Something’s Gotta Give (Watching Paint Dry)

Valuations are too high. Something’s gotta give.

That generic complaint, or some version of it, is ubiquitous.

If “this time is never different” (to employ the five-word, bearish version of the most dangerous phrase in finance), then all you need to know about equities is that if you exclude the tech bubble, valuations are in the 100th%ile (figure below).

On Deutsche Bank’s cyclically adjusted earnings measure (which is different from the standard CAPE), the S&P trades beyond 26X, which the bank noted this week is “easily the highest outside the late 90s bubble.” In aggregate, the S&P is 94th%ile on LTM PE, 93rd%ile on NTM PE, 99th%ile on EV/EBIT, 99th%ile on EV/EBITDA and 100th%ile on OCF/EV.

Market participants have offered all manner of explanations for nosebleed valuations across metrics, ranging from the simplistic to the highly nuanced. Deutsche’s Binky Chadha summarized them in a note dated September 9. The list, he wrote, includes,

• Low interest rates
• The pandemic accelerating the adoption of technologies that raise productivity, margins and the level and/or trend growth in earnings
• Large firms (which dominate the major equity indices) gaining market share at the expense of small, raising the trend level of earnings
• The share of high growth companies in the market has grown
• The cash flow generated from earnings has risen
• A paradigm shift in monetary and fiscal policies has reduced downside risks to macro growth; and
• The increased participation of retail investors

The bank went into considerable detail in the course of suggesting that most of those narratives lack sufficient explanatory power. I’d argue that together, they do, in fact, go a ways towards explaining elevated valuations — if for no other reason than investors’ belief in one (or more) of them helps market participants rationalize a decision to keeping buying.

When it comes to retail investors, I don’t see much use in scouring the thesaurus for euphemisms. The general American public isn’t very intelligent, and the more the general investing public resembles the body politic as a whole, the less intelligent the investment community becomes. I realize that’s caustic, but it’s almost unequivocally true. Vanguard democratized markets decades before today’s retail investor class was born. That revolution happened a generation ago. And its name was Jack Bogle. Everything else (e.g., the gamification of investing in an effort to lure the masses into a casino where their order flow is exploited) represents an incremental erosion of the market’s collective wisdom, culminating in this year’s meme stock frenzy.

“From a demand-supply perspective, retail investor participation in equity markets has clearly increased, and in our reading has been a driver of high valuations,” Deutsche said this week, adding that in their view, “retail participation peaked back in January, fell and has been noisily going sideways since.”

But the bank’s overall explanation for elevated multiples is straightforward: Nobody knows where we are in the cycle.

“At a fundamental level, we believe the key reason multiples are high is market confusion, in part reflecting the speed and surprise with which the economic recovery has unfolded and the large persistent beats this generated,” Chadha wrote, noting that “S&P 500 earnings have beaten the bottom-up analyst consensus estimate by an unprecedented 15-20pp for five quarters running.”

Amusingly, Deutsche reminded investors that consensus is typically the product of conversations with the C-suite, so the recurrence of outsized beats “suggests that companies themselves were surprised by the strength and speed of the recovery.”

Ultimately, Chadha thinks the earnings cycle may be getting a bit long in the tooth. Profits were back to trend by Q4 of last year. Now, they’re 10% above trend. On Deutsche’s estimates, they’ll be 20% above trend levels within four months, in line with historical overshoots during expansionary phases. Although the bank conceded there’s scope for an overshoot, the bottom line (figuratively and literally) is that “the earnings cycle is clearly very advanced,” as Chadha put it.

Signs of peak growth are everywhere, the consumer is faltering and the so-called “Triple Peaks” macro narrative is pervasive. Two-thirds of S&P 500 industries now have activity levels at least one standard deviation above trend, according to Deutsche Bank. One read through is that it’ll be harder for the data to keep surprising to the upside.

If activity continues to decelerate, it’s reasonable to suggest that revisions momentum will too (figure above, from Deutsche).

Of course, valuations can come down without triggering a dramatic selloff. Chadha noted that valuation corrections usually happen in “slow motion,” playing out over three years on average.

“Slow motion” indeed. Although there’s been no shortage of “under the hood” drama in 2021 (e.g., selloffs and dramatic deratings in frothy corners of the market as well as head-spinning rotations tied to the ebb and flow of the reflation narrative), waiting on the index to derate has been akin to watching paint dry (figure below).

The problem, though, is that the more advanced the cycle, the higher the odds of a valuation correction translating into a sharp drawdown. That’s why rampant confusion over where we are in various cycles is potentially perilous.

Throw in the old “we’re due” argument (US equities are currently enjoying the longest stretch without a 5% pullback since Janet Yellen’s short vol bubble) and you’ll be forgiven for suggesting last week’s nascent selloff has legs.

As Deutsche put it, “in the current context, the cycle has been advancing very quickly, so the risk that the valuation correction is harder is growing.”