"Have basic conditions so changed that old standard of value are no longer applicable and must be either drastically revised or completely discarded? Are Economic Laws which we had come to regard as inviolable, no longer of value? Are the United States - now a wealthy capitalistic nation - entering upon an era of such industrial prosperity, that Corporate Earning Capacities will mount in the geometric progression and within a reasonable time support the present high prices for Common Stocks?
"Or are we wandering from the straight and narrow path of financial virtue, and pursuing a dangerous course, resting upon false financial doctrines, which will ultimately lead to distress and disaster? Will we look back upon the present as a time when we lost our heads and sense of financial equilibrium, and disregarded the operations of Economic Laws and what these laws taught us in the past and indulged in a wild speculative orgy which was certain, in the course of time, to bring a day of retribution?"
Mr. Clifford wrote those words back in December of 1928. His grandson, Tony Clifford, has been sending me some of his client papers and they are interesting reading. Tony notes: "My grandfather, A. M Clifford, was the nations first investment counselor -- Scudder Stevens claims notwithstanding. He started out in 1915 in Los Angeles (and the firm survives as Clifford Associates in Pasadena). Like Ben Graham, he was a financial analyst and wrote extensively to his clients with the belief that (like you) the more educated your clients are in your thought process, the easier it is to guide their financial decisions. And avoid the crash of 1929."
Next, let's move forward in time to this morning. One of my favorite analysts, James Montier, the head of Global Equity Strategy for Dresdner Kleinwort Wasserstein in London sent this absolutely smashing (do the British still use that word, or is it just in the movies?) bit of prose on market valuation:
It's Official: The Bubble is Back
"A vast array of articles and notes pass across my desk every day. However, imagine my alarm to arrive at work this morning to see an article in the Wall Street Journal Online with the headline 'Internet Boom is Under Way, Says Morgan Stanley's Meeker'. I was so incensed I was forced to put pen to paper once again. Surely this can't be happening again. I know I always hark on about how the psychological evidence shows it is incredibly hard for people to learn, but surely investors must have learnt something from the experience of the bubble years!
"The article quotes Meeker as saying 'The enthusiasm was well placed, it just got ahead of itself in many respects... As we have said for a long time, from a wealth creation standpoint, we believe we lived through a boomlet, followed by a bust, followed by a boom.'
"The proof of this renewed boom? 'The combined market value of eBay Inc., Google Inc., Yahoo Inc., Yahoo Japan Corp. and Amazon.com Inc., which was $231 billion as of Wednesday' according to the WSJ!
"So simply because the market has risen the boom is back? This seems to be a little odd to me, but what would I know, after all I'm still a dinosaur who thinks that valuation matters. Even a cursory glance at the [figures] below shows that no investor who has even the vaguest respect for any concept of valuation could go near the stocks mentioned by the WSJ. The average PE across the four stocks is 121x, a 13x Price to Book, and 15x Price to sales.
"Now, as regular readers will know, I think price to sales is one of the most meaningless concepts ever thought up. The sheer ridiculousness of the measure is revealed by reductio ad absurdum. Imagine I set up a business selling 20 pound notes for 19 pounds, strangely enough I will never ever make any money, my volume may be enormous but it will always be profitless. But I won't care as long as the market values me on price to sales.
[Readers - please note that PE stands for Price to Earnings ratios, PB stands for Price to Book rations, and PS stands for Price to Sale. - JM]
Internet stock valuationsPEPBPSPrice -------------------------------------------- Amazon43.7NA2.438.1 eBay92.711.3022.8103.8 Google222.020.0019.5167.9 Yahoo126.48.2015.536.7 Average121.213.1715.1
(Source: DrKW Macro research, Bloomberg)
But even forgetting my gripes, 15x sales is quite simply insane. The following quotation comes from high tech insider, Scott McNealy, CEO of Sun Microsystems
" 'But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?' (Scott McNealy, BusinessWeek, April 2002)
"So a tech insider tells you that 10x sales is insane, yet the WSJ cites internet stocks trading on 15x as evidence of an internet boom! Looks more like yet more evidence of the collective madness of investors once again to us.
"Nor is Meeker alone in her proclamations. The venerable Fred Hickey, author of The High-Tech Strategist, cites Jim Cramer, self announced market maven, former Hedge fund manager and columnist for TheStreet.com as returning to the fray. Cramer recently opined 'The only way to catch up is to join the crowd... They are buying Google because, what the heck, when the market's up buy Google... There simply aren't enough trading days left to make a lot of money... The clock is ticking... The downside will be very limited here because the feeling you felt in your stomach when the market opened up huge is the feeling that comes from recognizing 'Darn it all, I gotta get in.' Because you do.'
"Well that is all right then, invest because you have a feeling in your stomach, just make sure it isn't trapped wind! Investors falling over themselves to buy tech are the investment equivalent of Pavlovian dogs. Just in case you aren't aware, Pavlov was a pioneer in conditioning. He showed that if a bell was reliably rung before dogs were fed, eventually the dogs would start salivating when they heard the bell, even if no food were present. Meeker, Cramer et al are the bell with nothing behind them.
"Keynes noted 'Our decisions to do something... the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.'
"The boom isn't back; rather it is the bubble mentality that has never left. Investors cling to the hope that the good times are about to return, urged on by the dream selling bubble blowers. However, conditioning doesn't last forever. Eventually investors will learn that investing in overvalued tech stocks is a short cut to the road to ruin. Unfortunately, this lesson is likely to prove an expensive one once again."
What Are Those Analysts Smoking?
The above quotes give us a great context to talk about the future of the market. As I noted a few weeks ago, corporate profits are at a 40 year high. After tax profits are at 7.6% of GDP. The S&P 500 has profits of 9.2% of revenues. In short, it doesn't - and can't for any length of time - get much better than this.
In the early 90's, after-tax profits were less than 5% or revenues and dropped to that level during the last recession. Since WW2, earnings have been all over the board, but rarely higher, and only by a small amount and only for short periods of time in the 50's, if I remember right.
Actually, that is only a natural function of the free market. If profits stay too high for too long, competition brings in new players willing to make a little less profit. Companies, not wanting to give up market share, lower their margins to keep customers. When profit margins are too low, companies go out of business or abandon markets, and prices can creep back up. It is part of the business cycle.
If profits keep humming, executives usually find ways to invest the money, although in the most recent cycle they have invested little and kept the hiring of new employees in check.
But to look at analysts' projections you would think someone has repealed the business cycle. Just so you can do the math yourself (if you are bored or obsessed, and you can decide which I am) you can go to Standard and Poor's web site and see the historical earnings and their projection for the S&P 500. http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&
You will note that they think "as reported" earnings will grow a fat 18% from the end of this quarter to the third quarter in 2005. And why not? They are up almost 2.5 times (250%!!!) since the third quarter of 2001? What's a mere 18% in the next 12 months? I spit on your measly 18%!
Of course, if you go back further in time, say exactly ten years (to the third quarter of 1994), you find earnings have grown only 72% since then, which means almost half of earnings growth in the last ten years is attributable to inflation.
That is a mean average of 7% a year, or a compound growth of 5.7%, which is historically actually not all that bad, as that is close to the long term average and is close to GDP plus inflation. As I have written at length before, large cap American stocks in the aggregate cannot grow much faster than GDP plus inflation over long periods of time. (Certainly some individual companies can.) I will not go back over that logic and math today.
If we are at what appears to be a high in profit percentages both in terms of margins and overall profits, and if long term growth of profits is GDP plus inflation or around 6-7%, then might not 18% be a little aggressive?
But so what, you ask, if earnings come in at a "mere" 9% or so. That would mean onwards and upwards, right? Well, not really, Market psychology is a funny thing. Investors do not like to have their expectations disappointed.
The P/E for core earnings for the S&P 500 is 21.58. If you want to use as reported earnings it is 20.3. If you use operating earnings, where companies deduct "Bad Stuff" from their expenses to make the numbers look better for the media, the P/E is a more reasonable 18.
Of course, once you account for the real stuff, subtract false pension fund profits and options expense, you get to the core earnings number, which is the one I like. You also find "operating earnings," what I like to call EBIF or Earnings Before Interest and Hype, overstate core earnings by almost 30%. But when you watch an analyst on TV, they are typically talking about the EBIF variety.
Professional bulls like to talk about forward earnings ratios. They like to look out a few years and say "Look, see what valuations will be in a few years? You have to buy now to get in on the growth."
Past Perception Dictates Future Performance
It typically takes years for valuations to fall in bear markets to levels from where a new bull market can begin. Why does it take so long? Why don't we see an almost immediate return to low valuations once the process has begun?
Investors overreact to good news and underreact to bad news on stocks they like, and do just the opposite to stocks that are out of favor. Past perception seems to dictate future performance. And it takes time to change those perceptions.
This is forcefully borne out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled "Investor Overreaction: Evidence That Its Basis is Psychological," is a well-written analysis of investor behavior that illustrates that perceptions are more important than the fundamentals. Let's look at that study in detail.
In any given year, there are stocks that are in favor, as evidenced by high valuations and rising prices. There are also stocks that are just the opposite. Dreman and Lufkin look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based on the companies' perceived market valuations. They separately study price to book value (P/BV), price to cash flow (P/CF), and the traditional price to earnings (P/E). This creates three separate ways to analyze stocks by value for any given year so as to remove the bias that might occur from using just one measure of valuation.
The top and bottom quintiles become stock investment "portfolios" for all three valuation measures. You might think of them as a mutual fund created to buy just these stocks. The researchers then look 10 years back and five years forward for these portfolios. There is enough data to create 85 such portfolios or funds. They first analyze these portfolios as to how they do relative to the market or the average of all the stocks. They then analyze these portfolios in terms of five basic investment fundamentals: cash flow growth, sales growth, earnings growth, return on equity and profit margin. They do this latter test to see if you can discern a fundamental reason for the price action of the stock.
Here's my review of the most relevant parts of their presentation. First, both the "outperformance" and "underperformance" of these stocks happens in the 10 years leading up to the formation of the portfolio. Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The in-favor stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.
I should point out that other studies, which Dreman and Lufkin do not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might at first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors there are who jump in. The 1995 Dalbar study ("Quantitive Analysis of Investor Behavior," http://www.dalbarinc.com), among many others, shows us that investors do not actually make what the mutual funds make because they chase the hottest funds, buying high and selling low when the funds do not live up to their expectations. The key word is "expectations." Other studies document that investors tend to chase the latest hot stock and shun those which are lagging in price performance. Thus, forming portfolios of the highest- and lowest performing quintiles is an uncanny mirror to what happens in the real world.
Why does this "chasing the hot stock" happen? Dreman and Lufkin tell us it is because investors become overconfident that the trends of the fundamentals in the first 10 years will repeat forever, "thereby carrying the prices of stocks that appear to have the 'best' and 'worst' prospects. Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues. Such forecasts result in favorites being overpriced, while out-of-favor issues are priced at a substantial discount to the real worth. The extrapolation of past results well into the future and the high confidence in the precise forecast is one of the most common errors made in finance."
Remember the study I mentioned a few weeks ago? The more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.
Since you are not looking at the graphs of the Dreman study, let me describe them for you. Predictably, the fundamentals improve quite steadily for the first 10 years for the favorite stocks in comparison to the entire universe of stocks. But the price performance rises at very high rates, far faster than the fundamentals, particularly in the latter years. It clearly accelerates. It seems the longer a stock does well, the more confident investors are that it will continue to do well and therefore they award it with higher and higher multiples.
The exact opposite is true of the out-of-favor stocks. Even though many of the fundamentals were actually slowly improving, in relation to the market as a whole they were lagging and the market punished them with ever lower relative prices. At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends.This reinforces the perceptions about these stocks and increases the level of confidence about the future. Again, past (and accumulated and reinforced over time) perception creates future price action.
Never mind that it is impossible for Dell Computer to grow 50 percent a year or General Electric to compound earnings at 15 percent forever. As many times as we say it, investors continue to ignore the old saw "Past performance is not indicative of future results." And that is not to say Dell and GE are not wonderful companies. They are. But their share values, and those of any in-favor stock, eventually rise too high.
How much better did the well-performing stocks do than the poorly performing stocks in the 10 years prior to creating the portfolios? The highest P/BV (price to book value) stocks outperformed the market by 187 percent. The lowest stocks underperformed the market by -79 percent for a differential of 266 percent! If you look at the P/CF (price to cash flow), the differential between the two is 172 percent.
Yet in the next five years, the hot stocks underperformed the market by -26 percent on a P/BV basis and -30 percent on a P/CF basis. The out-of-favor stocks did 33 percent and 22 percent better than the market, respectively. This is a huge reversal of trend.
What happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the allstars? The answer is a very curious "no." Dreman and Lufkin find that "there is no reversal in fundamentals to match the reversal in returns. That is, as favored stocks go from outperforming the market, their fundamentals do not deteriorate significantly; in some case they actually improve. . . . The fundamentals of the 'worst' stocks are weaker than both those of the market and of the 'best' stocks in both periods."
In some cases, the trends of the worst stocks actually got worse. Even as the out-of-favor stocks improved in relative performance in the prior five years, their cash flow growth actually fell from 14.6 percent to 6.6 percent. While cash flow growth for the best-performing stocks did drop by 6 percent, it was still almost 2.5 times that of the lower group. Read the following observations of Dreman and Lufkin carefully:
"Thus, while there is a marked transition in the return profiles [share price], with value stocks underperforming growth in the prior period and outperforming growth stocks in the measurement period, this is not true for fundamentals. In nearly every panel [areas in which measurements were made], fundamentals for growth stocks are better than those for value stocks both before and after portfolio formation . Although there is a major reversal in the returns [prices] to the best and worst stocks, there is no corresponding reversal in the fundamentals."
"In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks. The data and the graphs clearly show the fundamentals for the growth stocks clearly beat those of the value stocks even for the five years after portfolio formation. And yet, there is a very stark reversal in price. Why, if not based on the fundamentals?
Dremen and Lufkin go to another research paper, which shows "that even a small earnings surprise can initiate a reversal in returns that lasts many years." They demonstrate that negative surprises on favorite stocks result in significant underperformance of this group not only in the year of the surprise but for at least four years following the initial event. They also show that positive surprises on out-of-favor stocks resulted in significant outperformance in the year of the surprise, and again for at least the four years following the initial event. They attribute these results to major changes in investor expectations following the surprise.
So where was the overreaction? Was it in the years leading up to the surprise that resulted in a very high- or low-priced stock (relative to the fundamentals), or was it in the immediate reaction to the surprise? Other studies show that analysts (as opposed to investors) are too slow to react to earnings surprises by being too slow to adjust earnings forecasts. Even nine months later, analysts' expectations are too high.
How Bear Markets Begin
This, gentle reader, is how bear markets start. Analysts project rosy earnings forecasts. Companies disappoint once and then do it again. About the second to the third time they disappoint, investors get annoyed and sell. They sell in large herds.
Analysts, like average investors, anchor their future projections in past performance, seeing the future as a repeat of the past. It is a pretty normal human trait, and most analysts are human. Some, of course, are more human than others, and find more value in the companies with which their firms do business.
This market is fully valued, by any historical standard. The P/E ratio for the largest ten stocks on the NASDAQ is 41, and that is mostly before options expense. Those ten companies represent 40% of the NASDAQ 100, or QQQ's. But noting that we are once again seeing la-la land numbers in the internet and NASDAQ, it is possible investors will keep right on chugging.
So be careful about shorting. Short interest is very high right now, both as a percentage of trading and on an absolute basis. Bull markets typically end with a short squeeze, as the bears get wiped out, so this market could move higher for no apparent reason.
That is, until earnings disappoint. I think the potential for that disappointment is being set up by aggressive forecasts, full valuations, a rising interest rate environment, a slowing Europe and Japan, deficits, etc. If I am right about a recession within the next two years, then look out below.
I am looking forward to the time that valuation levels are low. Investing is so much easier then.
Let me be clear. I love Amazon, E-Bay, Google and most of corporate America as businesses. They are good citizens and savvy marketers. But there is a difference between how good (or excellent) a company is and how reasonable its stock price is. I love Google and use it 20 times a day. Google will be around for many years, but 222 times earnings? Almost 20 times sales? With Microsoft moving this week into search engines with some very good reviews? What company has ever performed well enough to grow their business from where Google is today to where the ratios suggest it will be in 5-7 years? I saw the founder of Google last week at the "futures" conference I spoke at. He did not look like he had god-like powers. I could give you many examples, but you get the picture.
Literally as I wrote that last paragraph, Brown Brothers Harriman sends me an email which illustrates the point about analysts better than I could:
"Investment Conclusion: We are raising our 2005 year-end target for the S&P 500 to 1300 from 1250. Our positive view of 2005 has not changed, but the market has shown that we were not aggressive enough when we set the target the first time... A target is a short way of stating the conclusion of a complex thought process. But sometimes events move faster or further than expected and a target change is appropriate even if the basic story has not changed."
So even if the basic story has not changed - that fundamental value is still the same - we must revise our targets. I read that to mean that since the market is going up (especially in the last few days) so we must revise our forecasts to reflect recent performance.
Sometimes they do ring a bell.
Toronto, St. Louis and Issues
I will be in Toronto next week, speaking at the Strategy Institute conference, looking at hedge funds, speaking at a few private functions and probably eating too much. I will be speaking at noon on December 6 in St. Louis. The public can attend. Details will follow in a later letter.
For those that are interested, here is a link to an interview I recently did: http://www.marketthoughts.com/john_mauldin.html
In the last few minutes, I am reminded how fragile life is. My mother has fallen and broken her hip, and will have her second hip replacement tomorrow. That will be two knees and two hips. She is on her way to becoming bionic. It is wonderful to be in a time where we can look forward to her recovery, but it does remind us how fragile we all become over time.
It is therefore quickly time to hit the send button. That means probably more mistakes than usual, but I think even the English teachers who point out my each and every mistake will forgive me this time.
Your running out the door analyst,
Did someone forward this article to you?
Click here to get Thoughts from the Frontline in your inbox every Saturday.