Why I don’t think we’re headed for a correction
Over the last few months, increased risk-taking by investors has led to ballooning prices for loss-making businesses, IPOs in unprofitable firms, and speculative ‘assets’ like cryptocurrency. This is usually a signal that the market is too hot, and is due for a correction. Is the market at risk of an imminent collapse?
There’s no doubt pockets of exuberance exist. The recent activity in GameStop, the gold rush in electric vehicle and battery makers, and the surge in bitcoin more recently point to some seriously illogical, if not stupid, behaviour. Even in Australia convincing evidence of euphoria exists. The “buy now, pay later” sector here trades on a combined market capitalisation of $40 billion despite the requirement for dilutive future capital raisings to fund book growth and despite generating an annual loss of $82 million.
US-based billionaire futures trader Paul Tudor Jones, recently observed more US companies are currently priced at greater than 100 times earnings than ever before and the number exceeds, by half, those that traded at more than 100 times earnings during the dotcom bubble.
Bubbles deflating in isolation
Despite the clear evidence of bubbles in certain pockets of the market, however, I believe they can inflate and deflate in isolation. Indeed, we have already seen this occur. Last year, Hertz, Kodak and Nikola all rose between 600 and 1600 per cent in just a few months before crashing between 80 to 90 per cent. The bubbles inflated and burst and yet the broader market was uninterrupted. Similarly, the current bitcoin mania can crash without dragging the equity market down. It’s done it before. It crashed – falling from nearly US$20,000 in 2018 to $4000 in 2019 – without any impact on the stock market.
Provided the entire market is not in a bubble, and the bubbling assets themselves are not held on the balance sheet of systemically important financial institutions, these bubbles can burst without wiping out the financial system or the returns for sensible investors who refrain from gambling.
What does a high PE ratio mean?
Speaking of the broader market, Robert Shiller’s CAPE (Cyclically Adjusted Price Earnings) ratio for the S&P500 currently sits at its second-highest level in 150 years. The only time the ratio has been higher was during the tech bubble in 1999. Some commentators note that the elevated PE ratio is not only a sign of overvaluation but a warning of an imminent crash. Robert Shiller himself, however, has noted the ratio is an unreliable tool for the prediction of crashes and prefers it to be used to estimate the average annual return for the forthcoming decade – something it is more reliable at predicting. Its lofty status suggests the next 10 years’ average annual return for the S&P500 might be in the low single digits.
Of course, whether the market is overvalued or not depends on which measure you use. On standard PE metrics, the S&P 500 is trading at about 22 times predicted earnings for 2021, higher than the long-term average of about 16, but lower than the 30 it reached before the dotcom bubble turned into DotBomb.
25 per cent of the S&P500 is weighted to just six names
And before concluding the market is at risk of an imminent collapse, one must appreciate the fundamentals supporting the constituent companies, remembering 25 per cent of the S&P500 is weighted to just six names — Facebook, Apple, Amazon, Microsoft, Google and Tesla – known as the FAAMGT stocks. The FAAMGTs are collectively worth more than $US8.1 trillion ($10.7 trillion), and account for almost one quarter of the $US33.3 trillion S&P 500.
For decades Warren Buffett espoused the importance of owning companies able to sustainably generate high rates of return on equity, noting that such performance could only be driven by the presence of a sustainable competitive advantage. Anyone who understands competitive advantages knows the most valuable is the ability to raise prices without a detrimental impact on unit sales volume. With the arguable exception of Tesla, in these monopoly companies inheres the most valuable of all competitive advantages.
Our own analysis reveals these companies to be incredible wealth creation machines. In almost every case their returns on equity are higher today than when they were smaller enterprises. The bigger they get the more profitable they become. Today’s internet giants enjoy the benefit of infrastructure, such as computing power and storage, mobility networks and data speeds, that was inadequate back in 1999 when the first internet boom crashed. And there’s a long runway for growth ahead.
Growth companies have simply seen more economic value accrue to them relative to more traditional companies with lower valuations, and unless antitrust legislation stops them, more value will accrue to their owners.
So, while the market does seem overvalued overall, there is merit in the idea that the companies driving the market higher have powerful economic moats and are themselves individually inexpensive — excepting again perhaps Tesla!
Finally, as we discussed here, based on current bond rates (which of course could change – keep an eye out for a steepening yield curve) the Australian market appears to be fairly valued rather than expensive.
The market might be expensive but it is being driven by a serious weighting to companies with highly desirable and prized characteristics. Pockets of irrational exuberance do exist and they’re easy to find but they can inflate and deflate without upsetting the rest of the market. And finally unless bond rates start to ratchet up, the market appears to be about fair value.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Andrew Ronan
:
Hi Roger, have you seen commodity prices lately? Nearly all of them shooting higher, copper, oil, iron ore, silver, live cattle, lumber, wheat, uranium, etc.
The 35 year down trend in commoditys looks like it’s bottomed and breaking out higher.
That can only spell one thing, inflation.
Also it looks like we are experiencing somewhat of a crack up boom, with housing shooting higher, and many collectors items etc, I wonder if this all means the 35 year down trend in rates is over as well, in which case stocks will have to be re priced quite dramatically.
Roger Montgomery
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I have some sympathy for that view Andrew.
Joe Di Carlo
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I agree with your analysis 100%. I also feel that if some sectors/and large individual stocks of the market are overvalued the overall market can sustain higher prices as we have interest rates at almost zero and money printing set to continue in order for the world economy to grow significantly.
In my view significant growth and a period of high inflation is the only way Governments worldwide can pay interest on debt and repay some principal , and at the same time nominal debt will deflate in real terms. Win win in my view.
High growth and high inflation are the only tools to get out of the debt bubble and inflation is much easier to control than deflation.
Deflation and high debt is a recipe for disaster with the world economy falling into the financial abyss, which is not an option.
Therefore shares and precious metals have huge upside under to growth& inflation scenario.
I feel confident that we may see a repeat of the market move from early 1930’s to late 1950’s — when the DOW moved from 80 to about 1000.
With easy money and liquidity history can repeat, in my view.
Marvin
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Thanks for that Roger. However bond rates are picking up a notch and if they continue to rise, at what point will that rise in bond yields put downward pressure on equity valuations?
All this govt spending in the US is already pulling the $USD down which presumably will be inflationary. And so the cycle starts. A time to be watchful and cautious at lease particularly so after major rises in the equity market. Or am I wrong?
Roger Montgomery
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Hi Marvin, I have been writing about the alternative view, noting the risks of rising bond yields, and the rising inflationary expectations in The Australian and elsewhere here on the blog. Each day we upload two blog posts so keep an eye out, or you can type keywords into the search bar to find these articles.