Expectations Running High
RJ Steinhoff, CFA Investment Process
Most major markets around the world have reached all-time highs. Unprecedented monetary and fiscal stimulus has bridged the economic hole created by COVID-19. Multiple vaccines are being distributed. All major economies now exhibit steep yield curves, a sharp contrast to the inversions seen in 2019. While unemployment remains elevated, leading indicators suggest a continuation of the economic recovery. And S&P 500 earnings are expected to eclipse 2019 this year.
However, markets appear to have risen too far too fast. In the U.S., valuation multiples for most indices are at or near record highs. The S&P 500’s trailing last-12-months EV/EBITDA multiple crossed 18x earlier this month. As seen in Chart 1, this exceeds the dot-com bubble. Part of this spike is a result of reduced profitability from the recession but even on a look-ahead basis, the next-12-months multiple is at a 20-year high.
CHART 1. 20-YEAR S&P 500 LTM AND NTM EV/EBITDA MULTIPLE
SOURCE: FACTSET, GENERATION PMCA
Some argue that today’s high multiples are justified by record low interest rates. While there is a strong negative relationship between valuation multiples and interest rates historically, the relationship breaks down when rates go below 4% (discussed in “Accounting for Interest Rates”). When rates are ultra low, the economy is typically weak or volatility is elevated—as in the current environment. As growth wanes and volatility rises, multiples contract. Since the current period is marked by such low rates perhaps historical experience should be ignored. Though, we do not think so.
Our favourite method to factor interest rates into the valuation equation is to measure implied growth. The implied growth calculation flips the typical valuation equation (i.e., discounting earnings or cash flows) on its head, setting valuation at current market prices and then solving for the long-term growth rate. In our approach, we use normalized earnings as a proxy for cash flows. Each company’s cost of equity is calculated using trailing 3-year betas (a measure of a stock’s volatility compared to its local market) and the 10-year Treasury rate for the risk-free rate.
As shown in Chart 2, even when accounting for record low rates, growth expectations are as elevated as they have ever been. Implied growth for the median S&P 500 company (dark blue line) stands at 5.5%. Using aggregate earnings for the index, implied growth is close to 6%. It’s important to look at both measures to gauge valuation levels. In 2000, the median stock was not as expensive as index earnings indicated, due to valuation extremes being mostly concentrated in technology stocks. Today, both are at extremes indicating both the index and the average stock are expensive.
CHART 2. 20-YEAR S&P 500 IMPLIED GROWTH
SOURCE: FACTSET, GENERATION PMCA
While harder to quantify, pockets of rampant speculation have also emerged. IPOs, SPACs (even 3 SPAC ETFs have launched), and cryptocurrencies are the pole stars of late. Companies specializing in nascent technologies such as electric vehicles, with profitability in some cases projected to be several years away, have been bid up aggressively. Perhaps the most astonishing development has been the extreme moves in heavily shorted stocks, driven by trading cohorts organized on Internet forums such as Reddit’s WallStreetBets. Like most speculative fervours, it will not end well for most.
Since earnings are rising and economic data is strong, we do not expect a large correction. But, at these lofty levels, we see little margin of safety for the broader markets and would not be surprised by a correction or a prolonged period of consolidation. Market index hedges are in place for long/short strategies while we continue to hunt for undervalued, high-quality companies, particularly in foreign markets or individual securities where prices may be detached from our fair market value estimates due to specific misperceptions.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
Most major markets around the world have reached all-time highs. Unprecedented monetary and fiscal stimulus has bridged the economic hole created by COVID-19. Multiple vaccines are being distributed. All major economies now exhibit steep yield curves, a sharp contrast to the inversions seen in 2019. While unemployment remains elevated, leading indicators suggest a continuation of the economic recovery. And S&P 500 earnings are expected to eclipse 2019 this year.
However, markets appear to have risen too far too fast. In the U.S., valuation multiples for most indices are at or near record highs. The S&P 500’s trailing last-12-months EV/EBITDA multiple crossed 18x earlier this month. As seen in Chart 1, this exceeds the dot-com bubble. Part of this spike is a result of reduced profitability from the recession but even on a look-ahead basis, the next-12-months multiple is at a 20-year high.
CHART 1. 20-YEAR S&P 500 LTM AND NTM EV/EBITDA MULTIPLE
SOURCE: FACTSET, GENERATION PMCA
Some argue that today’s high multiples are justified by record low interest rates. While there is a strong negative relationship between valuation multiples and interest rates historically, the relationship breaks down when rates go below 4% (discussed in “Accounting for Interest Rates”). When rates are ultra low, the economy is typically weak or volatility is elevated—as in the current environment. As growth wanes and volatility rises, multiples contract. Since the current period is marked by such low rates perhaps historical experience should be ignored. Though, we do not think so.
Our favourite method to factor interest rates into the valuation equation is to measure implied growth. The implied growth calculation flips the typical valuation equation (i.e., discounting earnings or cash flows) on its head, setting valuation at current market prices and then solving for the long-term growth rate. In our approach, we use normalized earnings as a proxy for cash flows. Each company’s cost of equity is calculated using trailing 3-year betas (a measure of a stock’s volatility compared to its local market) and the 10-year Treasury rate for the risk-free rate.
As shown in Chart 2, even when accounting for record low rates, growth expectations are as elevated as they have ever been. Implied growth for the median S&P 500 company (dark blue line) stands at 5.5%. Using aggregate earnings for the index, implied growth is close to 6%. It’s important to look at both measures to gauge valuation levels. In 2000, the median stock was not as expensive as index earnings indicated, due to valuation extremes being mostly concentrated in technology stocks. Today, both are at extremes indicating both the index and the average stock are expensive.
CHART 2. 20-YEAR S&P 500 IMPLIED GROWTH
SOURCE: FACTSET, GENERATION PMCA
While harder to quantify, pockets of rampant speculation have also emerged. IPOs, SPACs (even 3 SPAC ETFs have launched), and cryptocurrencies are the pole stars of late. Companies specializing in nascent technologies such as electric vehicles, with profitability in some cases projected to be several years away, have been bid up aggressively. Perhaps the most astonishing development has been the extreme moves in heavily shorted stocks, driven by trading cohorts organized on Internet forums such as Reddit’s WallStreetBets. Like most speculative fervours, it will not end well for most.
Since earnings are rising and economic data is strong, we do not expect a large correction. But, at these lofty levels, we see little margin of safety for the broader markets and would not be surprised by a correction or a prolonged period of consolidation. Market index hedges are in place for long/short strategies while we continue to hunt for undervalued, high-quality companies, particularly in foreign markets or individual securities where prices may be detached from our fair market value estimates due to specific misperceptions.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
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