"I will go to my grave... believing that really loose monetary policy greatly contributed to the Financial Crisis. There were obviously problems with regulation, but when we had a 1% Fed Funds rate in 2003 after, to me, it was pretty obvious that the economy had turned (up) and I think the economy was growing at 7% to 9% nominal in the fourth quarter of 2003 and that wasn’t enough for the Fed. They had this little thing called "considerable period" on top of the 1% rate just so we would make sure that their meaning was clear. And it was all wrapped around this concept of an insurance cut… I’ve made some money predicting boom-bust cycles. It’s what I do. Sometimes I am right. Sometimes I am wrong, but every bust I had ever seen was proceeded by an asset bubble generally set up by too loose policy."
- Stanley Druckenmiller
In writing a recent article, titled Parallels Of Index Funds To Subprime CDOs, I investigated how perceived quality stocks have strongly outperformed in 2019, as interest rates have cascaded lower, which I think is a temporary, illusory development.
To illustrate the outperformance of quality stocks, I examined the holdings of the iShares Edge MSCI Min Vol USA ETF (USMV) and the Invesco S&P 500 Low Volatility ETF (SPLV), which have seen inflows of roughly $8 billion this year in 2019, only slightly trailing the $8.3 billion in inflows to the biggest U.S. ETF, the Vanguard S&P 500 ETF (VFINX).
The rush to quality is occurring as almost all market participants have positioned for what they think is an inevitable recession, and this flight to safety has come with a price, as the following quote illustrates:
"Low-volatility stocks (high quality stocks with lower volatility, which includes Procter & Gamble shares) are trading at almost three standard deviations above the mean. That means low-vol is more expensive than it has been nearly 99% of the time, relative to the mean, since 1990."
The Leuthold Group
Procter & Gamble (PG), whose shares have risen a remarkable 35.8% year-to-date in 2019, outpacing the robust YTD 20.4% gain of the SPDR S&P 500 ETF (SPY), fits firmly into this quality story, with the kicker that it is a hallowed Dividend Aristocrat, meaning it has increased its dividend, at least once annually, for 25 consecutive years. So PG has another devout group of sponsors who will buy shares at almost any price, so long as the streak of increased dividends remains intact.
In a time of perceived economic uncertainty, investors pay up for quality, with Procter & Gamble's shares being at the forefront of this quality movement, and this pay up for quality has happened to a historic degree in 2019, as Leuthold's quote illustrates above.
However, in this blind rush for quality, almost all market participants have ignored that Procter & Gamble has actually seen a decrease in its revenues, operating income, and net income the past decade. So the business is not growing, it is actually shrinking, and PG shares trade at the top end of their decade ranges on a host of valuation measures, setting up PG shares for a nasty fall once the rush for quality abates.
Quality is overpriced.
Procter & Gamble Shares Are Having A Fantastic Year
It has been a banner year for PG shares, up 35.8% year-to-date in 2019, outpacing the strong gains of the S&P 500 Index, as measured by the SPDR S&P 500 ETF, which is up 20.4% YTD in 2019.
Bigger picture, Procter & Gamble's shares have surged since their 2018 lows, almost doubling in roughly a year and a half of price action.
What is behind this skyrocketing stock price of Procter & Gamble? It is a three-part answer, in my opinion.
First, a decline in interest rates, specifically longer-term interest rates, has sent many investors searching for yield. On this note, investors consider stocks like Coca-Cola (KO), Johnson & Johnson (JNJ), McDonald's (MCD), Procter & Gamble, and Verizon (VZ), as bond surrogates, with higher yields than many sovereign bond prices today.
Second, many market participants fear a near-term recession, especially with so much commotion about the recent yield curve inversion, so there has been a concentration in perceived quality stocks.
Third, in a market that is more trend following than ever before, momentum takes over.
Quality Stocks Are Historically Overpriced
The decline in longer-term interest rates, the mad dash for quality and the price momentum have collectively combined to make quality stocks, particularly low-volatility quality stocks, historically overpriced, specifically relative to other value oriented investment candidates.
This valuation gap, according to researchers at JPMorgan (JPM), is more pronounced than it was in the late 1990s, with a focus on low volatility equities, which have significant overlap with the perceived quality equities.
What is the resolution to this historic divergence in the stock market?
The answer is a historic capital rotation, and we started to see a glimpse of this yesterday, September 9th, 2019, with the largest one-day momentum shift since 2009, with the worst performing equities year-to-date, notably the economically sensitive equities like energy equities, staging their best day of performance, while the best performing equities year-to-date generally retrenched.
(Source: Bloomberg, SENTIMENTRADER)
Procter & Gamble's shares followed the script, declining 0.57% on the day, in contrast to SPY, which was up 0.05%.
Building on the narrative, the Russell 1000 Growth ETF (IWF), which houses some of the dominant growth stocks, like Alphabet (GOOGL) (NASDAQ:GOOG), Amazon (AMZN), Apple (AAPL), Facebook (FB), Microsoft (MSFT), Netflix (NFLX), and Salesforce.com (CRM), declined 0.78% yesterday, while the Russell 1000 Value ETF (IWD) actually rose 0.86%.
Thus, there was definitely the start of a long overdue capital rotation, though we will have to see if this burgeoning capital rotation has legs in the days and weeks ahead. From my perspective, I suspect it will, because underlying valuations have become historically bifurcated, and the views about the future economic growth trajectory, specifically lower for longer and the belief about a near-term recession, have become too uniform.
Procter & Gamble Valuations Are Through The Roof
Lost in the shuffle of the almost parabolic rise in Procter & Gamble shares is that the business is struggling, not flourishing.
Specific evidence of this struggling business backdrop for Procter & Gamble is present in revenues, which peaked in 2012, and have flattened out in recent years.
Overall revenues for PG are lower than they were a decade ago. Additionally, net income is lower than a decade ago too.
Procter & Gamble's book value has actually declined over the past decade, as shown below, so it is not like they have been compounding the value of the business with retained cash flows.
Looking at Procter & Gamble's book value on a price-to-book value basis, this measure shows how extraordinarily expensive PG shares have become, as investors eschew all valuation measures and flood into perceived quality names.
When you look at PG's revenues, net income, and book value, which have all declined the past decade, it is hard to reconcile how the stock price has roughly quadrupled from its 2009 lows.
Bigger picture, PG shares have skyrocketed in value, yet they are expensive by traditional value ratios, including a forward price-to-earnings ratio of 23.6, which is higher than the S&P 500's current price-to-earnings ratio of 22.6 and its forward P/E ratio of 17.6.
Closing Thoughts - Avoid Quality Stocks, Including Procter & Gamble, As They Are Historically Overpriced
With almost all market participants believing a near-term recession is preordained by the all knowing yield curve, bond yields plummeting, and dividend growth yields still prized above almost all investment characteristics, quality stocks have become historically overpriced, alongside their historically overpriced sovereign bond contemporaries.
Even among its overvalued peers, Procter & Gamble's quadrupling of its share price since its 2009 lows and near doubling of its share price since its 2018 lows stands out as an egregious move, as the underlying business of Procter & Gamble has unequivocally declined over the past decade, with lower revenues, lower operating income, and lower net income.
With rising wage pressures and rising input costs both putting pressure on profit margins, threatening to reverse a decade of paradise for big businesses, there are significant headwinds that Procter & Gamble stockholders face today, and this statement is true for the stock prices of most quality companies, which have been chased by yield oriented investors to the point that their respective stock prices are in the stratosphere, compared to past valuation levels.
Personally, I have run a financial model on Procter & Gamble for years, and I have a $77 fair value, which would equate to roughly 37% downside potential from PG's recent closing price of $122.17.
For comparison, Morningstar, which gives Procter & Gamble a wide moat rating, sees fair value at $103 per share, implying downside of roughly 16%.
Ultimately, investors face a dilemma today, specifically do they dance while the music is still playing, hiding in perceived quality, when it is historically overpriced, and perceived quality names like Procter & Gamble trade at all-time high valuation levels, or do they get out ahead of the inevitable price discovery that's coming?
Personally, I can make a case for shorting Procter & Gamble shares at today's prices, and I have done this recently, as part of a long/short portfolio. Now, shorting, or using a long/short portfolio are two investment approaches not practiced by a a majority of investors.
Thus, I think there is a more palatable alternative approach. Specifically, it's to avoid the overpriced quality equities and go where the passive and ETF fund flows have not been, where investors have not crowded, which is where I think there is historic opportunity.
Building on this narrative, embracing shunned economically sensitive assets, when almost all market participants are buying quality, front running the passive and ETF flows, and preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity.
These economically sensitive equities include energy equities, which are historically out of favor, and which I have written about recently (extensively), with a public article on Exxon Mobil (XOM), an article providing a historical comparison of the natural gas industry in the United States, and another public article on Antero Resources (AR), with all of these articles providing perspective on the historic opportunity from my vantage point.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are short PG, AMZN, AND SPY IN A LONG/SHORT PORTFOLIO AND LONG AR, XOM. 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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.