The Bubble Nobody Is Talking About – Part I
There’s a new bubble in town.
It’s in an asset class that pretty much everybody loves and agrees on, and I’ve heard very few people discuss the possibilities of fallout here.
You probably even have some of these investments in your portfolio. In fact, I’m almost certain of it. By the end of this post I’m going to be an extremely unpopular guy. I kinda hope that this letter just fades through your inbox and doesn’t get linked in any high-traffic destinations elsewhere on the internet.
Because I believe there’s a bubble in blue chip U.S. equities.
I realize that this has been the single most popular investment thesis to emerge in the post-crisis years. “Buy U.S., buy quality.” It’s such an easy thesis to sell. The U.S. may be struggling economically, but it’s not as bad as other places in the world. Plus, it’s familiar to us. And twice during the last decade we learned that quality is where you want to be when times are tough. Quality is better at preserving capital, and, given a range of factors from the volatility we’ve lived through, to the uncertainty we anticipate ahead, to the demographic changes in the market, capital preservation is of greater interest to more of the marketplace than it has been in my entire life.
I understand why nobody wants to talk about this. It’s an uncomfortable conversation. And the fact that nobody wants to have it makes me uncomfortable.
Here’s what else our collective silence could mean:
- It means it could actually be legit. The most destructive bubbles are always the ones that we manage to, paradoxically, ignore until they’re unwinding. We do this because of cognitive dissonance; our brains simply reject data that doesn’t conform to its pre-existing worldview.
- It means it could continue inflating for a while. Every bubble in history has run far longer and swelled far larger than most believe possible.
One of the most frustrating qualities of bubble markets is that they have their own reality distortion field. If this all makes you feel awkward or angry, go ahead and slip back into your cocoon of denial. I understand. I swear, I won’t hold it against you. It’s possible that I’m the one who’s wrong here. So if you want to just write me off as a wacko today, you get a pass.
But if you do want to hear me out, be warned, we’re going to look at a lot of data and a range of examples that are going make you really uncomfortable and, depending on how married you are to the blue chip thesis, could create a lot of disharmony in your brain.
The good news is that I’m also going to talk about some alternative strategies. Unlike some of the other bubbles we’ve seen, this one hasn’t affected the entire market. That doesn’t mean there won’t be any collateral damage if it all starts deflating, but it does mean that there will be places that long-term investors can hide and, in a relative sense, outperform.
The Bubble in Blue Chips
I really wish I had Liz Ann Sonders on speed dial so she could give me some hard data on this, but my guess is that most of the investing public in this country is overweight blue chip equities. Back in the early days of this newsletter, this was even one of my primary investment theses. In the summer of 2009 I wasn’t particularly bullish on the stock market as a whole, but I was a big fan of high quality U.S. corporations (and especially their debt).
In retrospect, there was a little bit of right and a little bit of wrong in that general view. I obviously should have been more bullish on the whole market as none of that broader caution was warranted. But at least I managed to pick the segment that probably had the best long-term risk/return characteristics. Loading up on beaten up blue chips and their bonds may not have been the highest-returning strategy, but it was a pretty good one given the risks at the time.
But really, the reason why I liked those blue chips was because of what I alluded to at the top. The narrative was just so much easier to talk about. Investors needed a lot of encouragement during those years where risk aversion was at its apogee. Unless you’re a perma-bear with a perma-freaked readership, you have to tell your audience to buy something. You can’t just tell them every single week to go to cash, build a bunker, and wait for the next apocalypse. So even though we were all a little jittery in 2009 and 2010, there were some themes we were more open to than others.
That’s part of what laid the foundation for the bubble in the first place. Bubbles don’t just magically appear, y’know. Psychology plays a role, but fundamentals have to play a role too. The housing bubble had its own psychology to help it inflate, but low interest rates and loose lending standards were fundamental jet fuel that accelerated the inferno from 2004-2006.
In the case of blue chip equities, one of the fundamental drivers is that the post-crisis recovery environment has been exceptionally beneficial to these large corporations.
Interest rates are again at play here. The biggest and highest quality companies are able to borrow at rates that haven’t been seen in a long time. When they can finance growth a whole lot cheaper than you & I can, it only adds to the edge they already have in the marketplace.
This trend really accelerated after 2010, but notice how it has reversed in mid-2013. (File this point away because we’ll be revisiting it in a few minutes.) Even though the trend is changing, this is still a fantastic environment for AAA corporations to borrow money in. That translates directly into both the top and bottom lines of corporate profits.
And to that point, take a look at just how these corporate profits have been doing.
It won’t stop. These are the biggest profits on record.
Unfortunately, FRED doesn’t have data back into the 20’s and 30’s, which I’d really like to see. But this is the best that corporations have had it in most of our lifetimes. And this is a group that has become especially concentrated, too. Then ten largest companies in this country represent nearly 14% of total U.S. corporate profits. The 20 largest represent roughly 20%.
Who would have thought in the winter of 2008 that not only would these companies recover but that they would soar to heights we may not have even imagined during the boom days of 2006? As a percentage of GDP, corporations are over twice as profitable as they were in the late 90’s. Could anybody have expected that?
I know I’m not the first person to write about this. And I know that you’ve also heard a thousand reasons for why an epic bull market was born in the 1980’s. But really, the answer is shockingly simple and straightforward:
- Equity valuations were historically low i.e. investor psychology was awful.
- Corporate profits had a long way to run. Both in absolute terms and relative to GDP.
Wanna define any secular bull market? Just identify those two criteria.
Conversely, the origins of secular bear markets are defined by opposite criteria. They begin when valuations are high and corporate profits have less room to run.
Now that we’ve identified some key points of our backdrop, we can get more specific in describing the bubble.
The Bubble, Defined
With a large-scale, widespread bubble, you need to have those background criteria. You need to have crazy valuations from an over-enthusiastic psychology and you also need to some kind of fundamental force holding it up. Bubbles burst when both of those factors reverse, when psychology collapses and we realize the fundamentals are false or unsustainable.
Valuations & sentiment changes much more rapidly than do fundamentals, so it’s this component that I’m obviouisly most concerned about. When it comes to individual companies, this is where I’m now convinced that something really crazy is happening.
The term “blue chip” is one with a fairly loose definition. I’m not sure of any quantitative criteria to describe these types of companies that are both necessary and sufficient. Basically, they’re stocks that have been around a long time and are businesses that are market leaders and household names. Usually they have very large market caps.
Spiritually, this is what the Dow Jones Industrial Average is all about. If you scroll through those 30 names, I think we’d agree that these are what “blue chip” companies look like.
So the first thing we can do is take a look at how blue chips have fared relative to the rest of the market.
I don’t want to sound alarmist, but this thing may already be starting to unwind.
Now, technically, the S&P 500 consists of 500 really elite companies. Compared to some of what you’ll find in the Wilshire 5000 or that trade on smaller exchanges, these are blue chips too. Still, the Dow is the bluest of the blue.
Check out how the Dow has fared relative to the NASDAQ. I’m sure we agree that the NASDAQ is not generally high quality to the same extent we agree that the Dow is.
Were you even aware of this?
Folks, something happened in July of this year. The rest of the market rallied right back and then on to new heights. But a lot of blue chips didn’t.
There’s a similar break between the Dow and the total U.S. market. We can use the Vanguard Total Stock Market ETF (VTI) for that. This guy includes 99.5% of all companies that trade on the NYSE, Amex, or NASDAQ.
The total market index has been the slightly better bet for a while, but again, that really accelerated this summer. I know Exxon has been a drag, but surely not that big a drag, right?
To understand why these things have begun to diverge and whether or not that’ll keep up, we need to look at some specific examples. This will also give you an idea of how much farther these things can fall, in both absolute terms and relative to the market.
Let’s arbitrarily select one of the bluest of the blue chips, Johnson & Johnson.
(OK, maybe it’s not totally arbitrary, because I wrote an in-depth piece on this earlier this year at Seeking Alpha.)
JNJ currently trades at a 20x PE, well above its industry average of 16x and a full third higher than the 15x the company was trading at back in 2007. Book value per share is about 50% above what it was in the years before the crisis. Both operating and gross margins are lower than they were in 2006.
It’s a (significantly) more expensive stock by pretty much every metric. That means there is a downside valuation risk in JNJ that we may never have seen before. Along with that substantially pricier valuation, the payout ratio has ballooned to 60% after being in the 30% range in the pre-crisis/recovery years. So one of the stock’s most attractive qualities, the dividend, may have less potential to grow in future years than we may be aware of.
Kudos to JNJ management for keeping the stock sexy in the last few years, but the rest of us should understand that they can’t keep raises like that going forever. Eventually it’ll have to be driven by raw earnings growth, and that’s partly a function of all those macro factors we discussed above. That could happen, but it may not, and the present valuation relies on the fact that it will.
This is what the stock price looks like, by the way.
What was once a boring, defensive stalwart is now something… else.
Next let’s look at Home Depot, another Dow stalwart.
It’s stock price is even more astonishing.
I mean, holy cow, right?
I get that Home Depot is linked to the housing recovery and all, but these guys are way above where they were even during the real estate boom days!
Let’s play a little game called “2006 versus Today”.
|Metric – Home Depot||2006||Today|
|P/Sales||1x||1.3x (dropped as low as 0.5x in 2009!)|
Home Depot is trading at 7.6 times tangible-freakin-book!! Home Depot! I am simply blown away by this. Step aside from all of these blue chip narratives swirling at present and whatever yarns your financial advisor has been spinning since 2009 (which weren’t always wrong, by the way).
How valuable is Home Depot’s business, really?
And even if you can’t answer that question in absolute terms, ask yourself it it’s twice as good a business as it was during the peak of the housing boom.
MCD is now trading at 17x earnings, which may not be as expensive as Home Depot or Johnson & Johnson, but it’s expensive relative to its historical norms and it’s meaningfully more expensive by other metrics as well.
And take a look at Disney, one of the more colorful stocks in the Dow.
Today it trades at just over 20x earnings. That’s almost 20% higher than where it traded in 2005-2006. It’s at least 20% more expensive by virtually every other valuation metric as well.
I will concede the point that Disney today is a substantially better business than it was when Bob Iger took the helm. Earnings and revenues are way up. Margins are way up. This business has been lights-out for the last decade. It’s tough to quantify actual CEO impact and performance, but Bob Iger deserves mention alongside the great executives in history.
To a certain extent, that kind of performance can justify richer valuations. But at some point, however, one must ask questions about sustainability. I’m not talking about sustainable operations — I actually think Disney’s operations are extremely sustainable and relevant for any type of economy up ahead. I’m talking about the sustainability of expectations.
Are they going to keep growing their earnings at 15% per year? Maybe. But it won’t take much to cause investors to re-assess their expectations. One or two little hiccups and the market could once again say that this is a company that ought to trade closer to a market PE rather than a 25% premium to the market.
It’s not like that’s never happened before. During 2008 the PE went down below ten.
That was a good time to buy Disney. I’m not sure I can say the same about right now.
Here’s one final Dow favorite, Nike:
Nike has destroyed the S&P!
But its PE is 50% higher than it was as recently as 2010, just before Nike really pulled ahead in the race. Some of Nike’s out-performance has been because it’s grown its earnings faster than the market, but its multiple has also grown much larger and much faster than the market as well. There’s nothing more awesome than being in a stock that’s growing both its earnings and its multiple faster than the market. But by definition, that sort of thing doesn’t last forever. It can’t. And it’s very rare to see it with very large companies like Nike.
Nike’s Enterprise Value to EBITDA — which is another fancy metric that sounds cool that analysts myself use to make ourselves sound smart — swelled from 10x in 2010 to nearly 17x today! And you could have argued that the business was expensive at 10x in 2010. Before that the stock had averaged under 9x.
This is a good business with good fundamentals. Keep in mind the fundamentals of real estate in 2006 and the economy in 2000 were pretty good too. They have to be to support expensive valuations.
Anyway, I could go on and on. I’m seeing this phenomenon all over the place. Proctor & Gamble, 3M, Visa, Pfizer, Boeing. BOEING! These companies are crazy expensive, not just relative to the years before the crisis, but relative to where they were 2010 and 2011.
We feel safe right now, and that’s why I’m a little scared.
It Wasn’t Always This Way
Here’s an article I wrote back in early 2010. At the time I was hooked on this conceptual thesis of investing in companies that were centered around the rebuilding of the middle class as well as companies that were integral to our daily lives. Bonus points if they paid a good dividend.
This is what I wrote:
I like companies that will benefit from this ideological push to bolster the middle. Companies like Coca Cola, McDonald’s, Nike, and Toyota. Disney is a favorite of mine here.
I like companies that dominate industries and are an inseparable part of our lives. Companies like Exxon, Johnson & Johnson, and Microsoft. Google, too, I suppose.
The bad news is that these are super-boring companies. There isn’t a ton of upside in these names. But when it comes to long term investments in the stock market, I know that capital preservation trumps all, so I like boring.
I honestly had no idea some of those stocks would perform this well. I liked them, sure. But for incorrect reasons.
When I re-read that old newsletter, I don’t feel like I got the call right. I feel like I got it wrong.
My process led me to some stellar stocks but for the wrong reasons. The result was great, but this tells me it had mostly to do with luck. At least the gains portion. We’ll never know how well those names would have acted as capital preservation vehicles had the market gone down from that point. It may have still worked. It’s possible my process was only half broken instead of fully broken.
Anyway: I do not like these companies anymore.
These companies are not boring. They are no longer good places for capital preservation. They don’t suit my long-term needs as an investor.
I’m not even sure how much upside they’ve got left in them, either. With stocks that are priced to perfection, the question of upside is a question that is virtually impossible to answer because it is so dependent on the sustainability of existing psychology. It’s like knowing when the music will stop in a game of musical chairs. Nobody knows. Hopefully you’re just faster than everybody else once it does.
I realize this is not a popular perspective. Whatever. It certainly isn’t the first time I’ve climbed up here on my tiny little pulpit with my tiny little megaphone and said something that went against the psychology of the moment.
With all the rambling and charts and data, I notice I’ve exceeded my weekly word limit. And there’s still a lot more to discuss. We need to identify the macro factors that could act as a pin and we need to map out some investor response strategies.
We’ll get to all that next week.
In the meantime, take a hard look at your portfolio. My guess is that you probably own some of these stocks or stocks with similar characteristics. Ask yourself why you own them. If you own them for growth or you own them for capital preservation, I’m telling you: there are better opportunities elsewhere. This is what the data suggest. At least over the next market cycle. If you own them because it’s easier to sleep at night knowing you’ve got Disney and JNJ and McDonald’s, then keep right on owning them. You’re doing the right thing.
I realize that sounds strange. I just spent three thousand words telling you why they may be dangerous. Yet the reason why investors like these stocks is because we’ve never had to worry about names like this before. We sleep easier with blue chip names in the portfolio. That comfortable psychology is another quality of bubbles (or moments of acute over-valuation) and it’s another reason why they’re so difficult to identify until after they’ve popped. Nobody worried about real estate in 2005, not after a century of gains, and nobody worried about the stock market in 1999, not after a twenty-year bull market.
What reason could we possibly have to worry about blue chip U.S. equities today? The narrative makes us feel so good and the past performance is so incredible.
Anyway, we’ll pick this discussion up next Thursday. If you enter your email in the box below, you’ll get it automatically. Don’t worry, it’s safe. I care as much about your privacy as I do mine. I hate being bombarded by junk mail, but I really like using email as a notification tool and reminder. Maybe you are the same way? So I only send one message per week, I never include ads, and there’s a nice little “unsubscribe” link at the bottom that I never have a problem with people clicking. Don’t worry, you won’t hurt my feelings if you sign up and then leave.
See you then!