Tuesday, June 16, 2015

In Search of a Stock Market Bubble

So, (the sentence starts with "so" because this is a sort of ongoing discussion that's been going on here for years) I've been thinking about the overall market again.  Despite my telling people to ignore this and ignore that, I can't help it; sometimes I think about this stuff.  Well, it's OK to think about it as long as it doesn't lead to irrational decisions.

Anyway, as usual, there is a lot of talk of the market being insanely overvalued, median P/E's at post war records and all the usual.

I look at the charts and some are scary, but I still don't get the sense of a bubble.  I've seen the Japan bubble in 1989, the 2000 internet bubble and some others.  I see the Chinese bubble going on right now.  But I still don't really get the sense that the U.S. stock market is in a bubble.  Yes, there is a pocket of bubbliness, like in some parts of the tech sector (social networks, biotech etc.), but overall I just really don't see it.

Like Black Monday?
Also, there were comments to the effect that 2015 feels just like 1987 before Black Monday because interest rates spiked up right before the stock market crash.  Well, back then the stock market was at 20x P/E and bond yields spiked up to 10%.  So that was a Fed model yield gap of a whopping 5% (earnings yield of 5% versus bond yield of 10%).

Today, we are talking about interest rates spiking up to 2.5% with the P/E ratio under 20.  So in that sense, there is no stretched rubber band ready to snap based on interest rates.  And I showed in recent posts that the market is fine with interest rates spiking up to 6% (of course there will volatility based on that, though).

Nifty Fifty 1972
I made a post just like this one two or threes years ago when people were saying the market is overvalued.  I looked up the P/E ratios of the Nifty Fifty stocks in 1972 to see what a real bubble looks like.

Here is what you were dealing with if you were investing in blue chip stocks back in 1972:



What is really interesting to me here is that the S&P 500 index P/E ratio at the time was 19.2x.  But look at the nifty fifty P/E ratios.  To me, this is what a bubble looks like.  These 'ordinary' companies were trading at higher P/E's than high growth social network stocks or fast casual restaurant chain today!

So, while everyone focuses on the big scary charts of market P/E ratios and whatnot, let's just look under the hood and see what's actually going on.

To be totally neutral, I just picked the Dow 30 stocks.  They are large caps, representative of major U.S. companies.  Despite the horrible structure of the index (price-weighted), it does correlate pretty closely with the S&P 500 index.  I plan on looking at the S&P 500 index in the same way in the near future.

Dow Jones Industrial Average Component Valuations


I just scraped this data off of Yahoo Finance.   I ranked it from cheapest up based on forward P/Es.

It's sometimes a good idea, when trying to figure something out, to invert.  To get comfortable being long something, let's see what it would feel like to be short it instead (just because it's not a good short doesn't automatically make it a good long, though).

People say that the market is tremendously overvalued.  Is the market so overvalued that I would be comfortable with a massive short position?  I just imagine myself with a big short position to see how I would feel.  What do I need to make money?  What can go wrong?  Is there really a big margin of safety in terms of valuation; are things so overvalued that it's a no brainer to be short?  At this point, I would not be comfortable short at all.  Sure, earnings for everyone might be bloated due to QE-infinity and budget deficits.  There are other reasons to be bearish, but I just don't see it from a valuation point of view.  The market is certainly not cheap.  But it's not so expensive that it's a no-brainer short either.

It's true that many of the Nifty Fifty were the growth stocks of the day.  So shorting those back then may not have been any easier than shorting Facebook or Amazon today.  In that sense, this is not really apples to apples.  I'm comparing the Nifty Fifty of 1972 to the Dow 30 stocks now; not fair.

Here, by the way, is the list of Dow 30 stocks as of 1976 from the Dow Jones website (they didn't have 1972, but I assume it hasn't changed much):



But anyway, if you look slowly through the current Dow stocks, which ones are really overvalued?  I mean overvalued in a bubblistic sense?  I don't want to comment on each one, but most look pretty reasonable to me.  Most of the high P/E stocks (NKE, DIS, V, KO etc.) seem to be stocks that always had high P/Es, so don't feel like bloated P/Es based on a bubble.  Many others are just totally reasonable and some are really cheap (AXP, for example.  It has a close to 30% ROE, 12-15% long term EPS growth target, and it's trading at less than 14x P/E and less than 10x pretax earnings per share!).

Let's say you think the market should go down 50%.  I remember reading a comment by a hedge fund manager who said that he likes to buy stocks where if you doubled the price it would still be cheap and short stocks that if you cut the price in half, it would still be expensive.  That's quite a margin of safety built in!

If you look at the Dow stocks above, do I really think that the fair value of each of those is half the current P/E ratio?  I would say no to most of them.  OK, margins are bloated.  But just finger through the list slowly from the top to bottom.  Which ones are over-earning with bloated, bubbled up margins?  Honestly, I don't know.  Nothing jumps out at me as a candidate.  Readers here know that I am not a big long term fan of Apple as an investment, so I would argue that AAPL would be an example of possibly bloated, long-term unsustainable margins (and I know, I know, a lot of people don't agree with me on that and that's OK!).

But otherwise, it seems like a lot of them are actually under-earning.

Berkshire Stocks
As another 'sample', let's just look at BRK's portfolio, which in aggregate is down on the year so far.


Berkshire Hathaway Large Stockholdings Valuations


Here too, I come to a similar conclusion as the above (well, there are overlaps).  Nothing jumps out at me as needing a 'crash' or big bear market to correct.  I don't really see a stretched rubber band here either.  Most seem to be under-earning and I don't really see any unsustainably high margins.

Buffett Dogs Strategy?
So, looking at this, it's interesting to see that there are three stocks down a lot this year.  WMT, PG, and AXP are down -16%, -14% and -15% year-to-date respectively.  And as I said above, AXP has incredible margins and ROE and is trading under 14x P/E.  I know there are worries about competition; alternative payment systems (Munger said there is more competition now than before, but it's still a great business).  And the loss of Costco is certainly weighing on the stock.  This will cause earnings to be flat, but AXP expects EPS to start growing 12-15% again in 2017.

Conclusion
I've been saying this sort of thing since 2011 when I first started this blog; that the market is fine.  But sooner or later the bull market will end.  The market will tank and people will go back and read these posts and have a good laugh.  I know that will happen for sure.  But that's OK.

I'm not trying to predict anything, nor am I saying that we won't have another bear market again.  The market will go down for sure, 50% or more.  There is no doubt about that at all.  But I don't know when that will happen.

I am just looking at a bunch of facts to see what's actually going on.  Sometimes, it's hard to see what is happening just looking at big, macro charts; they can be misleading, like flying over a disaster zone in an airplane.  Sometimes you have to get on the ground and walk around to see for yourself.

18 comments:

  1. This market is the inverse of 1999/2000 - back then the higher quality large cap growth plus technology stocks were wildly overvalued while everything else was cheap. Today, higher quality large cap growth stocks are fairly valued while the legions of mediocre companies trading at high teen P/Es on bloated margins are where the overvaluation is centered.

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    1. This is exactly right. Also want to note as far as original post the market IS over 20x PE. Anyone who says otherwise is using forward or operating numbers, which are of course not comparable to the historical data for a trailing true PE

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    2. OK, the trailing P/E for the S&P 500 is 21.5x. But the trailing p/e of the Dow (simple average) is below 20, so I guess I can point to that, lol... And yes, forecast P/E's aren't comparable to ttm p/e's, of course, as earnings grow over time. So whatever 'error' you have is going to be whatever analysts expect earnings to do over the next year, which admittedly they tend to overestimate. Plus analysts don't know what kind of write-offs and one-time charges will occur over the next year so it's fair to say the eps estimate will be on the high side.

      But I like to look at forecast P/E because it's sort of an indication of normalized earnings for that reason.

      In any case, whatever the market P/E is, the point of the post is more about the p/e ratios of the individual stocks, and there, I really don't see a big problem.

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    3. I agree the market is not in a bubble. But the strange thing is that volatility is really low nowadays. I mean on a bottom-up basis (I track prices/moving averages for 1000s of stocks for my personal investing). Right now, apart from oil & gas companies, railroads and the odd biotech, there are very very few stocks falling sharply.

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    4. A simple two stock comparison to categorize the type of market today. Walmart vs. Shopify. Shopify is "projected" to continue growing revenues at 100% per year ad infinitum, and "they" lap it up. Shopify trades at 23x sales. Walmart is likely to grow revenue at 1-2% per year and "they" sell it in favour of chasing Shopify (or substitute Shopify for Amazon). Walmart trades at .5x sales, and a P/E of 15x ttm. Maybe it gets down to a P/E of 11 or 12 x in an overall correction. Maybe not. It's irrelevant as it's an autopilot investment.

      "They" would rather chase the illusion of exponential growth rather than look for slow but certain growth. Now extrapolate this across the market, you get the investment thesis for chasing Netflix (with $5B+ of off B/S liabilities), Amazon, Tesla, IBB, Skyworks, Sketchers, Alibaba, or whatever other illusion of exponential flavour of the year growth you want.

      Incidentally, Alibaba has a market cap in excess of Coca Cola. This is called an "efficient" market.

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  2. Interesting as usual.
    The problem with AXP, competition apart, is the return on assets that is a bit on the low side.
    Also, from my calculation AXP is now 11 times pre-tax earnings.
    How do you get to the less than 10x pre-tax ?

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    Replies
    1. ROA of AXP is not bad given it is a financial business; a lot of the assets are card receivables and loans. Given that, it's not a bad ROA at all (look at other financials/banks).

      For my pretax figure, I just used the 2014 full year pretax earnings of around $9 billion divided by 1.05 fully diluted average shares outstanding for a pretax EPS of $8.57. AXP is trading for less than $80.

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  3. Great post and thanks for all you do. Personally, the word bubble is waaay overused these days. There is no comparison between the S&P 500 today vs. the year 1999/2000 IMO. Back then, the word bubble was never used in the mainstream. Instead, there were all kinds of justifications for why we should pay 60 times for GE or CSCO or INTC. The fact is that in this environment of low interest rates, people have gone out on the risk curve and bought utilities, dividend aristocrats, etc. to try and generate yield. Also, people surely have bought index funds due to the Megaphone used by Bogle and Buffett. I wouldn't dive in and buy indexes here. I would rather buy BRK at 1.4 times book value.

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  4. Interesting post and thoughts as always.

    ps. There seems to be some problem with your email subscription list, I'm not getting new posts.

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    Replies
    1. Hi, thanks. Yeah, I know. I got a big burst of email once not too long ago. I don't know what's going on; I don't think I can do anything from here. Most people use readers these days, like feedly, I think...

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  5. I concur the market isn’t in a effervesce. But the strange fad is that instability is actually low nowadays. I suggest on a bottom-up foundation.

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  6. Great post and excellent review. Thanks for sharing. I love it, I love it so much that the greedy gnome in me wants more ...

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  7. I see the Chinese bubble going on right now. But I still don't really get the sense that the U.S. stock market is in a bubble. Yes, there is a pocket of bubbliness, like in some parts of the tech sector (social networks, biotech etc.), but overall I just really don't see it.

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