In the cult firm Meatballs, Bill Murray attempts to motivate his team for a big game with an unorthodox speech in which he gets everyone to chant, “it just doesn’t matter”. That’s about where we are, collectively, as equity investors. The main reason to keep buying today is that…it just doesn’t matter. After the “convincing” correction in February, the Nasdaq-100 took less than three weeks to regain all-time record highs. The Russell 2000 is set to follow and the S&P 500, in all probability, will soon regain January highs.
The steeper the Wall of Worry (the more risks that accumulate), the faster the equity indexes climb.
The U.S. 10-year T-Note looks poised to break above 3%. Technically, the long-term downtrend in the 10-Year U.S. T-Note rate has been broken and a “double bottom” on rates (1.40% hit in 2012 and 2016) seems to have launched the reversal. Fundamentally, all the fiscal and monetary stimulus measures are heating the economy to the point that higher inflation is inevitable. Not to mention that the Fed will begin lifting short rates to contain inflation. Higher interest rates slow economic growth and increase the cost of doing business for firms. Sell risk assets? Yes, for two weeks. But in this market, interest rates just don’t matter.
President Trump imposes trade tariffs on steel and aluminum, defying the counsel of all economists and angering trade partners. Trump boasts that a trade war is a good thing and easy to win. Sell risk assets on a potential increase cost of global trade? Yes, for three days. But in this market, trade wars just don’t matter.
Equity markets are at nose-bleed levels due to the Fed’s endless supply of liquidity. The new Federal Reserve chairman Powell testified before Congress, coming across as hawkish in estimating four rate hikes this year. Certain Fed members, such as Esther George, are warning of the consequences of languid pace of central bank balance sheet shrinkage. Our updated chart below confirms that that Fed’s purchases have ended and the balance sheet unwinding has begun (however you’d need a magnifying glass on this multi-year chart to make out the downturn). Sell risk assets on prospects of a removal of excess liquidity by the Fed? We’d believe so. But in this market, Fed baby-step measures just don’t matter.
Typically extreme optimism among investors has corresponded to major market tops. If everyone is in love with stocks, it’s highly probably that investors have very little dry powder (cash). In January, the American Association of Individual Investors Bullish Sentiment Reading hit 60.0, the highest level since December 2010 (remember that 2011 proved to be a difficult year for equities). The WMA Market Sentiment Indicator below hit 89.5 (Extreme Optimism), the highest level since late 2013. Sell risk assets on euphoria? No, in this market, euphoria just doesn’t matter.
It’s hard for Wall Street analysts to keep a straight face when saying “valuations remain compelling”. The best thing that Wall Street can do is to continue to revise higher future company earnings estimates, then point to “relatively attractive forward P/E ratios”. The first chart below shows the trailing 12-month P/EBITDA (our preferred measure of earnings) in blue for the S&P 500. The P/E using consensus forward EBITDA for 2018 is shown in red. On a trailing P/EBITDA basis, we are above Tech Bubble highs. But be reassured, company earnings will grow such that P/EBITDA will not quite as high as in 2000. Fortunately Wall Street analysts are usually correct (except in 2007 when predicting 25% EPS growth for 2008).
Since the Shiller P/E is only at 33.71 (second highest in over 100 years) and at the peak of the Tech Bubble the Shiller P/E reached 44.0, one could argue (with difficulty) that there is still “upside potential” for equities.
How excessive are prices relative to earnings this cycle? The next two charts show the S&P 500 index price versus EPS (EBITDA per share) and the S&P 500 versus Operating Earnings. A picture is worth a thousand words.
Certainly the Warren Buffet Yardstick will matter. The next chart shows the ratio of U.S. market capitalization to GDP. Even Buffet no longer believes in his “yardstick”.
The equivalent valuation measures for European stocks (less extreme than for the S&P 500) are available here. Sell risk assets on excessive equity valuations? We’d believe so. But in this market, valuations just don’t matter.
Conclusion
Risk managers and thoughtful analysts continue to be losers. Caution equates to underperformance. Experienced, savvy investment professionals know that markets cannot be manipulated forever and that martingales (such as FANG stocks) are a sucker’s bet. The accumulation of risks and excessive valuations will end the bull market, one day. In the meantime, investors can either sell on corrections (like in February) and buy back on rallies or just let portfolios run, assuming that “someone” will catch the equity market and bid prices back up. Neither option sounds too exciting to us. We like cash.
For those who can’t stand sitting on the outside of an unstoppable bull market, we leave you with a final thought:
“The trend is your friend,
just to the end”