Thoughts from our Domestic Equity Team
In the financial press we have recently noted a number of articles using the word “bubble” to describe the current state of affairs in the stock market, including a recent cover article in Barron’s(1). While we believe the reporters who author such pieces are well-meaning, history is replete with examples of magazine covers as contrarian indicators. Notable among these are The Economist’s “Drowning in Oil” cover in March 1999, shortly before crude oil embarked upon a multi-year 400% rally, and Business Week’s “The Death of Equities” in 1979, just before the inception of a two-decade long bull market. In general, calling out bubbles in markets is not something that has been met with a great deal of success. In our opinion, typically bubbles are easy to identify only in hindsight, with recent classic cases being the internet-driven tech bubble of 1999/2000, the housing bubble that precipitated the recent financial crisis, and the nifty-fifty era of the mid-1970s.
Back in the 1998-2000 bull market the S&P 500 index was valued at over 20 times estimated earnings, and reached a peak of 26 ½ times in March 2000. In the post-bubble era of 2002-2006, the S&P 500’s P/E valuation ranged between 14 and 17 times forward earnings estimates. In general, an inverse relationship has historically been observed between interest rates and inflation and equity valuations. During the post-bubble era, yields on ten-year Treasury notes at that time ranged between 4-5%, well above today’s 2.7%, and core inflation ranged between 1.5% and nearly 3%, compared to today’s reading of 1.7%. Today, the S&P 500 index trades at 15 times estimates of 2014 earnings, which we do not think is out of the ordinary in the context of history or relative to current interest rates and inflation levels.
There are certain pockets of the stock market which undoubtedly have been assigned very high valuations by the market. Stocks in the cloud computing industry, for example, currently trade at very high multiples. As is often the case with the technology sector, disruptive technologies (in this case offered by upstart cloud-computing companies) threaten the business models of well-established older tech companies (such as IBM, Cisco Systems, and Oracle). The industry is changing so rapidly that many of these larger companies are unable to respond quickly enough to the threat, opening up large opportunities for the cloud upstarts to take share. Such inflection points are often associated with high valuations for the group of companies viewed as potential share takers.
The shares of social media companies also provide fodder for the bubble argument. Analogous to the cloud computing example above, stocks such as Facebook and Twitter threaten to upend the old advertising model of television and publishing, particularly as mobile handsets become ubiquitous and users grow immune to the minor intrusions of ads in their feeds and tweets. While it may have been an open question as recently as a year ago, we now have solid evidence that the advertising industry has traversed a major inflection point towards ad spend on social media. No one can know with certainty who among the social media companies will be the ultimate winners, but we do know that the shift towards social media is real and that it is taking share from the older forms of media.
Biotechnology is a third area which has been referred to in the popular press as a bubble, given the group’s year to date return. Fortunately many of our clients have benefited from the sector’s rally this year, as during 2012 Roosevelt identified a number of biotech companies as beneficiaries of our “Healthcare Revival” theme. This theme combines what in our view is a more constructive FDA with improved productivity in new drug development. We believe that rather than being evidence of a bubble, this combination has helped lead to the double whammy of expanding valuation multiples and increased future earnings estimates, as the investment community has grown to better appreciate the revenue and earnings potential of these companies.
Nevertheless, we see valuations across the entire market that are higher than they were 12 months ago. One of the most frequent criticisms of bearish market commentators is that profit margins are unsustainably high, and when they inevitably regress to their historic mean, that will negatively impact valuations and send the market lower. This line of reasoning may sound logical, but we believe it is too simplistic. While it is true that a cyclical upturn in the economy generally provides companies with operating leverage that results in margin enhancement simply because revenues are growing faster than expenses, there are many sources of margin improvement which we view as more secular and permanent in nature.
Over the past two decades, many lower-margin manufacturing businesses have shifted away from the U.S. to lower-cost environments, perhaps never to return. Relatedly, many companies have embraced outsourcing and have moved significant parts of their cost structure overseas. These trends have facilitated a mix shift in which the margins of the remaining businesses are higher, on average. Also enhancing the overall mix of margins in the U.S. economy is the emergence of certain internet-based digital businesses which not only have extremely high margins but give away their productivity-enhancing products for free. As well, the increasingly entrenched trends of enterprise software and robotics in manufacturing have likely permanently shifted productivity (and hence margins) to a higher plateau. We believe it is highly unlikely that businesses will ever revert back to the days where these productivity-enhancing tools are discarded.
It has been said that the market climbs a ‘wall of worry’, and recent media chatter about a bubble may help provide impetus for the market’s continued climb. We do not currently see a bubble in the stock market, but as students of stock market history we continue to watch for signs of trouble on the horizon. The financial crisis of five years ago emanated from excess leverage in the system and residential and commercial real estate bubbles brought on by the easy availability of credit. Ever since then, investors have been closely scrutinizing all kinds of credit spread metrics for any hint of trouble. But in our view it is more likely than not that the next bubble will have its origins elsewhere. As Mark Twain once said, “history does not repeat itself, but it does rhyme.”
Submitted by:John Roscoe, CFA
(1)Bubble Trouble, Barron’s November 16, 2013
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