201411.16
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Bubble Behavior?

I really hate the term bubble. With regard to markets, frankly it has no meaning. One man’s bubble is another man’s rational bull market. There is no agreed upon valuation metric which, once exceeded, pegs a market or a sector or a stock as a bubble. My view on the matter is that “bubbles’ are about behavior, about seemingly normal people believing unbelievable things. Like, for instance, believing that real estate prices haven’t fallen for a very long time and therefore won’t ever fall. Or, that a company that has grown at a very high rate, hundreds of percent say, is deserving of a valuation that assumes that growth rate will continue for years or decades (in the case of the dot com mania). It is as if there are times when people forget, if they ever knew, how capitalism works.

“Bubbles” – I’m going to use that term because it’s the one everyone else uses – are grown from rational seeds. The real estate “bubble” of the last decade was a product of monetary policy, housing policy and dollar policy. It was perfectly rational to buy houses based on the conditions that existed when the rapid rise in house prices started in the late 90s. It was rational to continue buying houses during most of the decade while interest rates were low and the dollar declined. But there came a point where buying houses no longer made economic sense and that didn’t keep prices from rising further. People were “buying” houses, often with little of their own capital at risk, just for the opportunity to sell them to someone else at a higher price. People were refusing to sell houses at ridiculous prices just because they were afraid of missing out on more gains. It wasn’t some particular price point or valuation that pegged housing as a bubble; it was the behavior of the people acting in the market. The assumptions they made to justify paying higher and higher prices were mere rationalizations that allowed them to stay in the market and ultimately pay the price for their inability to control their own greed.

And so we find ourselves today with a stock market that many have labeled a bubble. But there have been plenty of rational reasons to buy stocks the last few years. The economy has been growing, albeit at a rate that satisfies few, earnings – the real driver of long term returns – have been growing, the dollar has been fairly stable (and recently rising), companies have been buying back their own stock reducing share counts, dividends have been rising and there has been the perception that the Fed “has your back”, meaning I suppose that the Fed will prevent stocks from falling very far because part of their recovery plan is based on the “wealth effect”. No matter, of course, that the Fed has never been able to keep stocks from falling in the past if the economic and market environment dictated a need for them to fall. The Fed didn’t stop stocks from falling 50% after the dot com boom and they couldn’t stop them from falling 50% after the real estate boom ended. So, I guess if there is anything irrational about the stock market rally of the last few years, it would be that last one.

My personal antipathy to the US stock market as a whole – not all stocks and not all stock markets – is not based on any belief that stocks are in a bubble. It is rooted in nothing more than a belief in reversion to the mean – a belief in capitalism – something that has moved markets for centuries. US stock market valuations today are, depending on your valuation method, a bit over average, high or very high. There are no valuation techniques of which I’m aware that would call market valuations today cheap. I suppose if one looks at a very short history that includes only the period back to the mid 90s, one could say stocks are not expensive relative to that period. But that seems very shortsighted and the kind of rationalization that gets investors into trouble.

For those who believe in reversion to the mean the problem with most valuation techniques is that they don’t take into account today’s corporate profit margins which are near their all time highs. Indeed, if one believes that today’s high profit margins will be sustained far into the future, one is, in a sense, saying that either capitalism does not work or that it isn’t being tried anymore. For high profit margins, in a capitalist, competitive world, are not sustainable. High profit margins are for entrepreneurs like a flame to a moth, honey to a bear or another metaphor of your choosing. High profit margins can only last if entrepreneurs are prevented from entering markets and bidding them down. And despite whatever one chooses to believe about our current economy, that is not the case today. Profit margins will fall and that means valuations today are higher than even the most optimistic believe.

We see this all the time in markets and to believe it won’t happen again is, in my opinion, foolish. The perfect example is what has happened in the commodity markets. Commodity prices were high most of the last decade because of the Bush and Obama administrations’ preference for a cheap dollar. It was that cheap dollar policy that drove capital into emerging markets – what Greenspan and Bernanke called a savings glut – and created a boom. The demand for commodities and their high prices during that time cannot be separated from the weak dollar. But high prices and margins in commodities created a boom in new capacity as well. Entrepreneurs dug new mines and brought old ones back into service to take advantage of high prices and profit margins. New oil and gas wells were drilled and fracked. And after a time and a reversal in the dollar’s fortunes, the new capacity brought down prices and profit margins. In other words, capitalism worked just as it is supposed to work.

But let’s get back to behavior. I am starting to see what I believe to be bubble behavior in markets. Sentiment toward stocks is, as a friend of mine put it, off the charts bullish. Any dip in stock prices, no matter how small, is seen as a reason to buy. Any news, good, bad or neutral, is seen as a reason to buy stocks. If economic news is good that means better earnings and higher stock prices. If economic news is bad that means the Fed will step in to keep prices from falling. Bad economic news outside the US is seen as positive for US stocks because people selling international stocks will be forced to buy US stocks. There are only a few times in history when sentiment has been this lopsidedly bullish and none of them, in retrospect, turned out to be good times to be a buyer.

I also see evidence of bubble behavior in some individual stocks. The poster child for a company with a high valuation and no competitive advantage is GoPro, valued at 200 times trailing earnings and 60 times next year’s estimate. This is a company where the barriers to entry are, as another friend put it, access to an Asian manufacturer of cameras and a piece of elastic. There is no rational reason to believe that GoPro can sustain its margins and continue to grow at the pace of the last couple of years. And yet, the stock is within spitting distance of its all time high with a market cap of $10 billion. And by the way, the margins aren’t even that good, less than 10%. And also by the way, the company just recently filed for a secondary stock offering of $800 million of which $700 million will go to existing shareholders, including the CEO.

There are plenty of other examples of stocks like GoPro but perhaps the most interesting area of bubble behavior is in the blue chips that everyone seems to think of as “safe”. Proctor & Gamble is a fine company but at 24 times trailing earnings and earnings growth in the single digits, it is certainly no bargain (which might explain why Buffet was willing to swap his P&G stock for Duracell). Likewise Colgate and Kimberly Clark two more very well run companies sporting P/Es around 20 and anemic earnings growth. The list of blue chips that fit that description is long and very distinguished and may explain to a large degree why so many see this market as not all that expensive. It is reminiscent of the Nifty Fifty of the early 70s, the one decision stocks that you could buy and hold forever. Forever is a long time by the way and while the Nifty Fifty mostly performed pretty well if you had a 40 year time horizon, you had plenty of opportunities to buy them cheaper after the ’73 bear market.

Maybe profit margins will, for the first time in history, not revert to the long term mean. I’ve read plenty of “explanations” why high profit margins are here to stay but to me they sound more like rationalizations. The most common is that the US economy is more service based and service businesses have higher margins. Believing that though is tantamount to saying that capitalism doesn’t apply to service companies. As a man running a service company, I can tell you without a doubt that isn’t true. High profit margins are high profit margins and if allowed to work, capitalism will bring them down every time.

So, I won’t call the US stock market a “bubble”. Anything is possible and maybe paying 20 times earnings for a blue chip growing at 5% is rational. Maybe P&G is about to come up with a revolutionary soap or Kimberly Clark has invented a digital diaper that changes itself and posts to Twitter. Or maybe paying 200 times earnings for a company with a pedestrian product and the public’s fascination – for now – is perfectly rational. Yeah, sure it is. It might not be a “bubble” but bubble behavior abounds.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773. You can also book an appointment using our contact form.

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