For the past 14 months, I’ve written a string of articles that I’ve called Bubbleville. If you pardon the snark, the articles were only an appeal for sanity and an assertion that what we were witnessing was not normal. In a week in which the S&P 500 entered bear market territory I think it is fair to say I am not alone in my concerns. So today I want to look at what normal looks like, and how we are trending toward that, as the closer we come to normal, the closer we come to ending this bear market.
Humans have recency bias, which is a fancy way of saying that we assume the future will be like the near past. It helps explain why the majority of economists, policymakers and fund managers we spoke with said inflation would be transitory. It was hard for them to envision high inflation because prices had been low for so long. Central bankers believed that large doses of fiscal and monetary stimulus wouldn’t lead to inflation because that hadn’t been the case during previous rounds of stimulus after the so-called Global Financial Crisis. Crypto investors thought building a high pyramid of DEFI ‘innovations’ without use case on top of Blockchain wouldn’t fall down. They believed it because nothing had yet collapsed. This is recency bias and it is a reason so many people during a decidedly non-normal time came to believe what we were bearing witness to made sense and would go on doing so.
Take interest rates. We’ve been hearing a lot about the level of interest rates. We were told (correctly) they absolutely wouldn’t rise until 2024. Then it was ‘still plausible’ they wouldn’t go up until 2024. As a ploy to simplify RBA press releases, they eliminated the adverb ‘still’. We were still calling it ‘plausible’ that rates would rise over 2022. The moral of the story is that rates are going up, they are climbing faster than we anticipated, and the bet is that we have no idea where they will stop. And yes, I’m aware of the indebted Australian consumer and the politics of defending housing prices. Either way, I believe one way or the other we’re going to get back to normal.” The average RBA cash target is 4.68% per month since 1990. That is down sharply from 10.74% average from 1950 to 2008, and even from 3.85% from 2000 to 2008. As “non-normal” as those average rates sound we must remember that before long inflation may be all we have left to mark “non-normal” for the market. Since 1990, the average annual inflation rate in Australia has been 2.54%. Phillip Lowe had just declared inflation would be 7 percent at the end of the year. You explain to me what is ‘plausible’.
Interest rates and valuations are inextricably connected. One of my favorite long-term valuation data points to use is the Cyclically Adjusted Price to Earnings or CAPE ratio. Looking back at earnings over a decade we smooth out the cyclicality of business cycles and by accounting for inflation we are able to compare earnings over time. In podcast after podcast, Shani and I have stressed the lofty level of the CAPE ratio. At this point I’m so sick of saying it, even! The CAPE ratio on the S&P 500 was north of 38 at the close of 2021. It had only been over 38 once before, in late 1999 and early 2000. No inkling of normality when valuations are second highest ever since 1881. The CAPE ratio is at a historically high level nonetheless, despite this year’s drop. I am putting these thoughts together on June 14th after a brutal sell off of the US market triggered by yet another inflation reading that issued a strong “not yet” message. Right now the S&P 500 is only at 2,749.63 which puts us at a CAPE of a little over 33. Average CAPE ratio from the year 2000 till now has been 26.91 which indicates 8 percent more to reach average. Unfortunately, bear markets almost never bottom at average valuation levels and if we zoom out to 1881 the average monthly CAPE ratio is just north of 17.
A savvy reader will note that we’ve only scratched the surface of the CAPE ratio, the P or price. E or earnings is worth exploring Conventional wisdom tells us that earnings increase over time and that the market will bring down valuation levels if it is flat. If the market is going down, this process is quicker. And profits have continued to grow. According to the Wall Street Journal S&P 500 earnings per share grew by an average of 7.7% a year over the past decade. That is really strong. But the underlying driver of that earnings growth has been margin expansion. When you have margin expansion you can sell the same amount of goods and services, and still grow earnings. We witnessed earnings margins expand from 9.2% to 13.4% on the S&P 500 over the past decade. This is not normal. Now if we go back to 2000 to 2011 the S&P 500 had 6.2% average profit margin. Margin expansion has been glorious for corporations and their shareholders, but believing that this can last forever is likely to be an instance of recency bias.
One reason to be sceptical: our golden age of globalisation may be coming to an end. Beginning in the 1970s, it provided cheap labour and the efficiency dividends of just-in-time supply chains. Companies also reaped the rewards of low borrowing cost, and the comfort of a low inflation environment. The last great era of globalisation began about 1870 and ended in the trenches of the first world war. Is our age drawing to a close in the bombed-out cities of eastern Ukraine, the hostile language between China and the West? Are higher borrowing costs going to eat into corporate profits? Will consumers rebel against higher prices and compel companies to eat input costs and higher wages? Will our long-overdue efforts to decarbonize end up being more expensive? I don’t have the answer to any of those questions. Innovation has solved innumerable problems over the years but the aforementioned does not augur well for profit margins to continue to grow.
Reading about the imminent death of globalisation as we know it isn’t as much fun as listening to Cathie Wood do her spiel about transformative innovation. But the companies in her ARK innovation ETF between them make roughly as much money as the sausage sizzle at your local polling station. The indifference toward earnings is not normal. When normality returns, the reality that 60% of the 3000 largest companies at the highest valuation levels represented by the Russel 3000 growth index is showing losses, isn't going to fair too well.
Think of this as an ode to mean reversion. If this sounds scary, the good news is that a return to normal is not a nightmare for investors. It will be a wreck for speculators. It is time for you to decide what camp you belong to. I would be dusting off the old investing playbook if it were me. I am not in the business of making predictions but it is time to be thinking about what the central banks will have left to work with when they return interest rates back to the 3% to 5% region. What performs when growth and value shares are closer to valuation parity What needs to work as it gets tougher for companies to just dial down expenses and dial up earnings. Sadly, many corporations and many indebted Australians are simply unprepared for this.
I have previously been guilty of declaring we are at an inflection point and that what has worked, will not sustain. Maybe this is a bad way to think about this. What I should have said is that what worked over the long-term will start working again. Returning to normal means returning to fundamentals. A period where the slow and gradual compounding power of economic moats is more powerful than the hyped up instant gratification of momentum. When a larger share of what you earn each year comes from dividends and a smaller share from the risky and back-breaking ascent of ever-escalating valuation levels. Normal means you pay attention to building your portfolio with quality.” Companies that are good and bought at compelling prices, not compelling stories to justify starry eyed valuations. Normal won’t be exciting. But investing isn’t supposed to be exciting.
