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Is the US stock market at bubble levels? Poll


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Is the US stock market at bubble levels?  

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  1. 1. Is the US stock market at bubble levels?

    • Yes
    • No


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Buffett has answered this question, but I've never seen anybody point it out.

 

In his 1999 Fortune interview he says " If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks."

 

At the time, the market multiple I think was 30x+.  He was just hypothesizing on the only ways that investors could do well investing in stocks at that time over a 17-20 year timeframe, but he accidentally predicted the future.  Interest rates are 3%.

 

This question is just a derivative of "Is the bond market at bubble levels?"  And for that, who knows?  Real interest rates have been declining for decades across the developed world.  It doesn't seem unreasonable to assume that an aging population that has more savings to invest coinciding with a time period where there aren't many investment opportunities could produce much lower real rates.  The biggest companies in the world today need no capital to grow. 

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The biggest companies in the world today need no capital to grow.

Which are these biggest companies in the world than need no capital to grow?

 

Well, the top 10 biggest market caps in the world today are Apple, Google, Microsoft, Amazon, Berkshire Hathaway, Exxon, J&J, Facebook, JPMorgan, and Wells Fargo.

 

Apple ($160Bn net cash), Google ($90Bn net cash), Microsoft ($50Bn net cash), Amazon (no net cash, but finances itself entirely with working capital), Facebook ($30Bn net cash).

 

WFC/JPM need capital to grow, but generate 150% of their capital needs from earnings.

 

J&J, not sure about their capital needs, are consumer branded companies growing volumes meaningfully?

 

BRK, generates all of its capital needs internally.

 

Not far from the list are V/MA, who need no capital.

 

With an economy increasingly dominated by web based and/or service based businesses, there is simply less capital needed to grow than in a manufacturing intensive economy. 

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Looking at market cap is not a very good way to measure contribution to economic activity. Revenue is the way to do that. Looking from the prism of economic activity a company like Facebook is actually quite small. Aggregate all social media and it's actually quite a small part of economic activity. Despite their value caps Barkshire generates more than 2.5x economic activity than Apple.

 

Also keep in mind that capital comes in debt as well as equity terms. Moreover a company like Berkshire requires large amounts of capital to grow. Just because it gets its capital from FCF doesn't mean that it doesn't need it. Oh, and it also uses quite a bit of external capital, just look at BHE and BNSF borrowings. In addition, most large companies historically have made enough FCF that they didn't have to raise equity. That's nothing new.

 

Regarding manufacturing, while manufacturing % of GDP declined some over the past couple of decades, American manufacturing has been employing ever increasing amounts of capital. That's why you have more machines, less people.

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Undervalued relative to yield. Think of the 1950s as high real interest (despite financial repression to burn down WWII debt on the gov bond side), lots of demand for capital, lack of supply of capital. We are now living in inverse world, where there is no demand for capital (companies are buying back shares) and lots of capital everywhere. One just has to look at Japan to see what a low rate world looks like. Now we have slightly  better demographics than Japan that keeps the U.S. from full deflation and bond hoarding Japan has seen, but it is not unreasonable to project a Japan-lite scenario where rates are low for a long long time and asset prices just slowly grind up.

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Looking at market cap is not a very good way to measure contribution to economic activity. Revenue is the way to do that. Looking from the prism of economic activity a company like Facebook is actually quite small. Aggregate all social media and it's actually quite a small part of economic activity. Despite their value caps Barkshire generates more than 2.5x economic activity than Apple.

 

We'll have to agree to disagree.  Facebook has a market cap of $480 billion.  Who owns that capital?  The public.  What can they do with it?  FB is worth what it's worth because it'll soon by able to distribute out $20-30 billion/year.  What are the shareholders going to do with that capital if it doesn't just pile up on the balance sheet like at AAPL/GOOG.  McKesson generates 5x more revenue than FB, but the market cap is 7% of FBs... so what? FB created much more value (i.e. savings), and didn't create any reinvestment opportunities along with it, so now that capital has to compete with prior capital for the same universe of investment opportunities.

 

Also keep in mind that capital comes in debt as well as equity terms. Moreover a company like Berkshire requires large amounts of capital to grow. Just because it gets its capital from FCF doesn't mean that it doesn't need it. Oh, and it also uses quite a bit of external capital, just look at BHE and BNSF borrowings.

 

Yes, if you pick out the businesses that Buffett labels "capital intensive," they are capital intensive.  My point was more about AMZN/MSFT/GOOG/FB/etc., not BRK. But outside of the capital intensive parts of BRK, which maybe represent 25% of the $420Bn market cap, does the rest of the business have enough reinvestment opportunities to invest more than a tiny fraction of earnings in new projects (not acquisitions of existing businesses)?

 

In addition, most large companies historically have made enough FCF that they didn't have to raise equity. That's nothing new.

 

The point I'm making isn't that todays companies don't need to raise equity and historically companies did, the point is todays largest companies can barely reinvest any of their profits, whereas historically companies, even the largest ones, had many opportunities to reinvest capital. 

 

Regarding manufacturing, while manufacturing % of GDP declined some over the past couple of decades, American manufacturing has been employing ever increasing amounts of capital. That's why you have more machines, less people.

 

Do you have any statistics behind this, or is it just anecdotal?  The question isn't "Is the # of machines today greater than it was 10 years ago."  It's "Is the investment, in real terms, in machines greater today than it was 10 years ago as a % of savings."

 

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today. Plenty of places of have lower yields than the U.S. AND lower P/Es.

 

Support for a bubble:

1) Corporate profits are at 2014 levels while U.S. equities ~40% higher from there. Contraction in profits can continue if margins trend towards average or below.

2) On a trailing P/B and P/E multiples, we're in the very top percentile of historical market valuations ever.

3) On longer term metrics like CAPE ratio and Tobin's Q, we're ridiculously over valued requiring a 40-60% drop to get back to average

4) In the middle of 2016, we had never been more expensive RELATIVE to Europe (who has lower interest rates!!!!)

5) Real assets have never been cheaper relative to financial assets as measured by the GSCI/SPY ratio

 

And, for all those pinning their hopes on low rates supporting valuations, the long-end is currently pricing in a negative term premium and inflation expectations significantly below the long-term average for the next 10+ years. If the economy is actually healthy, continues to grow, and term premiums and inflation expectations normalize to reflect that, you'd see long-end rates more than double decimating any relative valuation to equities and the cost to roll any debt that corporations have issued to support share repurchases and dividends over the past 5 years.

 

U.S. equities require a Goldilocks scenario of "just right" when it comes to inflation, interest rates, and corporate profits or the entire story implodes and a 40-60% decline doesn't seem unreasonable. I am skeptical that "just right" can be held for any considerable period of time - particularly considering this is already the third longest economic expansion in U.S. history.

 

 

In hindsight, everything you needed to identify this equity bubble will have been obvious.

 

The million dollar question is where is the top?

 

 

 

 

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today.

 

To argue that there has historically been zero statistical correlation between equity values and interest rates, therefore interest rates aren't a factor in determining intrinsic value, is ridiculous.  If you don't think equities would be worth more in a world with interest rates permanently at 3% than they would be in a world with interest rates permanently at 6%, you shouldn't be investing. 

 

If you believe markets can predict future interest rates with 100% certainty and are perfectly efficient, the lack of correlation would matter.  But both of those points are false. 

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today.

 

If you don't think equities would be worth more in a world with interest rates permanently at 3% than they would be in a world with interest rates permanently at 6%, you shouldn't be investing. 

 

 

 

But there is no such thing as a world with interest rates that are permanently at 3% with no fluctuation. Just like equities, interest rates fluctuate. Even when specific yields are targeted by central banks, like the BoJ, bond prices and equity prices still fluctuate.

 

Given a market where interest rates fluctuate, and the risk profiles of debt and equity are NOT interchangeable for a large number of investors, and there has been no historical correlation to support equities being priced off of interest rates, it's even more absurd to use it as an argument to justify some of the highest equity valuations EVER witnessed even while it doesn't hold true across other equity markets.

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Your point was that in the largest companies don't need capital to grow. It works very nicely if you cherry pick a couple of companies that don't need capital and which make up a small part of the economy and then extrapolate. The rest of the companies still need to employ capital to grow.

 

Plus it's always been thus. Go back 30 years and lo and behold ABC, CBS and Washington Post did not really need capital to grow and generate huge shareholder returns. They were the Google and Facebook of their days. The existence of those companies did not negate the need for capital. The guard has simply changed.

 

Interest rates may be low, but it's not because of Google and Facebook, and it's not because the economy doesn't need capital to grow (it does). The roots of the problem lie elsewhere.

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today.

 

If you don't think equities would be worth more in a world with interest rates permanently at 3% than they would be in a world with interest rates permanently at 6%, you shouldn't be investing. 

 

 

 

But there is no such thing as a world with interest rates that are permanently at 3% with no fluctuation. Just like equities, interest rates fluctuate. Even when specific yields are targeted by central banks, like the BoJ, bond prices and equity prices still fluctuate.

 

Given a market where interest rates fluctuate, and the risk profiles of debt and equity are NOT interchangeable for a large number of investors, and there has been no historical correlation to support equities being priced off of interest rates, it's even more absurd to use it as an argument to justify some of the highest equity valuations EVER witnessed even while it doesn't hold true across other equity markets.

 

You're correct.  But the lack of correlation is meaningless if you agree that permanently lower interest rates make equities worth substantially more. 

 

Look at my prior posts, I'm not saying these equity prices are fair.  I said to ask if equity markets are in bubble territory without asking if bond markets are in bubble territory is a worthless exercise.  Because if bond markets aren't in bubble territory (judged in hindsight 20 years from now), equities will have been by far your best option at preserving and growing purchasing power (i.e., not in bubble territory today). 

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Interest rates may be low, but it's not because of Google and Facebook, and it's not because the economy doesn't need capital to grow (it does). The roots of the problem lie elsewhere.

I've argued this on other points, but I'm not sure I agree. A lot of society is pretty developed. We've built the highways, the dams, the housing, the utilities, the railroads, the oil rigs/drills, etc. From here on, it's mostly maintenance. And what we are building, we're building cheaper. Of course there's still other areas of the world which are under-developed, but it's shrinking every day. And now we're building robots to do all the manual work, so even the human capital element is decreasing.

 

I think over the next 50 years, we're going to be less of a capital-intensive society. That's what I hope for at least. And that is one of the big reasons I think returns on capital (interest rates) are low.

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Your point was that in the largest companies don't need capital to grow. It works very nicely if you cherry pick a couple of companies that don't need capital and which make up a small part of the economy and then extrapolate. The rest of the companies still need to employ capital to grow.

 

How is picking the top 10 biggest companies cherry picking?  I'm not saying no companies need to employ capital to grow...

 

Plus it's always been thus. Go back 30 years and lo and behold ABC, CBS and Washington Post did not really need capital to grow and generate huge shareholder returns. They were the Google and Facebook of their days. The existence of those companies did not negate the need for capital. The guard has simply changed.

 

Ok.  Cap Cities was a $10-15Bn company in todays dollars in the 80s.  Washington Post was smaller.  It's not nearly the same scale.  Yes, there have always been some businesses that had minimal investment needs. 

 

Interest rates may be low, but it's not because of Google and Facebook, and it's not because the economy doesn't need capital to grow (it does). The roots of the problem lie elsewhere.

 

I never said the only reason interest rates are low is because the economy needs no capital to grow (and I never said the economy needs no capital to grow).  I said the reduced need for capital is likely one factor.  How big of a factor?  Who knows... 

 

What do you think requires more capital, a manufacturing business or a services business?  (If your answer is manufacturing businesses, you are right).  How is the mix shifting between the two?  (If your answer is services businesses are stealing share, you are right).  If you answered both questions correctly, it should be obvious that the economy has less opportunity to reinvest capital.  How much less, idk.

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today. Plenty of places of have lower yields than the U.S. AND lower P/Es.

 

You're disagreeing strongly with Buffett (among many others here).

 

Of course, interest rates are not the *only* factor, but they're a big one. Lower P/E's elsewhere also have to do with other kind of risks (ie. political, demographic, or just the opportunity cost between markets with different prospects), so that worse markets need higher equity-risk premiums over the risk-free rates (or if the local interest rates are even risk free -- don't trust Venezuela's central bank!), but there's not doubt in my mind that all else equal, as Buffett says, interest rates "act like gravity" on stocks.

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There is zero correlation between equity values and interest rates over the long-term. While the "yield" relative valuation argument makes sense theoretically, it has never held true and continues to not hold true today. Plenty of places of have lower yields than the U.S. AND lower P/Es.

 

You're disagreeing strongly with Buffett (among many others here).

 

Of course, interest rates are not the *only* factor, but they're a big one. Lower P/E's elsewhere also have to do with other kind of risks (ie. political, demographic, or just the opportunity cost between markets with different prospects), so that worse markets need higher equity-risk premiums over the risk-free rates (or if the local interest rates are even risk free -- don't trust Venezuela's central bank!), but there's not doubt in my mind that all else equal, as Buffett says, interest rates "act like gravity" on stocks.

Well TwoCities is right but perhaps for different reasons. Yes, the level of interest rates affect asset prices. That is the basic tenet of finance. But look further. Why did you get low interest rates? To compensate for a shitty economy. So the shitty economy has a negative effect on asset prices and the lower interest rate a positive one. These two factors negate themselves to a degree, and correlations get murky.

 

To go on further on rates, higher rates don't just happen out of the blue. Higher rates arise to cool down an overheating economy. Overheating economy good for asset prices, higher rates bad. Again some negating effects that blur correlations. All of this stuff is ceteris paribus. So overall stock prices aren't that much correlated to rates because of other effects.

 

Now if we move a little past ceteris paribus and introduce another variable, namely corporate profits profits as a % of GDP. This has expanded a lot since the GFC and has contributed greatly to the stock prices we see today. Basically since GFC you've had shitty economy (bad), low rates (good) and margin expansion (really good!). Going forward if you have higher rates (bad) you'll have good economy (good) all of this is pretty standard model that we know well and we know it won't affect stock prices much. The question is what happens to margins?

 

Let's that you have an overheating economy that leads to higher rates. Overheating economies lead to tight labour markets. If you get tight labour markets that lead to higher wages and margin compression that will really bonk stock prices. And the labour market is really the million dollar question. We really have no idea about the status of the labour market and that's a big driver of risk.

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Valuations might be extended. What is different this time is this.

 

Many of my friends who traded crazily during dot coms and pre-2007 learnt their lessons and are in either cash or in ETF's. What they've seen is that, major indices fall but always go back up. This might be anecdotal, but look at cash inflows into Vanguard funds.

 

It is likely that you may not see panic selling by retail at the end of fed tightening.

 

When people scream bubbles, it makes me cringe. Valuations depend on long term rates. Long term rates in turn depend on inflation, growth of GDP etc. These rates have fallen for last 30 years. Higher rates to tame higher growth is not bad for equity valuations. Now this leaves inflation as the unknown factor for long term rates.

 

Higher inflation can be caused by commodity price increase, labor shortage etc. Commodities had the biggest capital investment in late 90s and next decade. With China cooling, all commodities are in the toilet benefiting everyone else. When you had overinvestment in Oil sector after Arab oil embargo, there was a 30+ year suppression of oil prices. It is more than likely that we wont be seeing run away inflation in commodities. The rapid pace of progress in technology will ensure that (look at fracking companies adapted so fast to oil price drop).

 

There is labor shortage in high tech & health sector areas. Offshoring/automation & lower insurance reimbursement respectively are largely containing the inflation.

 

We are in extended goldilocks. At the end of tightening, there'll be a correction. I don't expect 50%+ drops like we had in 2007. You need run away greed to see that kind of correction. The only place I see that is in Unicorn valuations.

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Think of a share price as an intersection; the positive of higher earnings from improving business conditions, versus the negative PV arising from higher interest rates.

 

The higher the P/E multiple, the stronger the PV discount as we’re discounting more years. If the discount rate is already high, the PV of the additional years doesn’t matter much; different story when the discount rate is small.

 

Then add in that earning effects take a while to materialise, whereas discount effects are immediate.

 

A central banker increasing the discount rate is confirmation of an improving economy, and higher earnings – all good. But if the earnings promise was over-hyped before the rate increase, it’s a negative for earnings growth. Given that Trump was over-hyping, and hasn’t been delivering – most would expect a neutral/negative earnings impact.

 

As interest rates are at historic lows, and P/E’s are high (pre-paying for more years of current earnings), the negative PV effect is also currently exaggerated. Pretty hard to see how prices go much higher, until Trump actually meets his economic promises. So far it’s been zero, in how many times out?   

 

Given that central bankers in NA have been raising discount rates, and that most would expect them to continue doing so – the medium term economic position looks pretty good. Just not so much in the short-term.

 

SD

 

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