Vol. 1, No. 3
Vol. 1, No. 3
Are We in a Stock Market Bubble? Plus, Stock Valuation Rundowns and a Deep Dive on My Best Idea.
Welcome to Valuabl - a fortnightly newsletter for value investors with in-depth research, stock valuation rundowns, and deep dives on my best ideas.
In Today’s Issue:
Are We In A Stock Market Bubble? (9 minutes)
Stock Valuation Rundowns (6 minutes)
Deep Dive on My Best Idea (10 minutes)
1/ Are We In A Stock Market Bubble?
With the S&P500 consistently breaking through to new highs, many pundits argue that we’re in a stock market bubble built by the Federal Reserve (“Fed”). Further, they say that as soon as the Fed raises interest rates, the entire house of cards will come tumbling down.
In my book, The Little Book of Big Bubbles, I argued that to identify a bubble, we needed to answer two questions:
Are highly unlikely/impossible views of the future determining behaviour?
Is the pricing mechanism in this market based on a positive feedback loop?
The answer to the second question feels like an obvious yes for some markets (cryptocurrencies, meme stocks, and housing). Participants in these markets are buying almost exclusively because they expect the price to rise. There is such an enormous detachment from underlying fundamental value here that the game is purely speculative. I mean, Squid Coin, anyone? Come on!
But, are highly unlikely/impossible views of the future determining behaviour across the stock market in aggregate?
Yes, the market is at all-time highs. And yes, the implied return on U.S. equities is the lowest it’s been since 1961. But does that mean we’re in a stock market bubble?
Not necessarily.
The Implied Return on Stocks
Since 1982, the yield on a 10-Year U.S. Treasury Note (“yield”) has decreased markedly. However, Equity Risk Premiums (“ERP”), which declined from 1979 until 1999, are currently at similar levels to where they were back in 1982. This fact means that the reduction in the implied return on stocks is primarily because of cuts in the risk-free rate, not a change in investors’ perception of equity risk. That is, the time value of money has decreased, not investors’ perception of riskiness.
Moreover, the current ERP is at the 68th percentile of annual ERP estimates going back to 1960. This suggests that historically speaking, investors are valuing equities as slightly riskier than they have on average in the past instead of less risky, as pundits suggest they are.
The current relative normality of ERPs is in direct contrast to the Tech Bubble that burst in 2000/01. Through the 1990s, the Equity Risk Premium steadily declined until it reached a historic low of 2.05 per cent in 1999. For reference, if we applied that Equity Risk Premium to the current market, the intrinsic value of the S&P500 would be around 10,700.
Historically speaking, in 1990, the Equity Risk Premium for the S&P500 was at the 49th percentile of historic levels. By 1994, it had dropped to the 30th percentile. By 1996, it had fallen to the 15th percentile. In 1997, it was at the fifth percentile. And, in 1998 it was at the first percentile. Investors built the Tech Bubble by continually valuing equities as less and less risky - this is not happening now.
There is no evidence that investors are valuing equities as less risky than they have historically. However, this is not the main argument for the existence of a bubble. The standard view is that the Federal Reserve has kept rates artificially low, below what they should be. And, this is causing the time value of money to become distorted.
There may be some merit to this. Let’s have a look.
The Time-Value of Money
From this chart of yields on the 10-Year U.S. Treasury Note going back to the 1870s, we can see that yields have never been as low as they are currently.
For yields to ‘normalise’ to something in the 40-60th percentile range, they would need to rise to between 3.6 and 4.17 per cent - between double and triple what they are now. That is a considerable increase, but does this mean that the current rate is too low?
We know that the Fed sets rates based on economic growth and inflation. When growth and inflation are low, rates are low. When growth and inflation are high, rates are high.
I have plotted 10-Year U.S. Treasury Note yields and Nominal GDP Growth (Real GDP Growth + Inflation) in the following chart and have smoothed GDP growth by taking a rolling 5-year compound annual growth rate (“CAGR”).
We can see that the yield of the 10-Year Treasury Note and Nominal GDP Growth move in tandem (correlation of 0.91, p<0.05). This should be intuitive as the Fed nudges yields (using various tools) based on economic activity and targeted inflation. However, we should also notice that the Treasury bill yield seems to lag economic growth - the Fed reacts to the economy, not the other way around.
From the mid-1950s until 1981, Treasuries were yielding less than the compound average nominal growth rate. Then, as the growth rate fell until the mid-90s, Treasuries yielded more than economic growth. And, since then, as growth has continued to decline, Treasuries have yielded less, with the gap becoming more pronounced since 2014.
This month, the gap between the Treasury yield and the five-year compound GDP growth rate is -1.86 per cent, putting it at the 19th percentile of historical differences, suggesting that Treasury yields are slightly too low historically and economically speaking.
Raising Rates Won’t Destroy the Stock Market
So, what does it mean for the market if Treasury yields normalised? Let’s consider an intrinsic valuation of the S&P500 under a few scenarios in which interest rates and risk premiums normalise:
The above valuations are built on a two-stage dividend discount model using analyst consensus estimates for the S&P500s earnings over the next few years (LTM Earnings Q3’21: 195.05, FY’22 Earnings: 220.76, FY’23 Earnings: 236.48), with earnings growth tapering to the risk-free rate from ’26, and equity payouts (dividends + buybacks - issuances) going from the current LTM ratio to the fundamental rate assuming the S&P500 earns the average Return on Equity it has earned over the last ten years (16.2 per cent).
Based on this, if you’re in the ‘rates are too low, but equities won’t get less risky’ camp, then depending on whether you think rates will restore their relationship to economic growth (3) or return to their long-term average (2), the S&P500 index is overvalued somewhere between 7 and 18 per cent. This difference would seem like a correction rather than a bubble collapse.
Moreover, suppose you’re in the camp that thinks capital costs should all revert to their long-term average (5): in that case, the current market is fairly valued. However, if you’re in the rates will either stay low (4) or climb slowly (6), but risk premiums will normalise camp: the market is somewhere between 10 and 21 per cent undervalued‽
But if interest rates were to normalise, companies would pay more in interest and thus earn less. What if equity analysts are missing this in their projections of S&P500 company earnings? What if equities are riskier than they’ve ever been because of the amount of leverage involved, and we’re all missing it?
From this chart, we can see that U.S. companies are the most indebted they’ve been in the last eighty years. Moreover, the following chart shows that the U.S. private sector (households and non-financial corporations) debt levels are also at near all-time highs.
U.S. companies and households are highly indebted, and these debts have been building as interest rates have declined. But, these declining interest rates have been driven by slowing economic growth. Record stock market, low growth, and low interest rates - it’s easy to see why the stock market bubble argument gets airtime.
So, let’s introduce a seventh, ultra bearish scenario in which interest rates rise to the adjusted economic growth level, and Equity Risk Premiums jump to the 90th percentile value of their historical levels (5.79 per cent). In this scenario, the S&P500 is worth 3,460 and is overvalued by 25 per cent. These are extreme assumptions. But, what if they’re not radical enough. What if we are sitting on a 1930/1979/2008-esque financial crisis in the making, and Equity Risk Premiums should be at their highest levels ever (6.43 per cent)? In this scenario, the S&P500 is worth 3,113 and is currently overvalued by 32 per cent.
Sure, declines in the index of 25 to 32 per cent are extreme and would be painful. But are highly unlikely/impossible views of the future determining behaviour across the stock market in aggregate? No.
Sure, the market is at all-time highs. And sure, the implied return on U.S. equities is the lowest it’s been since 1961. But that doesn’t mean we’re in a stock market bubble.
Despite the prevalence of meme stocks, crypto scams, and some insane looking valuations out there, it is challenging to argue that we are in a stock market bubble.
I first posted this research on Twitter. You can go there to follow me and get timely updates on my research.
2/ Stock Valuation Rundowns
Over the past fortnight, I have valued:
Netflix, Inc. (NASDAQ: NFLX)
Nestlé S.A. (SWX: NESN)
Oatly Group AB (NASDAQ: OTLY)
NIKE, Inc. (NYSE: NKE)
Whirlpool Corporation (NYSE: WHR)
International Paper Company (NYSE: IP)
Kimberly-Clark Corporation (NYSE: KMB)
If you’re a subscriber, you can post your valuation requests here.
Netflix, Inc. (NASDAQ: NFLX) - A Valuation on October 29, 2021
Netflix ($299.4 billion market cap) is the world’s largest OTT streaming platform with over 214 million subscribers. They are the dominant player (16.7 per cent market share) in a hefty ($178 million) and rapidly growing market (11.5 per cent forecast CAGR). By continuing to invest in R&D, marketing, and content, they will increase this dominance (to 20 per cent market share), and by rolling out new content (including video games), entering new markets, and raising prices, they will grow (16.5 per cent forecast CAGR). By owning the content, their margins will become HBO/Disney-esque, but this structure also dramatically increases the capital intensity of the business ($0.90 in revenue per dollar of invested capital). However, they are FCF generative and have an attractive capital structure (5.8 per cent Debt/EV), meaning they can borrow money if needed.