‘The less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.’
Warren Buffet
Key Takeaways – Party Like It’s 1997
- The current global equity bull market will be five years old in March 2014
- Equities are no longer cheap, but neither are they alarmingly expensive
- Central Banks have enormous fire power to support equity prices
- We are entering the ‘over-confidence’ stage of the bull market but we haven’t yet reached ‘greed’
- In short, be cautious but party like it’s 1997 – not 1999
In March 2014, the current bull market in global equities will be five years old. Remarkable isn’t it. It certainly hasn’t felt that way – but the early stages of bull markets never do. In fact, bull markets are often at least three years old before you even know you are in one! The chart below traces the human emotions from exuberance to despair as the market rises and falls.
At Stanford Brown, we believe that markets move in cycles that are predictable in everything except their timing and extent. To paraphrase Mark Twain, ‘history doesn’t repeat itself, but it does rhyme.’ This note addresses the question of where we currently sit on the red line. Is this going to be as good as it gets or has the bull market only just begun? In order to come up with an answer, we list and discuss the key factors to watch over the coming months.
I. Valuations
There are numerous ways to gauge the ‘valuation’ of a market. We focus on two – the price investors are willing to pay for a company’s stock (the price/earnings or P/E ratio) and the level of corporate profitability relative to the economy. In the US, equities look expensive on both measures. Whilst the market now costs 18 times last year’s earnings (up from 14x just 18 months ago), the more accurate and reliable measure of price to the average of the last 10 year’s earnings (the so-called ‘Schiller P/E’) currently sits at 24.5x – dangerously high by historical standards (see below) and higher even than prior to the 1929 crash.
But it is important not to focus on PE ratios in isolation. Investors too often prioritise the P and ignore the E in the P/E ratio. In the US, company profitability as a proportion of the economy is at an all-time high (see chart below). Never have shareholders earned larger returns; never have workers suffered such stagnant incomes. Profit margins are cyclical and mean reverting, which makes the current valuation of the US market flash even brighter red.
Interestingly both Australian and Asian markets flash green on both measures. This is why our portfolios are focused closer to home. The PE ratio of the ASX 200 is approximately 16x (in line with the historical average) and earnings have been flat since 2007.
II. Leverage
Volatile assets like shares should only be purchased with low levels of debt – property is more suitable to gear up. Concerningly, the level of margin debt in the US has increased all the way back to the heady days of 1999 and 2007 – truly remarkable in such a short space of time (see below). This is the complete opposite of the situation in Australia, where margin debt is still shunned.
III. Sentiment
In Australia, the average household hunkered down during the GFC and started saving once again (green line). Whilst the savings rate remains elevated (a good sign), caution is giving way to optimism as the option of repaying the mortgage (boring, but generally great financial advice) becomes less appealing (black line). Though the trend is for more risk, the high savings rate and still conservative attitude to repaying debt is highly supportive for equities.
Again the contrast with the US is acute. Fund managers are maximum bullish and can’t get enough of equities as an asset class. This is a warning signal.
IV. Fear
The best measure of the amount of panic and fear in the market is the VIX Index. The VIX actually measures option volatility – the more nervous the market, the more volatile it becomes and the more investors are willing to pay to protect themselves from a sell-off. Volatility (fear) reached all-time highs during the collapse of Lehman in Sep 2008 – the epicentre of the GFC. But since this time, each successive sell-off has been accompanied by a less volatile and calmer market. The latest debt ceiling negotiations in the US caused almost no discernible change in option prices – a sign that the market has become too complacent. Not promising. We prefer nervous markets as they tend to be cheaper.
V. Technicals
What do we mean by technicals? Unlike the fundamentals that underpin equity valuations (for example, profit margins, revenue growth, etc), technical analysts focus more on patterns of price movement believing that equity prices move in predictable paths. The reason this tends to be true in the longer term is that markets are guided by human emotion, which swings from despair to exuberance in a well-trodden path (see chart on page 1).
The graph below plots the current 5 year bull market (blue circle) with all the bull markets since 1871. We draw two observations from this graph; firstly, a duration of five years is fairly typical for a bull market; second, if the current bull market ended now, it would be the one of the smallest price gains ever. Prices have roughly doubled from the bottom – the average gain is 2.7 times.
Net – though we do think a short term sell-off would be healthy, there is little to worry about from a technical perspective.
VI. Junk bond yields
Junk bonds were established as a significant asset class by one of financial history’s great innovators – Michael Milken (the book Predator’s Ball remains compelling reading even today).To gain respectability amongst Wall Street’s upper-middle class bankers, they acquired the more politically correct moniker of ‘high yield’ bonds. The definition of a high yield bond is one whose credit rating is below BBB-. These are bonds that have a not insignificant probability of defaulting – hence the name ‘junk’. However owning a diversified portfolio of such junk bonds has proven a highly profitable venture.
We monitor two metrics – the average yield of a high yield bond portfolio (left graph) and its average spread compared to US Treasuries (right). The latter at Treasuries + 5.34% poses no immediate threat (in line with long term averages albeit well down from the GFC highs of an almighty T+ 21.8%), whereas the former at sub-7% yields is problematic and indicates the market’s willingness to trade quality for yield.
VII. Innovation
In 2007, the smartest mathematicians in the world weren’t working in Universities attempting to further man’s knowledge of nature, but could all be found at the quantitative trading desks of American investment banks. They created, spliced, tranched and securitised equity and bond securities; they invented new products such as CDOs, CLOs, CDSs, SPIVs and PIKs to name but a few; they measured their books in terms of alpha, beta, gamma and even theta. Their models showed these were ‘money good’, impregnable to even the most precipitous market fall. Fund managers and insurance companies lapped it up. They were wrong and many left to return to academia, though not before collecting millions in bonuses.
Between the period 2009 and 2013, there has been little new financial innovation, no regulatory-avoiding products have emerged and the physics PhDs are still safely back at MIT. It is unlikely that this bull market will end before a new wave of financial innovation has yet begun.
VIII. Private Equity activity
Bull markets are always accompanied by increased buyout activity. First, they come for the easy targets (companies with predictable cash flows that can be leveraged and where layers of surplus management fat can be cut); next they increase the debt burden; then they issue securities to investors with increasingly awful terms. Prior to the GFC, the European and US leveraged buyout market (LBOs) became notorious for the use of PIK debt. PIK stands for ‘pay in kind’ and is a type of bond that doesn’t pay coupons in cash, but in more bonds! Yes, really. The acquisition of Manchester United by the Glazer family was financed with such PIK bonds (hence why United’s transfer activity has been so muted of late, but I digress…). During this cycle, buyout activity has remained relatively subdued – certainly nothing like the wild days of 2005-2007.
Another consistent feature of a frothy buyout market is the issuance of covenant-lite loans to fund acquisitions. Of some concern, $200 billion of so-called ‘covenant-lite’ loans have been issued so far this year – more than in 2007. Also of concern is the increasing leverage layered onto companies by private equity buyers. Debt is up to 5.37 times earnings this year, from just 3.69x in 2009, and just off the peak leverage of 6.05x in 2007. One to watch.
IX. IPO activity
Twitter priced its eagerly awaited initial public offering at $26 a share only to close at $44.90 on day one – a 73% market rise. Dick Smith is being offered to the market at a valuation more than four times greater than the price agreed by Woolworths just one year ago. And finally, Channel Nine is back to the public markets this week at a somewhat lofty valuation. Yet, despite these few examples, IPO activity has been almost nonexistent for five years, and has only recently picked up. Move along, nothing to see here.
In Summary
The riskiest time to invest is when investors believe there is no risk. But that sentiment, which prevailed in 1999 and 2007, is not at all the case today. There is still palpable fear about the dire mess that is Europe; about China’s long-awaited economic slowdown; about America’s shambolic and divided politicians; and about Shinze Abe’s desperate last roll of the dice to revive the moribund Japanese economy.
As it slowly dawns on investors that the derisory bank interest rates currently on offer will be here for a long time to come, the race to take on more risk has begun in earnest. We are well into the third innings of a four innings game. Some equity markets, such as US small caps and latest generation tech stocks look overpriced already and long term returns for those entering now are likely to be poor. However, we feel that in general, equities are not in bubble territory. Tread with some caution and fear, and always keep the words of the great Mr. Buffett at the start of this note ringing in your ears.
Good luck!
