The market has sure had a great run since March 2009. Those of us who concluded (in my case, somewhat belatedly) that we had put in a bottom comparable in importance to June 1932 or August 1982 have been generously rewarded (although I admit to selling some stock at the very bottom in March 2009). Isn't it likely that, after such a great run, "irrational exuberance" will break out and produce a "bubble" leading to a horrible collapse? It has happened before and surely can happen again.
Before addressing this question in detail, I think it is important to understand the dynamics of asset valuation. Assets which do or can produce cash flow are generally valued based on the discounted present value of future cash flow. Future cash flow is estimated and a discount rate is applied to future years to obtain a present value of the "stream" of future cash flow. For a number of reasons, that discount rate is affected by prevailing interest rates. Low interest rates mean that cash flow streams have higher present values. This converts to high price/earnings multiples for stocks and low cap rates for income producing real estate. I have written about why this works for stocks here.
Thus, one key issue is whether the fact that price earnings multiples are high is simply the rational response to lower interest rates or is, instead, a "bubble" (an example of "irrational exuberance"). I think it is the former for all the reasons I have written about (dividend yield becomes attractive, share repurchases can be financed with cheap debt, and cash for stock takeovers are accretive to earnings when interest rates are low enough). It is really no more of a mystery than is the fact that bond prices rise when interest rates decline.
I will acknowledge that it doesn't make sense for stock valuations to explode or collapse due to transitory changes in interest rates. Thus, what is important is the interest rate over a reasonable term - such as ten years - as reflected in long term bond prices or in consensus expectations of short term rates. This tends to produce a market in which stocks trade at a relatively high multiple of dividends (or at a relatively low dividend yield) as described here.
We are obviously in a period of very low interest rates and, for a variety of reasons discussed here, this situation is likely to persist. We are not likely to see the pattern of rapid, successive Federal Reserve increases in the Federal Funds rate that have occurred in the past when inflation was a real threat. If rates rise slowly, then, by the time they are significantly higher, corporate earnings and dividends will likely have increased as well.
A Value Investor's Definition of a Bubble - My basic investment philosophy is based on private market value. For stocks, an investor should ask if he or she would be willing to pay the current market cap to own the entire company. This methodology is admittedly a bit fanciful because most of us do not have anything like the amount of money necessary to buy most publicly traded companies. It is also a trap for those who are subject to grandiosity because it is fun to imagine oneself having that much money. At any rate, this exercise (as described here) quickly leads one to focus on enterprise value rather than market cap and owner cash flow rather than income. It has led me to favor companies with a large amount of net balance sheet cash and companies with depreciation and amortization which exceed capital expenditures. One can still find equities which are superior investments to virtually anything in the fixed income universe, although I will concede that it is getting harder and harder to do so. While an investor buying an entire company might be concerned about selling the company back into the market in the near term. I generally don't factor this into my calculus. Thus, my analysis tends to ignore "technical" factors.
A value investor's definition of a "bubble" should, therefore, be a situation in which investors are buying equities solely or primarily because they believe that the price will rise in the near future and they will be able to resell at a higher price. This is sometimes called the "greater fool" situation - buying stock in the hope of reselling it at a higher price to a "greater fool." Put another way, valuations should be so high that the private market analysis I describe does not identify many or any attractive targets.
A Modest Thought Experiment - The private market analysis approach I describe has some basic defects. First of all, it is unrealistic to assume most investors could buy entire companies. More importantly, a buyer of an entire company obtains control and it is generally agreed that there is a control premium. The buyer of stock in the open market obtains only a minority interest which should be valued at a lower level than its proportionate share in the entire company's valuation.
I think I have come up with a "thought experiment" which solves this problem. Investors concerned with whether they are buying into a bubble should ask themselves this question - would I buy the stock if the only way I could profit would be through dividends, spin offs, the sale of the company or very long term capital gains? Think about it this way. Suppose the government enacted a "capital gain confiscation rule" and decreed that all short term capital gains above the current price of a stock would be subject to a 100% tax with "short term" defined as less than 5 years. Let's also assume that there would be an exception for gains due to tender offers, takeovers, spin offs, or leveraged buy outs. Would it still make sense to buy the stock on the basis of expectations of future dividends and/or one of the above events? This tends to isolate the private market value considerations from the "greater fool" considerations. It is true that one could hope to sell to a "greater fool" 5 years from now but that would be long after any temporary irrational exuberance had worn off.
So, investors should ask themselves this question: what stocks would it make sense to buy under these rules? I try to look at stocks this way and target situations where there is a reasonable chance to double my money (based on total return) in 5 to 7 years. Stocks with strong cash flow and reasonable valuations can increase in value even though "the market" ignores them because they can buy back shares at low prices, reduce share count, and increase the value of each remaining share. If management is reasonably shareholder oriented, a temporary dip in price can be a blessing in disguise because it allows more shares to be repurchased for a given dollar amount of share repurchase authorization.
Results of the Experiment - Even in this market, I find a number of stocks that are more attractive than anything in the fixed income universe. The large cap tech stocks are still cheap on an enterprise value basis because of their large net cash positions and Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), and Western Digital (NYSE:WDC) all meet the above test; in each case, a very strong balance sheet plus strong cash flow should ensure ever increasing dividends so that, over the next 10 years, a holder of this group of stocks will collect more money in dividends than will a buyer of virtually any fixed income security. I also like the big banks, especially Wells Fargo (NYSE:WFC), again because dividend hikes are on the way. Lexington Realty Trust (NYSE:LXP) is inexplicably cheap as discussed here; of course, you also get a yield of over 7% while you wait. None of these stocks are trading at "bubble" levels and an investor should have no problem buying all of them subject to the capital gain confiscation rule described above.
The Spectre of Higher Interest Rates - In the United States, we are protected by two oceans and have peaceful neighbors. We are self-sufficient in food and most necessities and have the strongest military in the world. But the powerful human tendency toward vigilance (which probably developed over thousands of years as humans climbed trees to escape lions) is inescapable. Thus, we Americans manage to find things to obsess about and tend to develop phobias and overreact to these fears. Six months ago we were terrified that Ebola would break out. In the 1990's, we were convinced that Japan would surpass us in GDP. I am beginning to conclude that we may have overreacted to 9/11 in certain respects. Among monetary policymakers, the phobia du jour is a deflationary recession in which prices decline, buyers put off purchases in hopes of future declines, the economy slows down, debtors default, credit tightens, prices decline even more, ad nauseam. I happen to agree with their concern but that is not what is important. The concern is widespread and serious and it will continue for a number of years. Unless we see a very, very strong inflation threat, the Federal Reserve will be extremely careful raising interest rates. We cannot price equities as if current interest rates will last forever but it is probably the case that there will not be a substantial increase in interest rates until there is enough economic good news to make it likely that cash flow and dividends will increase. Thus, it does not make sense to ignore current interest rates on the assumption that a big change is on the way.
Multiples are high and stocks have moved a long way. But valuations are reasonable if one takes interest rates into account. Calling this result a "bubble" is like arguing that the increase in home runs in major league baseball in the early 1920's was "artificial" because it was caused by the "live" ball and the prohibition of spitballs. Artificial or not, it continued.
Disclosure: The author is long AAPL, CSCO, MSFT, WDC, WFC, LXP.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.