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Our friend and partner Charles Trafton of FlowPoint Capital recently pointed out to us some very interesting data: right now growth rates for 2017 EPS are higher for value stocks than growth stocks. He also notes, ironically, that there is no manual for this.

He’s right. There is no manual for much of what we’ve seen lately, and that is precisely the point.   The makeup of the market has changed dramatically in the last ten years, with significant new earnings drivers and business models appearing. The distinction between value and growth might indeed be blurring (perhaps permanently) and investors need to adjust and rethink portfolio construction. As always, it’s never a mistake to focus on earnings quality first, regardless of its source.

For example, a frequent lament today is that the market’s valuation, excluding tech and financials, is stretched. To which we would say: then own more tech. Any review of the market’s earnings stream today shows the importance of tech and why that is now a good thing, indeed almost necessary. As you can see from the table below provided by FlowPoint, tech makes up 22% of the S&P’s market cap but contributes 32% of its operating margin.

Source: FlowPoint Capital and Bloomberg

Today’s tech sector isn’t your father’s Oldsmobile, as we point out here. Tech earnings in 1999-2000, when the sector was 34% of the S&P’s market cap, were of a markedly lower quality. Dirty would be a charitable characterization. The old days of tech had companies doing things like trading network capacity between each other and recording it as revenue, and hiding the impact of stock options on earnings.

Today? Tech provides 38% of the S&P’s total Return on Assets, almost twice the contribution from the next most efficient sector, healthcare, which speaks to the quality of tech earnings now. Look at it selectively and the importance of tech’s earnings quality, and the efficiency of tech business models, becomes obvious. Apple’s return on assets is 14.29% currently, it levers those assets 2.5 times, for a return on equity of 35.0%. Apple’s weighted average cost of capital (WACC) is 11.0%. AAPL’s ROE is three-times its WACC. Now that is whack. We’re not saying AAPL is a buy here (we sold ours last month), only that its business model efficiencies produce a lot of operating leverage, as do most tech franchises.

What about tech companies that masquerade as financials, like MKTX? Right now, its ROA is 28.4% (only 3 cos in S&P 500 have a higher ROA–Altria, ebay and MasterCard) and it is levered only 1.1 times for a return on equity of 31.3% vs. its 10.3% WACC. Put another way, that’s $370,000 in after tax net income/employee.  These “tech” companies, especially non-tech tech like MKTX are all extremely efficient. A reason that NVDA is trading where it is, is this (among other good reasons).

It’s precisely because of what is occurring with respect to other sector’s earnings trends that tech becomes such an important pillar, and why investors need to rethink portfolio construction. Look at the chart provided by FlowPoint below. Six sectors of the S&P currently are contributing nothing to the S&P’s return on assets. By nothing we mean zero.

Source: FlowPoint Capital and Bloomberg

What’s most worrisome to us with respect to earnings are trends like the Amazoning of the consumer space. While Amazon hasn’t eaten the whole world yet, it is a massive deflationary force in a big space that right now contributes positively to the market’s return on assets and earnings growth. Amazon’s impact on retail recently has garnered headlines, and rightly so, but the real impact of the Amazon trend has yet to be truly felt. To us, this is a great risk today, that sectors become zero-sum games. If so, portfolio concentrations to the winners have to increase.

Is it any wonder then why tech stocks have become such core holdings for many? While tech is very much a crowded trade today, which creates its own risks, it is also a trade that appears to be selectively justified. The remaining question is will the other important market sectors make increasing contributions or not, and if not, are they worth owning at all?

The recent CCAR findings appear to indicate that banks will no longer be the drag or the concern they once were, so financials (at least the right ones) could start to help tech shore up the market’s earnings profile. What about energy? Historically it was a big driver of earnings but the current Administration is more likely than not to unleash a production boom (more on that in another blog post) that will act as yet another broad deflationary force. We have pointed out elsewhere what a train wreck consumer has been. Is that ever righted? Materials will always be a sector that responds to macro influences selectively, and should be played accordingly.

So, actively tilting portfolios toward higher quality earnings streams – sustainable, durable business models – will become more important if these earnings trends continue, as they seemingly are. Almost half of the names in the S&P posted negative returns for the past six months. The market is beginning to make distinctions between business models, as we have pointed out before, and so, then, should investors also address the real issue: not just the absolute level of earnings and valuation, but also the quality of the drivers, and who is driving. The evidence would suggest that greater concentrations around higher quality earnings streams is the better approach. We might be at the point where sector diversification is not the risk management tool it once was.

 

This week, Paul Ryan held a press conference to highlight tax reform initiatives. It didn’t get nearly the attention it deserved. But then, tax policy in general rarely gets the attention it deserves (more on that later). You know what also never gets enough attention? Public policy.

After years of hostility to the notion, the United States appears to be now embracing a move toward more energy independence. The byproducts of that (no pun intended) are just beginning to be felt, which will have far-reaching and positive economic implications for the U.S. beyond energy.

A great article recently appeared in the UK Evening Standard about fracking and the risk not pursuing fracking aggressively presents to the UK. The article, by Anthony Hilton, touches upon an issue that we never talk about enough – the positive mushrooming impact on jobs from energy exploration. It is worth quoting Mr. Hilton at length:

Once you have built a major chemical complex, your main (in many ways, your only) worry is the cost of the raw material you need to feed into it. This can account for half or more of total production costs, and is similarly crucial for other energy ­intensive industries such as refining, iron and steel, glass, cement and paper.

Until a few years ago Europe and America paid more or less the same amount for their petrochemical feedstock — the US had a slight advantage but not so great after transport and other costs had been factored in. (Middle East plants, sited right by the oilfields, did have such a price advantage but lacked scale.)

This is no longer the case thanks to the fundamental changes across the Atlantic. The Marcellus field, which spreads over several states and is just one of many in the US, produces 15 billion cubic feet of gas a day which is almost twice the UK’s entire consumption. But the result is that US prices have disconnected from the rest of the world and the subsequent feedstock prices have given American chemical plants so vast a price advantage that, on paper at least, there’s no way Europe can compete. It is staring down the barrel of bankruptcy, not now, but in a few short years, unless it can find some way to get its raw­ material costs down to American levels.

Thus far, the effect has been muted — and the European industry has had a little time — because the US petrochemical industry was originally not built for indigenous US gas and oil supplies but instead located near ports and configured to process supplies of oil from the Middle East.

But this is changing fast. There has been virtually no big petrochemical investment in Europe in the past decade whereas in the US since 2010 some $85 billion of petrochemicals projects have been completed or are under construction. Spending on chemical capacity to 2022 will exceed $124 billion, according to the American Chemistry Council, creating 485,000 jobs during construction and more than 500,000 permanent jobs, adding between $80 billion and $120 billion in economic output. After years where chemical capacity has run neck and neck with Europe, the American industry is about to dwarf it.

Plainly stated, fracking and horizontal drilling have produced for the US a great economic advantage over Europe and elsewhere. It would be irresponsible to stop. Thankfully, the War on Drilling appears to have ended last November. Let’s hope state governments stay out of the way. . .

I have heard too often in my lifetime that presidential elections aren’t that meaningful because Washington gridlock prevents the U.S. from lurching too far in any direction, which is supposed to be a good thing. I hope the article quoted above can help debunk that idiotic notion. We can think of few things more complementary to economic growth than sound public policy from the Executive branch. Tax policy might be the only thing that matters more.

We will have more on the impact of tax cuts in future posts, but If you are looking for events to cause a sharp pullback in markets, a delay in tax reform, or weaker than expected tax reform, or tax reform being tabled altogether gets our vote as Public Enemy No. 1 for markets.

 

 

Should we be worried about CAPE, the popular Shiller Cyclically Adjusted Price Earnings ratio? Experts tell us it is trading at exceedingly high levels and, the experts also say, those high levels portend poor stock returns, according to CAPE.   We’ve thought about that and have come to the following conclusion:

So what?

First, CAPE is a notoriously bad prognosticator. Second, CAPE has been high for the past 20 years, and has moved steadily higher since 2010. Anyone complaining about stock market returns this decade? Finally, what about the “E” part of CAPE? What do earnings imply about current levels?

For those unaware, CAPE is a price earnings ratio based on average inflation-adjusted earnings from the previous 10 years, sometimes called the Shiller PE Ratio, or PE 10.  As you can see from the chart below, CAPE valuations are at historically high CAPE levels relative to the average.

Source: http://www.multpl.com/shiller-pe/

 

But are CAPE valuations truly stretched?  This is a ten-year average calculation.  In the last ten years, adjusted SPY earnings included two years (2008-2009) that could easily be considered trough earnings based on recent history ($17.31 and $51.71 per share, respectively versus $95.00 for the 2010-2016 average).  When the 2008-2009 earnings fall out of CAPE starting next year, and IF those earnings are replaced by anything remotely close to recent history, is today’s ​CAPE multiple truly rich?

When we project CAPE by replacing trough earnings, we consistently see about a 15% decline in the multiple which puts CAPE on an adjusted basis today between 24-25, below the 27.12 average seen between 1996 and 2016.  Even if you kick out the goofy 1999-2001 period, CAPE’s average historical multiple drops only to 24 for the twenty-year period, again in line with our adjusted CAPE today.


Source: www.multpl.com/shiller-pe/

What about earnings?  How reasonable is our assumption that 2018-2019 earnings will stay within recent historical averages?  Google and Facebook account for about 8% of the S&P’s earnings today.  Facebook wasn’t even part of the S&P prior to 2012.  Ten years ago, Apple was a company in the index, not THE company.  Would you rather own 2017’s earnings quality or 2007’s?

We’ve said it before and it’s worth repeating: from 2001 through 2005, the S&P 500’s p/e multiple DECLINED from 29.55 to 16.33, and the index traded up 41% mostly because the “e” in the p/e ratio materialized.  Over the next two years, it seems entirely plausible that earnings driving CAPE ratios can hold. You could identify a handful of reasons for the market to trade down from here (China, North Korea, interest rates), but it is hard to argue that an over-valued CAPE is one of them.

 

 

 

In any general discussion of investment strategies on TV or in the press, the focus quickly and often turns to correlations, standard deviations, Sharpe and Sortino ratios, etc. What’s not discussed enough is “when.” As in, when you get in or out makes all the difference between good returns and bad. We have written in the past about performance dispersion between stocks and how important that is as an opportunity for managers. Our friends at FlowPoint Capital recently sent us more data on dispersion and volatility that reinforces the point, and should make everyone think hard about “when.”

In the graph below, you can see correlations between sectors is approaching multi-year lows (tech is almost 100% positive YTD and energy is almost 100% negative). FlowPoint notes that approximately 55% of stocks in the S&P are down year to date, and in many cases return dispersion within sectors shows more than a 50% difference between the best performers and the worst, which is something we haven’t seen in a while. This is good news for active managers and bad news for passive investors (we will do a post shortly on the problems lurking in many ETF’s). This dispersion, as we have noted previously, means the opportunity for outsized returns is high. But it also means that future volatility can be near at hand.

Source: FlowPoint Capital

A popular gripe on Wall Street and in the financial media is that the “Fear Index” is too low and investors aren’t scared enough of the stock market’s risks. But, as Chuck Trafton from FlowPoint notes, “the futures markets spin the opposite narrative – record high Vix contango means everyone is betting volatility will be higher in the future, and the lack of contango in SPX futures means no one thinks stock prices will be higher in the future.”

So, the futures market is betting on higher volatility and lower stock prices and it has been this way for eight years now. What the market has done of course is the opposite, and delivered lower volatility and higher stock prices. When that changes, Katy bar the door.

Below are two charts, courtesy of FlowPoint. The first is the VIX index level (orange) and SPY realized volatility (blue) which shows the VIX at historic lows. The second chart, which shows the VIX index price (orange) versus the volatility of the VIX index (blue), shows that Vol on the VIX is at a ten-year high. The futures markets are clearly betting on higher volatility. The point Trafton and FlowPoint are making is that this can be a very dangerous time for long equity entry points and a terrific opportunity to press shorts where the payoff is rising dramatically. What Trafton is saying is that the “when” part of investing is now becoming paramount.

Source: FlowPoint Capital and Bloomberg

Source: FlowPoint Capital and Bloomberg

 

Source: FlowPoint Capital and Bloomberg

When begets how and what. No doubt you’ve been hearing for quite some time how poorly hedge funds have performed relative to the broad market indexes. That viewpoint belies a reckless disregard of history.

The table below shows returns for a number of investment strategies for a 16-year period (I have deliberately left out the specific dates to help make a point). The strategies include tactical mutual funds, a mix of macro hedge funds ranging from fundamentally-driven to technically-driven, a 60/40 SPY/AGG mix, and a 100% long-only SPY approach. The period I’ve chosen includes three years where the long-only SPY strategy had at least a 28% return or higher. Yet, in spite of having three abnormally large returns, for that sixteen-year period, the long-only, passive, buy and hold approach underperformed.

Source: Richard Oberuc, “Historical Performance of Passive and Tactical Investments” Whitepaper, 2013, Morningstar, HFRI

As a group, the hedge fund categories performed extremely well. Their average annual returns were 2-3% better than the 60/40 benchmark and markedly better than the long-only approach. The standard deviation of the hedge fund categories was somewhat higher than the 60/40 benchmark, but inspection shows that the risk-adjusted returns, as indicated by the Sharpe ratios, are on a par with the benchmark Sharpe ratio. This indicates that the hedge funds delivered higher performance at a similar return per unit of risk, which is what they are supposed to do. The maximum drawdowns of the worst of the hedge funds are on a par with the 60/40 benchmark maximum drawdown. Finally, the hedge fund category returns during the time of the max drawdown were substantially better than the return for the long-only, buy and hold benchmark.

You’ve now no doubt now figured out that this performance was from the 1998-2013 time frame. What happens if we remove 2008 from the table? After all, now that systemic leverage has been dramatically reduced in all markets, the likelihood of another Lehman event is low. Doesn’t matter. The long-only buy and hold approach still underperforms every category except 60/40 and the technically-driven hedge funds. Which hopefully makes our point. Had you bought in in 1998, long and strong on the back of the Netscape euphoria and other Silicon Valley miracles, you would have underperformed an actively-managed hedged approach. You remove the worst performing year in the market’s history, which helps long-only returns and hurts hedge funds, and you still would have been better off in a hedge fund.

If you deconstruct the return periods above, you’ll see that absent 2008, the market had down periods of 9%, 12% and 21%, nothing abnormally bad and entirely likely to be reached again. Three periods in fifteen years where markets had a “normal” correction and buy and hold underperformed. That’s all it takes. “When” matters no doubt, but so does what you own.

 

Last week, amid some controversy, the SEC approved a 4x levered ETF. For a period of time, and rightly, the SEC was considering cracking down on the 2x and 3x levered vehicles so the move to 4x was surprising. Don’t misunderstand, the levered ETF’s offer gigantic arbitrage opportunities because of their structural problems, so in many respects we hope they never go away (we are invested in a fund that benefits greatly and almost daily from these arbitrage opportunities), but that doesn’t mean they are great products for the audience for which they were created.

Bloomberg recently reported that passive ETF indexes now outnumber individual stocks. Without getting into the multitude of problems created by the explosion in passive vehicles, the one overlooked point seems to be how many of these passive ETF’s, because of supply and structural issues, must use the futures markets instead of underlying securities to create their exposure, and therein lies the problem. Remember, a huge issue leading up to and exacerbating the 2008 crash, was the growth in usage of Credit Default Swaps (CDS). There are many parallels to today’s ETF markets.

For those of you unaware, CDS initially were born as a way for commercial banks to hedge their lending exposure. CDS were quickly latched onto as a way to solve a chronic problem in high yield: a lack of paper. If you were a high yield portfolio manager pre-2000, and you had a great idea about how undervalued a credit was and you wanted to buy a bond, often you couldn’t because there were simply no bonds available to purchase. It was not uncommon in the heyday of high yield for a $300 million new issue to be 80% owned by three holders with scraps available for the rest of the market. Enter CDS.

If one could create synthetic exposure, a high yield portfolio manager could reflect almost any view of credits and credit markets, arguably a good thing. And, like many good things, CDS quickly morphed into Frankenstein, and synthetic securities grew to be multiples of the notional value of the underlying securities and that leverage partly fueled the 2008 unwind.

The same situation exists with many ETF’s today, especially the commodity ETF’s, whose problems are exacerbated by contango. When a fund purchases forward to meet the creation requirements of the underlying ETF, and forward curves are more expensive (contango), value leaks away. It is a mathematical fact exemplified by the chart below, which shows that Crude Oil (the blue line) is up marginally in 2017 while the USO (the yellow line), the ETF that represents the price of oil, is down. It’s down because of the leakage in value it suffers when it sells a future for a lower price than the future it must purchase. For a period in 2016, Crude was up 27%, but the USO was down 1%. You can thank Contango for that result. And the USO isn’t even levered.

The levered funds magnify the contango effect geometrically. Capturing the gap between the value of the underlying ETF and the commodity it represents is commonly called “roll yield” and billions of dollars are in the market today arbitraging exactly that. As long as contango exists, this situation will persist. Sooner or later, something will give. We thought the regulators would step in and quash the levered ETF’s. For now, they’ve chosen not to. In the meantime, the market is giving you an opportunity.

In practice, it works like this: Assume a 1% daily move to make the math easy. Day one the market goes down 1%, the next day up 1% and so on for ten days (see table below). Under that scenario, the underlying security returns -0.05%, while both 2x levered vehicles would return -0.20%, the 4x levered vehicles -0.80%. Shorting both the long 4x and the short 4x would return 1.59%. The contango decay as outlined above adds a large measure of downside protection. Two of three potential outcomes are positive: if the underlying sells off, or if it trades with volatility. It is no wonder these strategies are becoming more popular. The odds are in your favor. Adding a long position to protect against an upside spike lowers the risk profile of this trade even further.

Source: Flow Point Capital and Archimedes Fund Management

“QE Works in Practice, But Not in Theory”
–          Ben Bernanke

Last week, in a post about current equity market valuations, we identified the unwinding of QE as a possible threat to today’s bull market. Let us be clear: we don’t think the unwinding of QE (which has already begun, actually) will have any material impact on stock prices. Rather, our concern is more about faulty investor conclusions, which are pretty likely in our opinion, resulting in triggers being pulled on the first QE Unwind-related headline.

A month ago, in the minutes of the FOMC meeting, language appeared that seemed to many a clear indication the Fed would start to let its positions mature without reinvesting proceeds from maturities and pre-payments. The Fed has about $1.5 trillion in maturities due within the next five years, so the great Fed unwind is likely to be gradual. After all the fears about “helicopter money,” rampant inflation and monetary ruin, one can make the claim that QE might have actually worked.

Why the unwind shouldn’t be feared is perhaps best explained by Don Luskin of Trend Macro, who makes the following subtle but excellent point: “QE1 worked because it wasn’t quantitative easing at all. It was a classic prudential intervention, the central bank acting in its role as the lender of last resort – in this case, soaking up agency and mortgage-backed securities that were being dumped world-wide. QE2 and QE3 worked because, well… did they actually work? We don’t think there’s any particularly strong reason to think they did anything at all.”

Trend Macro’s data on QE illustrates the point perfectly as one can see below:

While stocks sold off immediately following the cessation of QE I and QE II, they also fairly quickly afterward assumed their upward march (as they have pretty consistently for most of the past 100 years. . .) The bond market sold off immediately following the onset of QE I and QE II, and then also proceeded to rally (driven by basic market fundamentals). So, one could indeed claim the impact of QE was. . . not much really, so why should the unwinding of QE III be any different?

If long-term yields actually went UP in periods after QE was initiated, why should we fear that yields will rise dramatically because the Fed is ceasing purchases? A credible case can be made that rates will indeed rise, but it will be because of stronger economic activity, as has been the case throughout history.

Indeed, the biggest issue with QE is the introduction of the unknown – we’ve never had a sustained period where rates were driven by the central banks to zero and below. But, pre-QE, rates always moved in relation to economic activity. Returning to that kind of normal organic behavior should be healthy for markets, just as rates falling in response to economic weakness will also ultimately be healthy.

Back in January of this year (seems so long ago. . .), headlines in the Canadian financial press were bemoaning the fact that (1) the Canadian economy was growing at its slowest pace in 60 years, and (2) real estate and financial services now account for 20 percent of the economy.

We have some bad news for Canadians: it’s about to get worse.

When Home Capital Group blew up last week, it was initially shrugged off. Indeed, people have been concerned about HCG for a long time. For a period last month, you actually couldn’t even borrow it from your prime broker, it was so heavily borrowed. If you did get a borrow (back in February), it cost you 30-40% annually. That is not a typo. So, someone’s short paid off, and hopefully those people were sitting on that borrow for months prior (if not years).

What’s interesting to us now is the impact that HCG is having on the EWC, the Canadian ETF. It’s not Greece or Italy at the nadir, but it’s still interesting. The Rest of the World is ripping higher as Canada sells off. And it’s all because of HCG. In case anyone was wondering if we’ve gotten over our fears of the impact of housing on an economy, the data would suggest no.

Blue line = CA
Yellow line = Rest of World

The Ol Double-Edged Sword

Source: Bloomberg and FlowPoint Capital Partners

Last week Consumer Lenders started reporting Q1 2017 earnings, which showed above average loan growth and better margins. But, in spite of the improving revenue trends, a surge in credit costs hurt results and stocks in the space sold off hard. It was Déjà vu for investors who have seen this twice in the past three quarters from the credit card issuers (COF, and SYF in particular raised their loss rate forecast).

Entering 2017, investors in the Consumer Lending/Credit Card sector were assuming those companies would face less pressure from new regulations, top line growth would come from increased consumer spending (animal spirits), and would realize higher margins on lending from rising rates. All of which, so far, has come true. What nobody counted on was the drastic increase in credit costs.

“We believe that our loss rate will continue to trend higher into 2018…We expect the net charge-off rate to be in the low- to mid-5% range for 2018. Given that expectation as well as continued strong growth, the reserve builds for the next couple of quarters are likely to be in a similar range on a dollar basis to what we saw this quarter.” – Brian D. Doubles, CFO of Synchrony Financial on 4/28/17 (Q1 Call)

Industry Delinquency Rates

(Source: FlowPoint Tickers ALLY, AXP, COF, CIT, DFS, NAVI, SYC)


(Source: FlowPoint Tickers AXP, BAC, COF, C, DFS, JPM)

The uptick in charge-offs is a problem for obvious reasons – it is indicating a change in trend. Since the “Great Recession” both consumer and corporate balance sheets have drastically improved, and are in substantially better shape than they were in 2008. Corporate cash balances are at record highs and household debt service as a percentage of disposable income has fallen, as you can see from the chart below.

On the other hand, the Transaction Processors (Paypal, JKHY, GPN, Western Union, Visa, MA, etc) which are reliant on transaction volume (picking up as you can see in the chart below), had good quarters.  The driver of growth for these companies is the shift from cash to plastic. Any kind of plastic – debit, credit, online, offline, whatever. Cash and check usage everywhere is declining, and electronic payments are rising.  It’s a 30-yr trend that isn’t going to stop.

Transaction Growth
Source: FlowPoint, SpendTrend

Transaction Processors are tech companies, not financial service companies.  They don’t lend money.  They process payments, have huge economies of scale (tech costs fall as transaction volume rises), and produce very high returns on assets and free cash flow.

Consumer lenders, on the other hand – credit card companies, auto lenders, mortgage lenders – take credit risk. They lend money, hoping to recover it plus some interest. Discover and American Express are not payment processors, they are lenders.  And their credit costs (bad loans) are now rising for first time in years. Meanwhile, tech companies like PYPL continue to exceed most of their relevant measurement metrics.

So, one industry is showing early signs of peaking while the other is still early cycle.  Dispersion abounds, which correlates directly to investment opportunities, both long and short.  Stock performance in the group is starting to price in the turn in credit risk versus the transaction toll takers, presenting clear winners and losers in a choppy market.

(Source: Bloomberg)

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So we are about halfway through Q1 2017 earnings, and the results are predictably mixed.  Our friends at FlowPoint Capital have alerted us to some pretty interesting data that is starting to show up in their proprietary risk screens, namely that the market is shaping itself into a barbell, and return dispersion among stocks is getting wider.

According to FlowPoint’s model, only 40% all liquid U.S. stocks are currently in a category which historically generated positive returns, and the performance spread between sectors is pretty wide.  For example, Consumer Discretionary as a category only shows 23% of its stocks with expected future positive performance, while Energy and Financials have the highest concentrations, at 63% and 59% respectively.

Currently, 54% of U.S. stocks are up year-to-date, and 46% are down.  For long/short managers this is manna from heaven.  Sector and pair-trade opportunities haven’t been this plentiful in years.  For example, even though Financials are currently showing positive expected future performance, only 31% of Financial stocks are up year-to-date.  Tech, in contrast, shows the opposite – 63% of Tech stocks are up year-to-date.

Some of the sub-sector dispersion opportunities are even more interesting (like payment processors versus consumer credit names), and we will have more on that in another post.  But this data confirms trends that have been in evidence for quite some time – that market returns are being dominated by fewer and fewer large names.  This is both an opportunity for investors and a cause for concern.

Source: FlowPoint Capital and Bloomberg, L.P.

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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.

Source: TrendMacro
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.