and the stock market as a result (given the stock market level is a function of corporate earnings).
I would argue that these three things are all deeply intertwined and have been driven by two broad themes which are not necessarily done and dusted: First, the impact of certain very real structural changes on companies – primarily technological development and related globalisation but also growing corporate power in politics. Secondly, the impact of what has been going on in the bond market – that is to say - the impact of interest rates, what I call real inflation and government policy in this area all over the world.
Structural change – “It really is different this time”
Companies have been able to buy back their own shares because interest rates have been extremely low (which we will come to in a moment) and because their profit margins have been historically high (the more profitable you are, the easier it is to justify taking on more debt and buying back your shares since lending banks and bond investors look at net debt to EBITDA ratios – i.e. your ratio of debt to your profits – EBITDA is a type of profit calculation – it stands for “Earnings Before Interest, Tax, Depreciation and Amortisation”).
Profit margins have, in turn, been higher thanks to low interest rates (you can have higher profit margins if you’re paying less to take on debt and to be able to invest in things like machines or people, which in turn make your more profitable) and one other over-arching trend: Technological development. Exponential developments in various technologies have enabled companies to do a raft of things to increase their profit margins – both in terms of bringing their costs down and in driving greater revenues (higher revenues on the same costs equals higher profit margins of course).
We should all understand this intuitively. BMW can build cars more cheaply in Vietnam than they can in Munich. Thousands of companies use software engineers or call centre workers in Eastern Europe, India or South Africa. Skype is free. Manufacturers of televisions, computers and mobile phones use enormous and hyper-efficient manufacturing companies in places like Taiwan. Even relatively advanced and complicated biotech manufacturing processes can be outsourced to facilities in places like China, enabling western biotech companies to focus on higher margin research and drug development.
I’ve written about this before, but telecommunication and computer technologies have enabled companies the world over to make their operations fundamentally more efficient and higher margin in a thousand different ways. This trend continues year after year. A new generation of depressingly ignorant Politicians who seem to have unlearned the enormous benefits of specialisation and global trade may attempt to slow this whole process down but I would hope that things have now gone too far for them to have much of an impact. I doubt that Donald Trump (or Jeremy Corbyn for that matter) is going to be able to prevent me and millions like me from using Skype for business calls or outsourcing any number of things I need doing to sites like Upwork.
As top-performing professional investor, Nick Train, has said:
"Virtually every company we meet tells us that digital technology is changing their business... either offering unprecedented cost savings, or, more important, new growth from enhanced products and services..."
Technology as it is today means that nearly every well-run company in the world should be able to optimise their cost base in a way their predecessors never could. But there is more good news: These very same factors have enabled companies to sell all over the world too.
Two generations ago there were relatively few companies that were truly international – today there are literally millions – including even tiny companies and sole traders. Not that long ago only the very largest companies (the oil majors for example) were able to operate in foreign countries. Today even tiny companies and individuals can aspire to sell in dozens if not hundreds of foreign countries. Thanks to economies of scale – a bigger sales opportunity drives higher margins, all other things being equal.
A century ago H&M or Inditex (the parent company of the Zara clothing brand) might have had a few dozen stores in Sweden and Spain (their respective home markets). Today they have hundreds of stores all over the world. We might joke about when people in Mogadishu will finally be lucky enough to experience the joys of skinny Nordic jeans – but it is almost certainly sooner than you think (if you had suggested to anyone in Beijing or Moscow in 1985 that they would have pretty much every major western brand in those cities by 2005, they would have thought you were stupid, mad or both).
Extraordinary changes have a weird habit of taking us all by surprise and then, even more weirdly, being taken for granted very soon indeed after that. What was really very unusual indeed two years ago, rapidly becomes normal today. I would argue this is a real shame and the reason for a great deal of human misery (i.e. when we don’t realise just how much better the world is getting because if feels ‘normal’ to us and we go back to focusing on everything that is wrong rather than just how amazingly right so many things have gone – but I digress and this is a subject for another time).
Facebook has more than 2 billion account holders – almost the population of China and India combined. In 2016, Apple sold just under 212 million iPhones. The global aviation market continues to power ahead and Boeing and Airbus are selling hundreds of planes to Africa, Asia and Latin America.
After about ten years working as a stock-broker it suddenly struck me one day that pretty much every single company presentation that I ever attended (probably approaching a thousand or so by that point) had a sales graph that went from bottom left to top right. How could every company I ever met be growing every year almost without exception?
The answer was partly that the companies I have met throughout my career are the ones that have succeeded enough to make it on to the stock market, but it is also because successful companies that have internationalised find they can grow their sales for decades, year after year, as they succeed in each new geographical region (and with a wider range of products too).
That said, another reason that revenues have “grown” year after year is a slightly more sinister and less real and healthy one: Because of real inflation. A can of Coca Cola cost about 20p when I was a child. Yesterday I paid 200p for one in a park in London. Last year, my parents sold their house in south west London for more than ten times what they paid for it in 1984. It is easier for companies to show sales growth when real inflation is increasing the price (if not the value) of their sales as much as tenfold over the course of one human generation!
I think that’s enough for today given this was something of a long one. In my next email I will look at another theme - neatly related to my point on inflation above - that has been driving corporate earnings and profit margins and, crucially, stock market valuation too… - interest rates, ZIRP, the bond market and QE… Until then...