Seems as though we have perpetual state of hedge fund conference with all those biggest and brightest men (wish I could say and women) in the world of finance. The conferences are set to provide a forum of discourse and a sharing of ideas. Surely has nothing to do with egos. Actually I’m sure it does but that’s no different from Hollywood and all of the self celebratory events they now have. This is our world, love it or leave it.
Listening to these guys today and over the past few conferences we definitely hear less euphoria but we still hear very little honesty from this crowd. Almost no one is willing to admit that the US markets have gone complete retard and are not just overbought but grossly overvalued to levels never before seen. I can’t tell you how many guys suggest and/or agree that the markets are about average relative to historic valuations.
Such a view of course is based on PE’s that have been totally synthesized by way of share buybacks and diverting capex to income. That’s it. And if these guys honestly believe that corporate performance has been strong enough to support what can only be described as the absolute best market performance ever well then I’d like to sell them my magic porcelain genie pot just full of treasure I know they appreciate.
This is going to be a short and to the point because there isn’t much we have to do to get at the truth this time. The view that markets are anything but euphoric is simply ingenuous or ignorant. Over the past year I’ve talked quite a bit about how sales seem to have disappeared from valuation models altogether. This is factual. I’ve had a look at BMO’s economic/market outlook (2yrs) and not once did they mention sales, not one time. So the reality is that when something is very ugly we just don’t bring it up. That pretty much sums up today’s market commentary. Another example of if it’s ugly leave it out is the U6 unemployment figure. We used to get it along with the U3 and that too has disappeared. Ugly is just so unloved.
But so let’s have a look at two periods of time. First is the 7 years following the peak year of the internet boom in 2000, so ’01 through ’07. And let’s compare that period to the 7 years following the peak year of the credit boom in 2007, so ’08 through ’14. Specifically I want to look at growth in S&P sales vs. S&P price level. The only single thing that all businesses in all the world MUST have is sales. Without sales there is no business, period. One would therefore expect sales to be a topic of much discussion when it comes to market valuations. But it isn’t and this is why.
What we find is that during the internet bust recovery, real sales growth led the market higher. That is perfectly reasonable. One would expect that as real sales grow the business expands and thus future expected cash flows too would grow pushing market valuations higher. So that period is a text book model of market growth. Then we move over to the credit crisis recovery. What we find here is that real sales have yet to make it back to pre crash levels. Given that sales growth has been sluggish one would expect market valuations also leave something to be desired. Remember real sales growth led market valuations higher during the previous recovery.
However, investors this time around have decided that those average PE’s coming by way of reducing the amount of shares outstanding (by about 5%) and by diverting capex to income justify just about a 40% increase in market valuation. That’s right, while CEO’s have been maintaining average PE ratios by shrinking the business, investors have been rewarding them with record high valuations. Investors have been getting rich, C-suite managers have been getting rich and employees have been getting laid off. Sounds like a can’t lose growth strategy eh??
Now this is the point where the market cheerleaders come to the rescue shouting that U3 is back to a 5 handle! Profits have never been higher! And those things support expected future cash flow valuations to increase by 40%! The problem is that growth of earnings through contraction of the business can only last a few years before the business is gone. This means no future business and no future cash flows. So I’m not sure how one increases future cash flow expectations by 40% when the strategy is actually contracting the capacity for the business to grow. And all companies are doing it.
Bottom line is very simple. Unless you are growing sales i.e. expanding the business, any growth in cash flow is temporary. And that is really the point of all this isn’t it? Today the market place has nothing to do with expected future cash flows because nobody is in a trade long enough to be around for future cash flows. So why pay any attention to them?? Well we don’t.
So go ahead boys tell me how the market is fairly valued. Tell me that PE’s prove it. Tell me how earnings are great and that unemployment is bang on in line with a full steam ahead economy. Tell me the lackluster economic growth year on year since the big bang is just transitory pains with a bit winter thrown in. I like you will smile and nod, both knowing it’s a lie and both of us preparing for the reset. But let’s see how many more retirees we can keep in this thing before the bottom falls out eh? Their loss is our gain and well that’s what it’s all about ain’t it boys?
Thad Beversdorf, Chief Global Economist for ABX