Investors considering a position in the Consumer Discretionary sector need to be aware of what they are buying: a basket in which one-half consists of mature, modestly-valued consumer brands, while the other half is two mega caps with excellent growth profiles and high absolute valuations. It would be a mistake to view this sector as a homogeneous set of companies.
Just after yesterday’s close, we loaded our precocious bull into an SUV and drove to the local veterinary clinic for a two-year checkup.
Our bovine buddy drew some sympathetic stares while we were waiting in the lobby. Noting our bull’s droopy eyelids and gray facial hair, an assistant informed us, “You know, you didn’t actually need to bring him here. We now have a mobile euthanasia service.” We just smiled, and waited for the veterinarian, who is said to be a specialist in this new super-species of bull.
The concept of “mean reversion” used to help build massive fortunes. Of late, a better mantra has been “maximum attraction,” as valuations and bullish psychology have matched or surpassed excesses of the Y2K Tech bubble. Meanwhile, corporate profit margins, once dubbed “the most mean-reverting series in finance” by Jeremy Grantham, have now topped those seen near the Y2K top by more than 50%.
In early 2018, we thought the market was expensive, but certainly not a bubble. Today, the trouble is not just high P/E multiples, but the sustainability of the “E” itself—with profit margins nearly 20% higher than ever before. Whether one believes U.S. Large Caps are engulfed in a bubble or not, we have a P/E ratio for you.
One measure of a bubbly bull market is the degree of speculative fervor embedded in the prices of companies with nebulous, indeterminate, or even nonexistent intrinsic values. Since the bear market low in March 2020, speculative manias have evolved in a menagerie of asset classes including Innovators & Disruptors, SPACs, meme stocks, crypto currencies, and NFTs. Based on the breadth of valuation extremes across numerous and diverse assets, this bull market may rank second to none.
Extremely loose monetary and fiscal policies during the pandemic have created distortions and disequilibria throughout the economy. The most visible bubbles may be in financial markets, evidenced by the boundless valuations applied to visionary startups and the speculative fascination for digital assets of all types. This report examines a bubble of a different kind; not a financial bubble but rather a real-world bubble in “fun”. Producers of recreational goods are flourishing during the pandemic, posting massive sales gains and a tripling of net income, yet selling for miniscule valuations.
Those in their peak earning years (40s and 50s) who’ve also enjoyed the stock market’s windfall gains are very likely to have seen their annual expenses climb much higher than the Consumer Price Index over the last several years.
Market environments are driven not just by industry preferences, but also by a bias toward the very largest companies. We have developed a new set of groups composed of the 10 largest companies from each sector. With several of these baskets sporting positive rankings, we felt a closer look was in order.
For years, we’ve noted the increasing valuation gap between domestic and foreign stocks. And for years, we contended that the most likely catalyst for a narrowing of that gap would be a recession-induced cyclical bear market in stocks. Evidently the 2020 bear market was not big enough to do the job.
By our count, the current bull market is the 13th of the postwar period. The 88% gain achieved by the S&P 500 in less than 14 months already places this bull sixth in terms of cumulative gains. We considered it a hindrance that this bull commenced from higher valuation levels than any other in history. Instead, they seem to have provided a head-start.
We launched a revamped version of our Major Trend Index. The objective of the new methodology is to increase the flexibility, and even the subjectivity of the MTI. This approach recognizes the “subjective reality,” without forcing us into the tedium of re-weighting sub-factors if they become more or less critical as market dynamics evolve.
A strong argument can be made that experiential consumer services was the economic sector hardest hit by the pandemic lockdown. Cruise ships were forbidden to sail, restaurants and theme parks were closed, and air travel and hotel occupancy dwindled—all in an attempt to minimize personal/public interaction. The stocks of experiential companies took a beating in March 2020.
In our mid-month Of Special Interest, “Valuation Extremes: Here Be Dragons,” we examined valuation outliers as a measure of market sentiment. The hypothesis was that exuberance is reflected in investors’ willingness to hold stocks priced on an aggressive “vision” of the future; companies that are either habitually unprofitable or trade at a Price/Sales ratio above 15x.
Top decile valuations are often the result of unduly positive investor sentiment that leads to inflated multiples. Bullishness comes in varying strengths: optimism, enthusiasm, exuberance, and, at the extreme, the mania of crowds. Because bullishness manifests itself in aggressive valuations for speculative companies, we believe the prices being applied to such companies - for which intrinsic value is dependent on a future that looks significantly different than today - are an excellent measure of investor sentiment. In that spirit, we examined past cycles of extreme valuations with the goal of understanding how they relate to investor sentiment and what they might tell us about market conditions and relative returns.
The “lower for longer” interest-rate thesis propped up the S&P 500 Low Volatility Index for more than a decade. Rising bond yields have since helped drive this former darling to an 18-year relative-strength low. Yet, assets in the S&P Low Volatility ETF are still five-times larger than its High-Beta counterpart.
Equity investors have had a multi-year love affair with TINA—the belief that “There Is No Alternative” to stocks in a world of ridiculously-low interest rates. This TINA romance has carried on so long that the S&P 500 is nearing valuations last seen in the Tech bubble’s final inning. If the fling with TINA has become prohibitively expensive, we’d like to introduce “SAMARA.”
Top decile valuations, such as those in place today, are usually the result of excessively positive investor sentiment that leads to inflated multiples. Bullishness comes in varying strengths: optimism, enthusiasm, exuberance, and, at the extreme, the mania of crowds. Leuthold research typically tracks valuation sentiment by examining median P/E ratios, but in this study, we are taking the opposite tack. Rather than looking at medians, we are focusing on the outliers in each tail of the valuation distribution.
Stock market valuations may be considered the ultimate in fundamental measures, but they can just as easily be considered long-wave sentiment indicators. What causes equity investors to pay as little as 10x for S&P 500 Normalized Earnings at one point (March 2009), but pay more than 30x a dozen years later? The Fed printing press was in overdrive at both points; only emotions can account for the difference.
Cap-weighted valuations for the S&P 500 and S&P Industrials are homing in on the all-time records seen in the first quarter of 2000. We’ll confess that after those valuations collapsed in the years that followed, we thought we’d never see them again in our lifetime—let alone a mere generation later.
Last spring and summer, we were incorrectly skeptical that a new bull had been born only five weeks after the death of oldest bull ever. But be careful with labels. Just as the “bear market” mindset caused us to overplay our hand last spring, equity bulls should not assume the current bull will look anything like the decade-long affairs we’ve seen twice in the last 30 years.
Driven by massive government stimulus, an imminent vaccine rollout, and the expectation of record earnings in 2021, investors seem to be on the verge of embracing a move away from Large Cap Growth stocks in earnest. The leading candidates offered as broad-based alternatives to Large Growth (LG) include Value, Small Caps, and Emerging Markets.
Mid and Small Cap stocks underperformed in 2018 and 2019. However, after the collapse of February and March, these “SMID” Caps have largely kept pace with the torrid rebound in the blue chips. Today’s valuations are priming the SMIDs for a similar “decoupling” in the years ahead, like that following Y2K.