Euphoria in the Rearview Mirror

There is a market adage that goes something like, “Bull markets are born in fear, and die in euphoria.”  In February 2018, while some were postulating that the markets were poised for a “melt up,” we circulated a research note supporting our view that euphoria was upon us.  Today, we revisit that analysis with a quick update on current market valuations along with some speculation about what the future may hold for US equity investors.

“Euphoria” Revisited

Although markets have come off their highs, we believe that equity valuations remain quite stretched in a broad historical context.  Below is the well-known Cyclically-Adjusted Price-to-Earnings ratio (CAPE), popularized by Robert Shiller.  While this metric indicates that US equity valuations are more reasonable than they were in early 2018 (when the ratio touched 1929 levels), it remains high relative to nearly 140 years of history.

Individual investors have also grown a little more cautious, albeit from bubble-level allocations.  This can be seen in the American Association of Individual Investors (AAII) equity-cash allocation spread, defined as individuals’ equity allocations minus their cash allocations.  As we pointed out in our missive last year, this spread was near Tech Bubble levels in early 2018.  As shown below, there has been a nice retreat, but the numbers are still high relative to historical averages.

P/E ratios, even cyclically-adjusted ones, are notoriously fickle because the denominator (earnings) are highly variable and hence the P/E can be high either because the price is high or earnings are low.  As a result, we prefer ratios with more stable denominators, such as enterprise-value-to-sales and enterprise-value-to-total-assets.  Here we see a similar story.  After reaching levels reminiscent of the Tech Bubble in early 2018, the latter ratio has fallen back – but only to the levels seen prior to the 2015 and 2016 corrections, and (again ex-financials) this ratio is still higher than that seen at the 2007 peak.

Enterprise Value to Total Assets Excluding Cash

One could assert that a higher enterprise-value-to-total-assets multiple is deserved if the return on invested capital has somehow fundamentally (and permanently) increased, but if that were true, we would see a sustained increase in profitability.  Shown below is the market aggregate (i.e., the sum over the entire equity market) ratio of operating profit to total assets,  which is a rough approximation of return on assets (ROA).  This time we exclude energy as well as financials from the analysis because the former distorts the 2015-2016 data to the downside as a result of the slide in oil prices.  While one could argue that there was a increase in ROA post the financial crisis, our analysis indicates that this was mostly due to asset write-downs and returns subsequently fell back to historical levels.  The fiscal stimulus and economic growth spurt from the tax cuts in 2018 did boost operating profitability somewhat (and after-tax returns even more), but history has shown that extra ROA tends to be competed away – this being an essential element of capitalism.  So unless we’ve entered into a new era of sustained oligopoly profits (a possibility, at least for a few companies), we would not expect these returns to last through an economic slowdown, let alone a recession.

Operating Profit to Total Assets Excluding Cash (ROA)

One indication of a potential threat to margins is an acceleration in invested capital growth.  Total public-market invested capital, excluding financials, has increased at a rate of 5.5% annually over the past 30 years, somewhat above the 4.7% annual growth rate of nominal GDP.  However, if we look at the past 8 years (i.e., the period since the last financial crisis), non-financial invested capital growth increases to 6.8% relative to an annual nominal GDP growth rate of just over 4%.  This high rate of capital growth has been partly fueled by the high margins (which encourage reinvestment), and it has also helped fuel investor interest in growth stocks – particularly Tech, where much of the growth has occurred.  Sooner or later, however, high investment rates result in lower returns, perhaps illustrated best by Warren Buffet’s quote that “geometric progressions forge their own anchors.”  Exactly where we are in this cycle is anybody’s guess (our guess in “near the end”), but the longer the cycle of over-investment relative to GDP goes, the bigger the drop will be when the correction arrives.

The bottom line is that, while valuations have clearly pulled back from their early-2018 highs, they’re still at the upper end of the historic ranges.  Market returns over the past 10 years have been driven by higher margins, as well as by higher-than-normal invested capital growth (which, in turn, generated a preference of growth over value on the part of investors).  As a result, to us the market looks very fully priced even assuming reasonable economic growth, and investors could find it quite overpriced in the event of a meaningful slowing in economic growth (and, in our opinion, “look out below” if we have a recession).

On the Margin – Watch Out for Wage Growth

We’ve been beating the drum for some time about the parallels between today’s market and that of the mid-1960’s.  Both then and now there was a combative President (Johnson vs. Trump) who didn’t like the Fed raising rates (Johnson is rumored to have shoved his Fed Chair up against the wall in response to an unwelcome rise).  The government had just put through a tax cut (the recent one being much larger than that of the mid-1960’s) and this generated angst over a rising deficit (with today’s shortfall swamping that of Johnson’s time).

While unemployment and inflation were both low in the early 1960’s (as now), rising wages, interest rates and eventually inflation created significant problems for the market.  The economy continued to grow, expanding at a 3.6% clip in real terms from 1966 to 1972, but wage gains meant corporate profits as a percentage of GDP fell (they’re now at or near an all-time high).  After peaking in early 1966 (with a high, but lower-than-today, CAPE ratio – see the earlier chart), over the course of several years the market endured a 22% drawdown (sound familiar?) followed by a 36% drawdown, and it didn’t reach the early 1966 highs again until 1972 – some 6 years later.

While history doesn’t often repeat, it frequently rhymes, and as a result the wage growth chart below strikes us as the most important graph-of-the-moment when it comes to investing.

Average Hourly Earnings Growth, Production & Non-Supervisory Employees (Source US Dept of Labor)

When wage growth kicks in, it often moves quickly – and this is exactly what we are seeing in the recent data.  While the most recent year-over-year growth figure is 3.40%, if we annualize growth over the last six months this increases to 3.64%.  Further, in our opinion there’s nothing on the horizon to slow wage growth that isn’t scary for the market.  A China-driven hit to global growth might well slow things down, but we have a hard time seeing the stock market holding up in this sort of environment.  A more aggressive Fed (something virtually no one is forecasting at the moment) could also do the trick, but this too wouldn’t be well received by the market.  And if wage growth does continue to accelerate, as it did in the 1960’s, we could have a reasonably strong economy but a stock market that is hampered by declining margins.

At present we don’t expect a market crash, or even a domestic recession (although the warning signs are getting more ominous), but the policy path that needs to be followed to prevent such events is a very narrow one indeed, and the chaos in Washington doesn’t make us hopeful that something won’t knock the market off course.  Once again, prudence in our opinion suggests a meaningful dose of uncorrelated investments (and perhaps cash) in any reasonably diversified portfolio.


Alambic Investment Management, L.P., is an SEC registered investment advisor.  The information in this article is intended for discussion and informational purposes only and does not constitute financial, legal, tax or any other advice.  All information contained herein is provided “as is,” including all graphs which used data from named sources, but were compiled by Alambic.  Alambic expressly disclaims making any express or implied warranties with respect to the fitness of the information contained herein for any particular use, its merchantability, or its application or purpose.

Nothing in this document should be construed as an offer to purchase or sell, or a solicitation to purchase or sell, any security or instrument.  Any offer will be made by only by means of a formal private placement memorandum and a related subscription agreement to be furnished to prospective investors.  Prior to making any investment or hiring any investment manager, you should consult with a professional financial advisor, legal and tax advisor to assist in due diligence as may be appropriate and determining the appropriateness of the risk associated with a particular investment

Please note that with regard to the historical market performance discussion contained herein, that past performance is no indication of how the markets will perform in the future.