What a year. What a strange year. (Perhaps you’d prefer to use a different adjective to “strange” when describing this year – feel free to choose your own.) How did this year shape up relative to expectations?
In terms of the markets, I was pretty spot-on with predictions made around this time last year. I predicted that this year would be challenging for investors. Specifically, I predicted that if the market continues to go up strongly, we’d likely under-perform owing to our defensive positioning. Conversely, I predicted that if the markets weakened, most investors would find the year challenging whilst we expected to do just fine.
This turned out to be correct. A year of relative under-performance. That’s okay – we’re in good company. A lot of prominent asset managers have struggled to keep pace with the major global indices – most notably the US S&P500. There’s a few good reasons for this. Today, as we get ready to farewell another year we’ll take a brief look at where markets are positioned along with some discussion about what we should be focusing on as we enter the new year
Not everything is as it seems
We end the year with the world’s most important equity index – the US S&P500 – touching all-time highs, having recorded gains in the order of 25% for the year. Yet for many investors, the year hasn’t really felt all that spectacular, has it?
Goldman Sachs discussed the reasoning for this in a recent note which included this chart:
Five glamour tech stocks have been responsible for much of the year’s gains. Just five stocks out of an index of 500.
Now, that fact in isolation isn’t very remarkable. These companies are very large in terms of market capitalisation. And the index is “market-cap-weighted”, meaning that the larger the market cap, the greater influence the company has on the index. It’s the same for Australia’s ASX200 – the big-4 banks, BHP and a couple of others have an outsized influence on the index.
There are two additional factors that are highly relevant to today – valuations and breadth.
Starting with breadth, we know from markets past that during a “strong” market, most things are performing strongly. This is because when investors are truly within a speculative “must invest…get rich” mindset, they tend to be indiscriminate – everything is strong. And yet at present with the S&P500 virtually at all-time highs, a large chunk of the index is struggling to surpass even its 200-day moving average:
Will investors re-find their enthusiasm? The clock is ticking because the ghost of markets past warns us that this sort of market action has historically been a precursor to a comprehensive market breakdown.
Passive Investing
Exchange Traded Fund have benefitted hugely from investor enthusiasm this year. Annual inflows into ETF’s has surpassed US$1 trillion for this year. That’s 1,000 billion.
Some of the biggest beneficiaries have been the Vanguard S&P500 ETF, the iShares core S&P500 ETF and the SPDR S&P500 ETF Trust.
This helps explain some of the relative out-performance of the S&P500. These funds mirror the index – that’s exactly what they are supposed to do. If they are given more money to invest, they buy “the market”.
Valuation Update
The cool thing about valuing companies is there’s no one way to do it. Further, many an analyst has been guilty of using whatever method yields the result required to support their view. “Yes, it’s quite expensive on a price-to-sales basis, but the EV-to-EBITDA is quite reasonable!”
A quote that has been making the rounds a lot this year belongs to the co-founder of Sun Microsystems. In the aftermath of the tech bubble, he had this to say during a 2002 Bloomberg interview:
“…2 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?”
Today, there’s a lot of companies trading at 10 times revenues. Google is around 8 times – a massive business that surely has seen its best growth days. If it abruptly deflates to a historically-lofty 6 times, there’s a bit of pain for investors – both Google shareholders and the broader market given we learned earlier just how important Google has become to market performance.
Now to be sure, this doesn’t mean that every company trading at 10x revenues will collapse and be a dud investment. But you sure need a lot of future revenue growth to justify it. And remember, a company generates revenues from the economy it operates in – if GDP is growing at 3%, not every business can grow their revenues at 10% – it’s simply not possible.
Market-wide Valuations
Just like there’s no one way to value an individual business, there’s also no one way to value the market as a whole. But here’s the key – once you come up with a valuation model you should then test it to see how useful it is.
The most common valuation metric we’re accustomed to is the good old price-to-earnings. In particular, the “forward-PE” – the ratio of current market price to estimated future earnings.
But here’s the thing… Its acknowledged that the market has very little correlation with any single year earnings – in other words, “forward PE” is shown to be an unreliable valuation metric. But it’s simple and widely understood thus it’s used a lot.
There are reliable relationships between economic growth and corporate revenue/profits. Smart people use these relationships in the development of market-wide valuation models that actually demonstrate a strong relationship with future returns.
The ones I frequently cite are those of Hussman Funds. The model below explains over 90% of subsequent market returns – in other words, it’s very useful:
The US market is more over-valued than it has ever been. Perhaps you’re thinking that maybe it’s only a handful of these biggest companies that are over-valued and the rest of the market is fairly priced. Unfortunately, that is not the case.
The chart below is enlightening. This breaks up the S&P500 index into 10 groups which are ranked based on their price to revenue ratio.
Start by looking at the tech bubble in 1999. Notice that there was a massive spike in valuation for the most richly valued companies, however the price-to-revenue for a lot of the market stayed fairly reasonable on a historical basis.
Look at the current episode – every single group has grown to levels rarely seen in the past. Make no mistake, everything is expensive relative to history.
Maybe you simply feel that in the age of activist central banks and the magic of “Quantitative Easing”, valuations have lost all meaning. You’re welcome to believe that if you want.
Earnings under threat
Many people have been pleasantly surprised by the way many economies have held up throughout the Covid pandemic. Corporate profits have also been strong.
As I noted throughout the year, the strength shouldn’t have come as a huge surprise. The size of the government spending measures in nations such as Australia and the US were staggering. Budget deficits pushing 20% of GDP – numbers we’ve never seen before. The “sectoral balances” concept is useful when interpreting this.
The economy can basically be broken up into three sectors – government, private and external.
The surpluses and deficits between the sectors must sum to zero.
Therefore, if the government runs a massive deficit, the other sectors must have offsetting surpluses.
This isn’t a theory – it’s an accounting identity.
Many economists noted that savings rates in the private sector rose through the pandemic.
The US trade deficit rose (an external surplus). Of course they did. Importantly, it wasn’t all to do with individuals’ prudent decisions – the government’s choice to run a massive deficit forced the other sectors to adjust into the offsetting surpluses.
You can follow the accounting identities through further and arrive at the reality that the massive deficits also goosed corporate profits to some degree.
As the government deficits unwind, a new equilibrium will automatically be established – this has to mean lower surpluses for the other sectors.
But there’s more… There’s clearly increasing pressure on wages in many parts of the world. Just like broader inflation, it’s hard to know where this is heading. However, what is clear is that increasing wages lowers corporate profits.
Many analysts are projecting already record corporate profit margins to climb next year. There are clear risks to this. Many of these analysts are essentially encouraging investors to pay a historically-elevated forward-P.E. ratio for earnings they project to increase via an increase to record profit margins.
If profits don’t increase as expected, the PE isn’t “reasonable” – it’s expensive. If investors collectively decide for whatever reason a lower PE is warranted, then there’s the doublewhammy for bagholders (sorry, I meant “shareholders”).
Inflation
The finance subject du jour as we end the year. “Transitory”? About to explode? I really don’t know and as smaller investors, I’d argue it’s really not all that important.
What I can practically guarantee you is we’re not about to see a major hyperinflationary spiral in the US or Australia. The ghost of markets past is clear on this.
There’s a common trait with all hyperinflationary events and that is a collapse in economic output. Reckless fiscal policy often plays a part, but it’s a collapse in supply of goods and services that’s been the key.
People seem to want to believe we will soon walk into our local supermarket and experience massive inflation – a loaf of bread will be $16, a bottle of milk $9… and yet there’s little sense that supply will implode. Somehow, the shelves will be full as usual, supply and demand will remain balanced yet the price level is about to spiral higher?
Monetary policy doesn’t play as significant a part in inflation as people believe. However, there’s no doubt that monetary policy is at least distorting people’s perceptions.
Take Australia for example. Official interest rates remain at 0.25% and the Reserve Bank continues with this silly “quantitative easing” thing. Simultaneously, we keep hearing reports of labour shortages, upwards wage pressure and inflationary pressure.
Inflation in Australia has so far been benign – yes, you can argue that the official “CPI” isn’t a true gauge of inflation if you want. In the US, they are recording the highest inflation rates in decades with low unemployment and are still merely talking about withdrawing monetary stimulus and raising interest rates.
Bill Hester from Hussman Funds had an interesting December note discussing inflation. As he observes, central bankers globally haven’t had to worry about inflation for 3 decades – for the most part, inflation has been steadily falling during this period. This has effectively bought them the flexibility to pursue their deranged “unconventional” monetary policies with the goal of achieving full employment and economic growth.
Attempting to put some context around where interest rates perhaps should be relative to the current inflation backdrop, Bill comes up with the following chart:
Interest rates are absurdly low almost everywhere. A “rules-based” approach to interest rate policy implies rates should be a lot higher. Importantly, this isn’t to say rates “should” be at these levels – the point is merely that there is a significant disconnect between recent central bank policy and historical “rules-based” policy. If central banks do need to fight a persistent inflationary breakout, this provides some perspective as to what that might look like in terms of interest rates. 4% official rates here in Australia anyone?
Here’s another interesting chart. This plots where market valuations have sat at the beginning of previous monetary tightening cycles compared to valuations today. If it is accepted that we’re beginning a tightening cycle, we’re beginning it at market valuations way higher than previous cycles. That should prove interesting!
The Outlook for 2022
I have a general aversion towards making predictions about the markets. It’s not so much about fear of being wrong… its due to the fact that our investment decision-making process isn’t particularly reliant on making predictions. In any case, here are some general observations and our views, however, you can draw your own conclusions:
We enter 2022 with key global equities markets as over-valued as they have ever been in history.
Markets showing signs of broad weakness.
Powerful, potentially destabilising forces in terms of inflation.
A likelihood that we’re entering an interest rates tightening cycle.
A corporate earnings outlook that’s anything but certain.
Major economies will likely chug along – no real signs of a major downturn – that’s a plus. However, there are headwinds as massive government stimulus runs off and the “baton of growth” is passed back to the private sector.
Faced with this backdrop, I maintain that it’s time to be defensive – just like the last 12 months.
Note that the above isn’t a prediction of future events. This is simply aligning investments with prevailing market conditions.
There are lessons to be learned from the ghost of markets past. I believe this market cycle will “complete” just like every other one in history – meaning valuations will revert to a level that we’re comfortable loading up. History suggests this will probably happen pretty quickly when it does happen.
Sadly, what the ghost of markets past cannot tell us is when this will occur.
It’s hard to do nothing. Especially when others are making money on silly things. Hard when our huge industry is here treating you like a bottomless money-pit, encouraging you to do things every day owing to their self-serving interests of “media content” and fee extraction.
So, for those of you in Australia, my suggestion is to enjoy the summer, try to stay safe and Covid-free… and make sure you keep significant cash reserves for some great investment opportunities – the ghost of markets past assure me they are coming.
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.
The Ghost of Markets Past
The Ghost of Markets Past
What a year. What a strange year. (Perhaps you’d prefer to use a different adjective to “strange” when describing this year – feel free to choose your own.) How did this year shape up relative to expectations?
In terms of the markets, I was pretty spot-on with predictions made around this time last year. I predicted that this year would be challenging for investors. Specifically, I predicted that if the market continues to go up strongly, we’d likely under-perform owing to our defensive positioning. Conversely, I predicted that if the markets weakened, most investors would find the year challenging whilst we expected to do just fine.
This turned out to be correct. A year of relative under-performance. That’s okay – we’re in good company. A lot of prominent asset managers have struggled to keep pace with the major global indices – most notably the US S&P500. There’s a few good reasons for this. Today, as we get ready to farewell another year we’ll take a brief look at where markets are positioned along with some discussion about what we should be focusing on as we enter the new year
Not everything is as it seems
We end the year with the world’s most important equity index – the US S&P500 – touching all-time highs, having recorded gains in the order of 25% for the year. Yet for many investors, the year hasn’t really felt all that spectacular, has it?
Goldman Sachs discussed the reasoning for this in a recent note which included this chart:
Five glamour tech stocks have been responsible for much of the year’s gains. Just five stocks out of an index of 500.
Now, that fact in isolation isn’t very remarkable. These companies are very large in terms of market capitalisation. And the index is “market-cap-weighted”, meaning that the larger the market cap, the greater influence the company has on the index. It’s the same for Australia’s ASX200 – the big-4 banks, BHP and a couple of others have an outsized influence on the index.
There are two additional factors that are highly relevant to today – valuations and breadth.
Starting with breadth, we know from markets past that during a “strong” market, most things are performing strongly. This is because when investors are truly within a speculative “must invest…get rich” mindset, they tend to be indiscriminate – everything is strong. And yet at present with the S&P500 virtually at all-time highs, a large chunk of the index is struggling to surpass even its 200-day moving average:
Will investors re-find their enthusiasm? The clock is ticking because the ghost of markets past warns us that this sort of market action has historically been a precursor to a comprehensive market breakdown.
Passive Investing
Exchange Traded Fund have benefitted hugely from investor enthusiasm this year. Annual inflows into ETF’s has surpassed US$1 trillion for this year. That’s 1,000 billion.
Some of the biggest beneficiaries have been the Vanguard S&P500 ETF, the iShares core S&P500 ETF and the SPDR S&P500 ETF Trust.
This helps explain some of the relative out-performance of the S&P500. These funds mirror the index – that’s exactly what they are supposed to do. If they are given more money to invest, they buy “the market”.
Valuation Update
The cool thing about valuing companies is there’s no one way to do it. Further, many an analyst has been guilty of using whatever method yields the result required to support their view. “Yes, it’s quite expensive on a price-to-sales basis, but the EV-to-EBITDA is quite reasonable!”
A quote that has been making the rounds a lot this year belongs to the co-founder of Sun Microsystems. In the aftermath of the tech bubble, he had this to say during a 2002 Bloomberg interview:
“…2 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?”
Today, there’s a lot of companies trading at 10 times revenues. Google is around 8 times – a massive business that surely has seen its best growth days. If it abruptly deflates to a historically-lofty 6 times, there’s a bit of pain for investors – both Google shareholders and the broader market given we learned earlier just how important Google has become to market performance.
Now to be sure, this doesn’t mean that every company trading at 10x revenues will collapse and be a dud investment. But you sure need a lot of future revenue growth to justify it. And remember, a company generates revenues from the economy it operates in – if GDP is growing at 3%, not every business can grow their revenues at 10% – it’s simply not possible.
Market-wide Valuations
Just like there’s no one way to value an individual business, there’s also no one way to value the market as a whole. But here’s the key – once you come up with a valuation model you should then test it to see how useful it is.
The most common valuation metric we’re accustomed to is the good old price-to-earnings. In particular, the “forward-PE” – the ratio of current market price to estimated future earnings.
But here’s the thing… Its acknowledged that the market has very little correlation with any single year earnings – in other words, “forward PE” is shown to be an unreliable valuation metric. But it’s simple and widely understood thus it’s used a lot.
There are reliable relationships between economic growth and corporate revenue/profits. Smart people use these relationships in the development of market-wide valuation models that actually demonstrate a strong relationship with future returns.
The ones I frequently cite are those of Hussman Funds. The model below explains over 90% of subsequent market returns – in other words, it’s very useful:
The US market is more over-valued than it has ever been. Perhaps you’re thinking that maybe it’s only a handful of these biggest companies that are over-valued and the rest of the market is fairly priced. Unfortunately, that is not the case.
The chart below is enlightening. This breaks up the S&P500 index into 10 groups which are ranked based on their price to revenue ratio.
Start by looking at the tech bubble in 1999. Notice that there was a massive spike in valuation for the most richly valued companies, however the price-to-revenue for a lot of the market stayed fairly reasonable on a historical basis.
Look at the current episode – every single group has grown to levels rarely seen in the past. Make no mistake, everything is expensive relative to history.
Maybe you simply feel that in the age of activist central banks and the magic of “Quantitative Easing”, valuations have lost all meaning. You’re welcome to believe that if you want.
Earnings under threat
Many people have been pleasantly surprised by the way many economies have held up throughout the Covid pandemic. Corporate profits have also been strong.
As I noted throughout the year, the strength shouldn’t have come as a huge surprise. The size of the government spending measures in nations such as Australia and the US were staggering. Budget deficits pushing 20% of GDP – numbers we’ve never seen before. The “sectoral balances” concept is useful when interpreting this.
The economy can basically be broken up into three sectors – government, private and external.
The surpluses and deficits between the sectors must sum to zero.
Therefore, if the government runs a massive deficit, the other sectors must have offsetting surpluses.
This isn’t a theory – it’s an accounting identity.
Many economists noted that savings rates in the private sector rose through the pandemic.
The US trade deficit rose (an external surplus). Of course they did. Importantly, it wasn’t all to do with individuals’ prudent decisions – the government’s choice to run a massive deficit forced the other sectors to adjust into the offsetting surpluses.
You can follow the accounting identities through further and arrive at the reality that the massive deficits also goosed corporate profits to some degree.
As the government deficits unwind, a new equilibrium will automatically be established – this has to mean lower surpluses for the other sectors.
But there’s more… There’s clearly increasing pressure on wages in many parts of the world. Just like broader inflation, it’s hard to know where this is heading. However, what is clear is that increasing wages lowers corporate profits.
Many analysts are projecting already record corporate profit margins to climb next year. There are clear risks to this. Many of these analysts are essentially encouraging investors to pay a historically-elevated forward-P.E. ratio for earnings they project to increase via an increase to record profit margins.
If profits don’t increase as expected, the PE isn’t “reasonable” – it’s expensive. If investors collectively decide for whatever reason a lower PE is warranted, then there’s the doublewhammy for bagholders (sorry, I meant “shareholders”).
Inflation
The finance subject du jour as we end the year. “Transitory”? About to explode? I really don’t know and as smaller investors, I’d argue it’s really not all that important.
What I can practically guarantee you is we’re not about to see a major hyperinflationary spiral in the US or Australia. The ghost of markets past is clear on this.
There’s a common trait with all hyperinflationary events and that is a collapse in economic output. Reckless fiscal policy often plays a part, but it’s a collapse in supply of goods and services that’s been the key.
People seem to want to believe we will soon walk into our local supermarket and experience massive inflation – a loaf of bread will be $16, a bottle of milk $9… and yet there’s little sense that supply will implode. Somehow, the shelves will be full as usual, supply and demand will remain balanced yet the price level is about to spiral higher?
Monetary policy doesn’t play as significant a part in inflation as people believe. However, there’s no doubt that monetary policy is at least distorting people’s perceptions.
Take Australia for example. Official interest rates remain at 0.25% and the Reserve Bank continues with this silly “quantitative easing” thing. Simultaneously, we keep hearing reports of labour shortages, upwards wage pressure and inflationary pressure.
Inflation in Australia has so far been benign – yes, you can argue that the official “CPI” isn’t a true gauge of inflation if you want. In the US, they are recording the highest inflation rates in decades with low unemployment and are still merely talking about withdrawing monetary stimulus and raising interest rates.
Bill Hester from Hussman Funds had an interesting December note discussing inflation. As he observes, central bankers globally haven’t had to worry about inflation for 3 decades – for the most part, inflation has been steadily falling during this period. This has effectively bought them the flexibility to pursue their deranged “unconventional” monetary policies with the goal of achieving full employment and economic growth.
Attempting to put some context around where interest rates perhaps should be relative to the current inflation backdrop, Bill comes up with the following chart:
Interest rates are absurdly low almost everywhere. A “rules-based” approach to interest rate policy implies rates should be a lot higher. Importantly, this isn’t to say rates “should” be at these levels – the point is merely that there is a significant disconnect between recent central bank policy and historical “rules-based” policy. If central banks do need to fight a persistent inflationary breakout, this provides some perspective as to what that might look like in terms of interest rates. 4% official rates here in Australia anyone?
Here’s another interesting chart. This plots where market valuations have sat at the beginning of previous monetary tightening cycles compared to valuations today. If it is accepted that we’re beginning a tightening cycle, we’re beginning it at market valuations way higher than previous cycles. That should prove interesting!
The Outlook for 2022
I have a general aversion towards making predictions about the markets. It’s not so much about fear of being wrong… its due to the fact that our investment decision-making process isn’t particularly reliant on making predictions. In any case, here are some general observations and our views, however, you can draw your own conclusions:
We enter 2022 with key global equities markets as over-valued as they have ever been in history.
Markets showing signs of broad weakness.
Powerful, potentially destabilising forces in terms of inflation.
A likelihood that we’re entering an interest rates tightening cycle.
A corporate earnings outlook that’s anything but certain.
Major economies will likely chug along – no real signs of a major downturn – that’s a plus. However, there are headwinds as massive government stimulus runs off and the “baton of growth” is passed back to the private sector.
Faced with this backdrop, I maintain that it’s time to be defensive – just like the last 12 months.
Note that the above isn’t a prediction of future events. This is simply aligning investments with prevailing market conditions.
There are lessons to be learned from the ghost of markets past. I believe this market cycle will “complete” just like every other one in history – meaning valuations will revert to a level that we’re comfortable loading up. History suggests this will probably happen pretty quickly when it does happen.
Sadly, what the ghost of markets past cannot tell us is when this will occur.
It’s hard to do nothing. Especially when others are making money on silly things. Hard when our huge industry is here treating you like a bottomless money-pit, encouraging you to do things every day owing to their self-serving interests of “media content” and fee extraction.
So, for those of you in Australia, my suggestion is to enjoy the summer, try to stay safe and Covid-free… and make sure you keep significant cash reserves for some great investment opportunities – the ghost of markets past assure me they are coming.
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.