Scarily, many believe the very high returns of the recent past will be repeated in the near future. Why else would they be holding stocks representing businesses that are either unprofitable or pre-revenue, with prices implying revenue growth and profit margins that have rarely been achieved? Perhaps they believe they’ll gracefully exit when the music stops.
Sadly, Buffett is right when he observes that, at any time, the light can go from green to red without pausing at yellow.
The simple fact is that when aggregate market returns today are higher than the long-term average, they are, quite simply, borrowing from the returns of the future.
It’s also important to remember that when recent returns are much lower than the long-run average, they are, in effect, storing up returns for the future. This latter observation should help you see any future correction as an opportunity to set yourself up for many very happy returns!
Focusing some attention on the US market makes sense now because we know, from our own research, that variance of returns between markets, and even between individual stocks, reduces during market dislocations. In other words, if the market were to correct – and we aren’t predicting it will any time soon – most asset classes, sectors and geographies, tend to move together. The correlation tends to rise and the differences in returns narrow. With the exception of cash, there are typically few places to hide.
The S&P 500 Total Return Index has risen 258.72 per cent over the nine years since December 31, 2008. During this period, 10-year US Treasury bond rates averaged 2.54 per cent. For the nine years prior to that, 10-year bond rates averaged 4.23 per cent, and prior to that, 6.26 per cent. The steady decline in bond rates has been a wind at the back of asset prices.
Since the lows of 2009, even inferior companies have risen dramatically, and they’ve been lent billions of dollars with few covenants, rather than being pushed out of business. However, that tailwind however is now easing, with 10-year US bond rates having risen from a low of 1.36 per cent in mid-2016 to 2.92 per cent today.
At the beginning of the most recent nine-year period referred to above, during which the sharemarket rallied 258 per cent, Robert Shiller’s CAPE Ratio was at just 15.17 times earnings. Today, that same CAPE ratio sits at 33.6 times as I write – a level unseen since the dotcom boom, and not seen ever before that.
When bond rates are no longer falling, and when the CAPE ratio is at record levels, the implication is that future returns will be lower. The only question is whether those future, lower, returns will be smooth or volatile.
We’ll answer that question momentarily.
What’s in the name ‘blockchain’
In recent months, reminiscent of the dotcom boom, we have seen companies simply change their name or strategic focus towards blockchain, and the market has rewarded incumbent shareholders with 300 per cent-plus gains.
On December 21, the Hicksville, New York-based Long Island Iced Tea Corporation announced a “corporate focus shift towards opportunities strategic to blockchain technologies. The loss-making company’s shares rallied from just under US$3 to over US$15 ($19) the day of the announcement. At their peak, the shares were trading 411 per cent higher than their lows only a week or two earlier.
On January 9, Kodak jumped on the buzzword, launching its own crypto-currency, KodakCoin – tokens for use in the blockchain-powered KodakOne photography rights management platform. Within days of the announcement, Kodak’s shares were trading 390 per cent higher.
Then eCigarette company VapeTek changed its name to Nodechain and said it would explore Bitcoin, Ethereum, and other crypto-currencies. The thinly traded shares jumped more than 360 per cent.
These recent name changes are reminiscent of the adoption of names ending with ‘.com’ during the tech boom of 1999 and early 2000. Back then, investors mistakenly believed that new technology – technology that can admittedly change the world – would render all companies involved profitable. It is a common mistake to believe all companies involved in a new technology will make it. They simply cannot.
The great migration
Three and a half decades of declining interest rates have fueled an investment migration that has devoured the implied returns of every asset class. As investors migrated away from cash and into shares and property, prices rose, and yields fell.
Such was the size and length of the migration that the yields on CCC-rated junk bonds, corporate bonds and emerging market bonds fell to their historical-low premiums, compared with the yields offered on US Government debt.
Eventually, the migration found its way to increasingly riskier investments and ended up at auctions for art, wine, rare coins, collectible cars, number plates and stamps – none of which earn any income and all of which achieved world-record prices.
Of course, by now you should be thinking this is abnormal, and I should note Berkshire Hathaway reported it had rejected nearly all deals presented to it in 2017, due to prices hitting record highs.
Australia has not been immune to the exuberance that has gripped global markets. Even on the ASX, there are profitless companies, and those being described by analysts as “pre-revenue” – let’s call them ‘concept stocks’ – that are trading at market capitalisations approaching a billion dollars.
For some of these concepts, we have calculated that their share prices imply earnings growth of more than 40 per cent annually for a decade, without interruption. This is rarely achieved.
Smooth or volatile?
Let’s return to the question of whether those low returns will be smooth or accompanied by volatility.
As Figures 2 and 3 show, the US S&P500’s Sharpe Ratio, when measured across most time frames, is at near record highs and at a level history shows has rarely been sustained. This suggests that even if the overvaluation, as measured by the CAPE ratio, doesn’t lead to a correction, volatility is quite likely to pick up.
Figure 1. S&P 500 Sharpe Ratio rolling 100-month periods
Figure 2. S&P500 Sharpe Ratio 12-month annualised to Dec 31, 2017
And if heightened volatility is a real risk, and prospective returns are in the low single digits, don’t the returns offered by cash present a superior risk-adjusted alternative?
Aggressive quantitative easing has deliberately manipulated the price of risk-free capital in global markets and corrupted investors’ appreciation of risk. Indeed, some asset classes with higher risks of capital loss than cash have been offering lower yields than cash. This is an irrational and unsustainable situation. Therefore, it certainly makes sense to us to be holding some cash, even if it means that returns are held back in the short term.