We don't even have an official bear market in the most widely followed stock market index (NYSEARCA:SPY) in the world, and already the bulls are smelling bargains. The prominence and experience combined with the ubiquity of the case they make for stock prices to rise a good deal makes the recent media comments of two figures important to analyze.
This article first presents the arguments of these two bullish and well-known experts, then shows some new data based on bond market spreads. The conclusion reached at the end is that US stocks have substantial valuation challenges, or headwinds, that perpetually leave them at risk of significant price declines, even if the abstraction we call an economy "performs" satisfactorily.
I'll begin with the thesis of the well-known economist and fisherman David Kotok.
The Kotok view - higher equity prices may well loom; maybe much higher
First, the redoubtable David Kotok of Cumberland Advisors has a blog post that argues:
The progression into negative rates is bullish for asset prices worldwide. As Ben Bernanke once indicated, if you discount the price of an asset indefinitely at zero, the asset price rises and becomes profitable. Imagine the same math applied when the interest rate discount mechanism is negative instead of zero. Mathematically, there are no limits when the discounting rate is zero or lower...
We are in an extraordinary world. Those who are following regression methodology to create pretty multi-colored pie charts are missing out. To paraphrase Keynes, when things change, I change. Markets are headed higher. Maybe much higher.
If one reads that carefully, the assets that he is referring to could be many types of assets - silver, emerging markets, etc., but another sentence in the post appears to clarify what he is emphasizing as his preferred asset:
At Cumberland, we are nearly fully invested in the US stock market.
I will assume that the major point he is making is regarding that which he is directing investment towards, namely US stocks.
Thus, he is asserting that NIRP (negative interest rate policy) is bullish for US stocks, even though the Fed moved away from ZIRP and thus farther from NIRP in December.
Let's evaluate his arguments in different ways.
1. Empirical results of NIRP
The ZIRP era coincides with the topping out of global stock markets, including those in the eurozone that led the NIRPing of the developed world.
This does not support the equity-bullish view of NIRP.
The German DAX Index is about unchanged in euro terms since the ECB went to NIRP. Since the DAX is the only major index that includes dividend payments, this is thin gruel indeed. It's even thinner given that very high-grade corporate bonds also traded around zero yield. In USD terms, a RECON ETF (NASDAQ:DAX) that was formed in Oct. 2014 shows the DAX down over 10% since then.
The stock market of Spain (NYSEARCA:EWP) has dropped by about 1/3 in price over the past two years. Italy (NYSEARCA:EWI) is down big, France (NYSEARCA:EWQ) less terrible, all in USD terms but they are also down in euro terms. These declines are despite huge declines in borrowing costs for their governments. If the Kotok view were correct, equities should have been capitalized at higher and higher levels.
2. Does the Kotok argument make theoretical sense?
It may not, for the following reasons.
A. Even in NIRP, the discount rate for government bonds of some duration eventually turns positive; at least it does in Europe outside of Switzerland, a very special case to be sure.
B. A government bond of a sovereign that controls its own currency (the euro versus national bonds of eurozone countries is a special situation) is not really a bond as we think of a bond. It used to be one when gold was the impartial currency that governments needed to respect and could not print. Nowadays, in a highly leveraged system, the government can monetize its debt via its central bank indefinitely. In a NIRP/ZIRP environment, essentially, the government can go back to issuing its own currency, such as by "selling" bonds of very long duration for zero or even slightly negative interest rates.
C. The theoretical value of equity has little to do with the yield on government debt. Switching to the US stock market and Treasury debt, let's say that Amazon.com (NASDAQ:AMZN) earned enough to have a 100X P/E. It also has some debt. Wouldn't one look at the rate its debt was trading at rather than the rate the US Government (which can print money at will even if there were no Fed) to compare what P/E one wants to value AMZN at?
I compare like to like and invest on that basis. One can compare one equity valuation with another equity valuation. Or, one can compare an equity's valuation with the debt of the same corporation, and so on.
But if the US returns to ZIRP or near-ZIRP, or goes all the way to NIRP, that's basically an exercise of sovereign power. The government debt is then being treated basically like cash. That's historically no big deal. The US Treasury used to issue dollars, which were just pieces of paper. Monetizing the debt by paying no interest would de facto be doing the same thing, but by a roundabout maneuver that keeps the form but not the reality of debt.
The above point can be supported as follows. Take AMZN again. One can pay whatever price one wants. There is simply no guarantee that at any time, ever, any of that money will ever be returned to the owner(s) of that share, no matter whether it is held until the stock is redeemed or cancelled or whether it is traded daily. The risk of loss is, ultimately, 100%, plus opportunity cost as one could own interest-bearing Treasury debt. This risk diminishes if one buys shares of a strong dividend-payer; then the risk may only be, say, 90% (dividends can be eliminated).
In contrast, the risk of the US Government not repaying its debt in the undefined units called dollars would appear to be close to zero.
Thus, my practice is not to compare a risky asset such as a share of common stock, which may fail to return its purchase price even without accounting for the time value of money, with a promise to pay security called a government bond issued by a strong sovereign such as the US Government.
3. NIRP and ZIRP are instituted because the times are bad, which is bad for stocks, not good
Finally, going back to the reason why I think the graph shown above is persuasive when correlating its timelines to global stock markets (and economic data) gets to the rationale for why ZIRP and then NIRP are instituted.
It's simple: these unpopular money confiscation schemes are instituted because of weak GDP growth, both real and nominal. This situation may be good for holders of very high quality bonds, but it's bad for stocks, which thrive on high GDP growth, both real and least nominal if not real.
4. Summary of the Kotok argument
All in all, the argument that NIRP is good for stocks is unpersuasive, in my opinion, on at least three grounds:
- empirical results since 2014,
- theory; government bonds are not comparable to equity,
- economic rationale for why NIRP and ZIRP are instituted.
Also, remember that the US is not in a NIRP situation.
Now let's look at the Bill Miller arguments.
Long-time bull Bill Miller makes his bullish case
Before the Great Recession, Mr. Miller was the most successful growth stock manager of the past 20 or so years. His views require respect along with those of Mr. Kotok.
The Miller arguments addressed below are two-fold. One is that stocks are just plain cheap, and the other is that stocks are cheap to Treasuries, as their dividends exceed the yield on a 10-year T-bond.
The first point is exemplified by the headline and lede of a Bloomberg News article:
Bill Miller is coming off a rough patch, which he says has created a good time to be an investor.
"The markets are a gift in the sense that there are prices out there that make no sense," Miller, whose Legg Mason Opportunity Trust (MUTF:LGOAX) lost 23 percent this year through Tuesday, said in an interview with Bloomberg's Betty Liu. "Almost everything is a buy in my opinion."
I have to disagree. I think that almost all US financial assets are either expensive or else at fair value. I believe that there are very few gifts the way there were 35 years ago in stocks, or even as there were at the bottom of the markets in 1987, 2002, and 2009.
This can be shown by looking at countless individual stocks, including those in his fund, of which AMZN is by far the most important. Or one can look at the various metrics of price:sales, market cap:GDP, Tobin's q, CAPE, etc. I've spent enough time on the overview in prior articles and add a few comments in that vein farther below, and most of us have read plenty on them. So I'll just say a few words about individual stocks.
As far as individual names go, I'm surprised that even a growth stock investor of Mr. Miller's experience would use this sort of uber-bullish language: "gift," "make no sense," "almost everything is a buy."
In that situation, in well-studied markets such as those in the US, most valuation trends nowadays tend to hang together. Thus, we saw aggressively valued IPOs in 2014 in all sectors of the economy, not just tech/telecom as in Tech bubble 1.0 years ago. In pricing those IPOs a year or two ago, which at one point had a higher percentage of unprofitable (i.e. start-ups for the most part) companies going public than at any time in the Tech Bubble 1.0 (Tech Bubble 2.0 has mostly burst already), the investment banks point to valuations of public companies to support the valuations of the IPOs.
One cannot have an IPO bubble without rampant overvaluation of the public stock market.
Forget tech and biotech, which are changing the world. Take something rather old-fashioned and low-tech: food.
The valuation is excessive there as well.
For example, two restaurant chains in the highly competitive chain concept business have been in the news recently for illness amongst customers. One, Chipotle (NYSE:CMG), is far off its high. Yet it still trades at 28X TTM EPS. Rapid growth is assured, one may wonder? Hardly. At $462, the stock is trading above 50X 2016 consensus EPS and above 30X consensus 2017 estimates.
Then there's Buffalo Wild Wings (NASDAQ:BWLD). At $144, this security trades at a trailing P/E of 30X and a forward P/E of 22X. Net income was $90 MM; the top 5 executives took home $6 MM. Total debt to equity is 17X, profit margin was poor at 5%.
Maybe BWLD is a gift, but maybe it's dangerously priced for any buyer paying these multiples. Only time, and plenty of time, will tell.
One can go up and down essentially every industry, even electric and gas utilities, and have trouble finding any "gifts." Two Wisconsin utilities, WEC Energy (NYSE:WEC) and MGE Energy (NASDAQ:MGEE) trade well above 20X TTM EPS.
The point of mentioning utilities is that there are no gifts in the US publicly traded markets anymore. One has to work a bit just to find reasonably valued securities.
Round after round of QE from the Fed, joined by QE from most major central banks, has seen to that. For those unfamiliar at this late date of the mechanics of QE, it involves direct injection of newly created cash by a central bank in return for, usually, a low-yielding government bond or the like. The recipient financial institution typically then goes shopping for risk assets with part of this cash while parking some of it right back with the central bank and/or using the cash to buy newly-issued government debt (thus, QE also serves to indirectly monetize Federal debt). This trickle-down policy eventually leads to this new money being used to purchase stocks and junk bonds, including from John and Jane Q. Public.
The net effect of QE everywhere it has been used has been to inflate the prices of everything from cash (near-zero yield) to bonds to risk assets.
Understanding this helps to understand two errors in Mr. Miller's other bullish argument, as described by CNBC:
"The S&P  yields about 2.3 [percent] and dividends grew last year 9 percent," he said. "It's sort of hard to see why anyone would own a 10-year Treasury when they could own the broad market at a higher current yield."
I have two criticisms of this argument.
First, he is making the argument that David Kotok made, in a slightly different form. A Treasury bond is simply money, deferred, a subset of cash but for now yielding more than cash.
Fractional ownership of a business is a completely different matter; receiving some emoluments in the form of dividends or in other ways does not change the key point that what matters is the ultimate and overall value of the business. Unlike a government bond, the value of any business is always changing in unpredictable ways. You simply cannot value the business by how much cash it returns to shareholders in any one year or any decade. If that were the case, then a stock that paid no dividend would have little or no value. Yet calls on AMZN, which has been public for two decades and has never paid a dividend (but Mr. Bezos has sold billions of dollars worth of stock) are listed as by far the top position in Mr. Miller's LGOAX fund (and AMZN shares are in the top 10).
Looking at the argument another way, the SPY is probably returning close to 100% of its earnings to shareholders via dividends and buybacks. Let's say the identical companies instead saw so many growth opportunities that they returned only 20% of their earnings with the same proportion as today between dividends and buybacks, investing the other 80% in growth plus cleaning up their balance sheets.
Would the SPY be worth more or less than it is now, even though the dividend yield was much less than it is now?
Dividends don't matter, ultimately, unless they reflect value. The mere presence of them does not prove value. Ask the owners of Citi (NYSE:C) stock in 2007 how their high dividend yield worked out for them.
The above conversation on CNBC was reported this way on Newsmax in a somewhat different way, which suggests that this organization is not taken in. Their write-up begins:
While some experts have turned bearish on stocks, legendary investor Bill Miller, manager of the Legg Mason Opportunity Trust, isn't one of them.
"I think they're fairly valued," he told CNBC. "They're cheap compared to bonds. It makes no sense for the stock market as a whole to yield more than the 10-year Treasury, unless we're going into a recession, because dividends are going to grow."
Then the piece points this out:
The S&P 500 index had a trailing price-earnings ratio of 20.03 Friday, up from 17.08 a year ago, according to Birinyi Associates.
Newsmax makes a cogent point. Stock prices are not up from a year ago, but P/Es are up reflecting lower EPS. Normally, I do not consider a security with declining earnings and rising valuation metrics to be a "gift."
Bulls on US stocks are running out of good arguments.
Thus, I present with limited comment a brief set of data before concluding with some more extensive comments.
Some bearish correlations
Here's a bearish correlation or two from the GaveKal blog:
These graphs show that the bond market is in some ways consistent with the SPY trading at a 50% off sale. In turn, this supports the updated case I've made recently that bonds in general, including certain junk bonds as well as Treasuries, may have a lot of relative value versus US equities.
Concluding remarks - do US equities, not bonds, have return-free risk?
Generalizing on these matters are rarely clear-cut. In the depressed period of 1979-82 for equities, there were certain seriously overvalued tech stocks. Who remembers Computervision?
Similarly, in the worst bubble from a macro sense in US history, 1999-2000, numerous neglected stocks in several sectors, mostly Old Economy sectors, performed well into the Tech Wreck.
It's important - nay, it's crucial - to evaluate any security on its own merits, if one has the time and expertise to do so. Even then, there will be errors made. One can be wrong for the right reason; it happens all the time. And one can be right for the wrong reasons, so I do not short anything and do not argue with Dr. Kotok that markets may be headed much higher (time frame unspecified but presumably sooner rather than later). All this may be.
But when it comes to value, I learned the basics of investing by reading Graham and Dodd and other boring stuff. I prefer the view of Ben Graham's most proficient student, Warren Buffett, that corporate profit margins are highly mean reverting. Based on that view, the TTM P/E of the SPY, currently 21X with the SPY at $191 using GAAP EPS, is "really" more like at 30X. Even if EPS for the S&P 500 resume growing at the 5% annual rate they have achieved since 1988 (S&P statistics), that would still suggest a mean reversion-adjusted P/E/G of 6X. With the SPY trading at about 2.5X book value, and thus trading as an earnings play rather than an asset play, a P/E/G of 6 is far too high to provide a margin of safety that attracts me.
In addition, it's important to also point out the even more basic, obvious point. Forget P/E/G if you wish. A mean-adjusted P/E of 30X easily allows for stock prices to drop to 1/2 to 1/3 or even less of their current value. For proof, see Gilead (NASDAQ:GILD).
This drastic revaluation would imply that should the next, marginal buyer of stock demand a historically average or historically low valuation based on earnings, a SPY below $100 is reasonable based on current earnings (i.e. no economic catastrophe).
That analysis comports well with the GaveKal graphs, even though it is derived from a completely different line of thinking.
In conclusion, I'm surprised that sophisticated, brilliant investors such as David Kotok and Bill Miller are using the tired "Fed model" and related arguments to be bullish on US equities.
It's one thing to make other bullish cases that can be made, such as pointing to the very long-term trend of stock prices and to the TINA ("there is no alternative) argument for stocks that continues to have some force (because what else is really attractive?). It's another to point to record-low Treasury bond rates and turn that into a highly bullish argument for stocks that are priced high precisely because of the lack of suitable safe alternatives.
I am not an investment adviser and am not advising anyone to do, or not do, anything with their or anyone's money. My view remains that unconventional monetary policy was born out of economic weakness and possibly even fraudulent behavior. I also believe that these novel monetary policies, whether it be NIRP, ZIRP or artificially raising short-term interest rates by various novel monetary techniques, may be part and parcel of new and unforeseen problems. No matter what the incoming data is on the economy and from real-time markets, I believe that the US stock market has valuation headwinds that at best will take some time to die down.
Thus, I remain cautious on US equities.
Thanks for reading. Good luck to all, including Messrs Kotok and Miller, and their clients.
Disclosure: I am/we are long GILD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.