EXUBERANT NORMALITY

December 14, 2020

The theme for 2021 is normalization.

Now that we can reasonably expect effective vaccination, possibly leading to near-normal profits sometime during 2021, we can normalize equity valuations. Bottom-up estimates for 2021 EPS are all around $169,  corroborated by several buy-side strategists currently using $170 under a vaccination scenario. At 3700, this gives a P/E of 21.8: Even more “normal”, 2022 estimate of $197, 21% above 2019: the P/E is then 18.8. Any way one looks at conventional P/E ratios, they remain at the very high end of their historical range.

On the Rule of 20 P/E: on current trailing EPS: 27.5. Using $170: 23.3 at 3700. All the way out to 2022: 20.3. Fair value is only found 2 years out at 1.6% inflation, not a sure bet.

And if you are still interested in CAPE, its latest data point is 35.7 on trailing 10-year EPS of $101.70.

On November 30, Robert Shiller and 2 colleagues, perhaps to bring new life to an almost forgotten measure, tried to normalize CAPE with a new twist called the Excess CAPE Yield (ECY), concluding that “equities will continue to look attractive, particularly when compared to bonds”.

This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive. The ECY in the US, for example, is 4%, derived from a CAPE yield of 3% and then subtracting a ten-year real interest rate of -1.0% (adjusted using the preceding ten years’ average inflation rate of 2%).

What is a “higher measure” that indicates that equities are more attractive? The ECY is 4% within a 0-10% range? At what level is it “a higher measure”? It worked on and off prior to 1931, pretty well between 1932 and 1980 and strangely since while hovering between 0% and 5%, well below its historical range.

And what does the ECY really have to do with the equities/bonds relationship? Simply adding bond yields may be saying something about equity values at certain levels of interest rates but says little about interest rate trends and future bond returns.

Telling Joe Stock he’s less ugly than Bill Bond may not be received very positively if Joe is not particularly enamored by Bill’s actual look. Objectively, Mr. Bond is not terribly attractive these days. In fact, $17 trillion of world fixed income securities currently change hands at negative nominal yields courtesy of central bankers. Ten-year Treasuries yield almost 1.0% nominal but provide negative returns after inflation. Even U.S. investment grade corps barely break even in real terms.

The only way Mr. Bond gets attractive is if observed through the prism of very slow economic growth and/or deflation, nothing that would make Mr. Stock win a beauty contest…

Gerard Minack argued similarly via a recent Bloomberg column by John Authers about Normalized CAPE:

• Shiller Sees Only Rational Exuberance This Time How far lower rates justify higher stock valuations isn’t straightforward, though.

(…) To some extent, all else equal, lower interest rates should justify paying more for stocks; they mean that bonds, the prime alternative to equities, are more expensive, and they also mean that the future earnings stream from equities can be discounted at a lower rate, making them more valuable.

The questions, then, are to what extent, exactly, do lower bond yields justify higher equity valuations? And critically: Are all other things equal? (…)

(…) But this leads to a question which Gerard Minack, of Minack Advisors, raises this week. Do low interest rates in their own right lead to higher earnings multiples? His answer is no; it’s not rational to bid up stocks just because rates are low. The reason is because not all else is equal. Usually interest rates are low because growth is bad, and when growth is bad that tends to be bad for equities. That leads to a curved relationship between rates and equities over time — when rates come down from very high levels, equity multiples tend to improve, but when rates then drop to very low levels, equity multiples fall because this generally means that the economy is mired in a recession. (…)

Real yields, compared to current inflation, are low at present, but not historically unprecedented. This exercise gives a slightly better correlation (although only slightly), makes the dot-com bubble look like more of an outlier and, sadly, also makes the current point look like more of an outlier. There have been a number of observations with 10-year nominal yields below the rate of inflation in the past, and this is the most expensive that stocks have ever been during such a period (…):

An important lasting problem with the CAPE is its earnings component which can get totally “irrational” in periods of dramatic drops in profits such as in the 2008-09 Great Financial Crisis and the current Great Health Crisis. CAPE’s ten-year averaging seeks to normalize earnings across 2 business cycles but equity markets are quick to normalize “truly abnormal” profit recessions. Carrying such cratered profits over 10 years is irrational, even using interest rates, unless one thinks such high profit cyclicality is the new normal, which should not lead one to pay up for equities.

The other problem is CAPE’s use of “reported EPS” as opposed to “operating EPS” which most rational investors use. The gap between these two series is 32% currently.

The Rule of 20 adjusts trailing EPS with inflation. Let’s use Shiller’s recent approach and adjust it with 10Y Treasury yields:

It morphs into the Rule of 22 (range 17-27) but with much less consistency than the R20 with inflation. This is particularly apparent between 1983 and 2004 when R22 valuations (using interest rates) would have suggested overvalued equities for 20 years whereas the R20 (using inflation) signaled strong undervaluation between 1983 and mid-1987, 1988 to 1991 and 1995 to 1997.

Superimposing both lines, we can easily visualize that using inflation provides a much more consistent and useful valuation range between 16 and 24:

Using interest rates implies adding fluctuating real interest rates to fluctuating profits. Real rates can be subject to various influences including central bank manipulations and investor sentiment. Inflation data offer a far more consistent and objective valuation range.

Everybody knows equities are overvalued and that bonds carry highly unusual risks of losing money, nominal or real.

But everybody also knows that in this highly abnormal Covid19 environment, governments and central banks are totally set to keep economies running and money flowing, whatever it takes.

In FEARFUL FEARLESSNESS on August 31, I observed that major valuation excesses only corrected when a hawkish Fed took it on itself to end the party. This time, Powell and just about every FOMC member have told us that inflation is not even on their radar screen and that lower for longer is now the only mantra. What’s to fear?

Well, bond investors might still have some say on longer-term rates and the back-to-normal theme seems to be humming here and there. Ten-year Treasury rates are up almost 40 bps since early August, an 82% jump. They were also up 50 bps (+31%) in the fall of 2020.

Real Treasury yields remain negative, a rather irrational investment unless one thinks they will get even more negative and attract other benchmarked investors seeking relative performances, never mind actually losing client money.

It is thus normal to hunt for higher yields and climb the risk stairs towards some real returns. The red rectangle below is where inflation, or inflation expectations, currently stand, showing that even US investment grade corporates are barely break-even in real terms. One needs to climb all the way down to High Yield debt to get half-decent real yields of 2.0-2.5%.

But it ain’t totally stupid considering what the CARES act has done to the riskier balance sheets…

…and to many S&P 500 companies, recipients of nearly $400 billion of Uncle Sam “pandemic loans” in 2020:

We shall see what happens to this excess money as we move towards immunization and normalization. For now, it is still rising and essentially stalled in bank accounts.

This liquidity flush keeps feeding financial markets, thriving on abnormality as never before. Bad normal world news is seen as good for investments, keeping governments and central banks focused on the immediate tasks, whatever the longer term effects.

The Bank for International Settlements, the central banks’ central bank, may be warning, again, that asset prices are disconnected from the real economy, nobody is listening. Claudio Borio, head of the BIS Monetary and Economic Department said last week that

we are moving from the liquidity to the solvency phase of the crisis. We should be expecting more bankruptcies going forward yet credit spreads are quite low by historical standards, and indeed while banks are pricing risk more carefully we don’t see the same in capital markets.

This move towards normality necessarily comes with people and companies paying off accumulated deferred liabilities (e.g. rents, mortgages, interest, payables). Money velocity will rise but excess liquidity will likely diminish.

For most ordinary people, normalization will be very welcome. For the investing crowd, it will mean seeking rationality in some basic, time-endured ratios when money-gushers dry out and normality becomes unsuspected reality:

• the labor force participation rate, which was finally trending up in 2019, dropped from 63.4% to 61.5%. Among 65-year old and over, it dropped from 26.0% to 24.1%. How will these ratios evolve as labor demand normalizes? Wage rates? Profit margins?

• core inflation in the USA eased from the 2.0-2.5% pre-pandemic range to 1.6% as services prices stabilized amid widespread lockdowns. But goods inflation went from negative to +3.6% on strong pandemic demand and constrained supply. Many economists expect normalization to unleash demand for services, the supply of which has been reduced by thousands of bankruptcies and closings. The Fed has repeatedly said it will tolerate higher inflation but bond investors may not. Rising long-term rates would boost discount factors, reduce P/E ratios, and push TINA to the sidelines, hurting equity demand.

This exuberant market sees silver linings everywhere with normalization on the horizon. Even sharply rising Covid19 positivity rates, hospitalizations and deaths can’t bring any adverse investor reactions: bad news can only beget continued official support, even more so now that vaccination is starting and normalization is visible.

Visibility is not the right word for corporate profits these days: Q3 earnings surprised by 19.5% (!) and ex-Energy profits were almost flat YoY (-1.9%)! Who now wants to believe the Q4 estimates of a 7.5% drop in ex-E earnings?

Actually, who cares about earnings? Just look at these IPOs. Unless you’ve been investing long enough, you would think this is simply normal. SentimenTrader’s Jason Goepfert dug historical data for the younger crowd:

Using Bloomberg data going back to the early 1990s, let’s look at the total number of U.S. listed initial public offerings that showed a negative net income at the time of the offering. If they didn’t report financials at the time, then we ignored the listing.

Over the past year, there have been 88 IPOs that showed a negative number on the net income line. That exceeds all other rolling one-year periods except for 2000. But that year also had quite a few IPOs that were actually making money at the time. If we look at a ratio of money-losing to money-making companies that issued shares, the current environment stands out.

Jason goes on with data on the age of IPO companies (here) and concludes:

When risk appetite is high, equity investors are willing to accept ideas and concepts in lieu of revenue and profit. The only other time when both the average and median age of a newly public company neared this low of an age was 2000. (…) When bankers can feed investor appetites to this degree, and the only concern seems to be finding the next candidate to feed them, investors as a whole have a strong tendency to suffer in the months ahead.

Doug Kass and Crescat Capital also think nothing is even close to normal equity valuations these days:

On December 21, Tesla will electrify the S&P 500, insanely or ludicrously zipping its way among the largest index stock, boasting a more than $600 billion market cap. The highest EPS estimate for 2021 is $5.35 (average $3.80), which is a 113 P/E. No worries, AMZN was selling at 560 times in 2015 and the stock has quintupled since. Will TSLA dominate the EV and solar markets like AMZN dominates the online retail and cloud markets? They are both mainly software companies.

Investors are truly exuberant. Perhaps the world should not normalize too much!

NORMALIZATION AND THE RULE OF 20 STRATEGY

The Rule of 20 Strategy applies strict rules based on valuation (R20 P/E) and trends in earnings and inflation (R20 Fair Value). Now that effective vaccination is underway, we can use normalized earnings instead of the pandemic depressed trailing profits. The only other time normalized earnings were substituted to trailing earnings was in early 2009 when governments and central banks were clearly taking charge putting the end of the financial crisis in reasonably clear sight. In the current situation, up to now, it was too risky to presume that effective vaccines would be found and made widely available so rapidly.

At 3663, the Rule of 20 P/E is 23.1, still at 100% cash, but it would revert to 50% cash at 3630 (R20 P/E of 22.95).