The boiling frog parable is often used as a metaphor for people’s inability to react to threats that arise gradually. The story goes that if a frog is placed suddenly into a pot of boiling water, it will jump out. However, if the frog is put in tepid water which is then slowly brought to boil, it will not perceive the danger and be cooked to death.
I believe this story is applicable to the current stock-market environment, because the price-to-earnings ratio for the overall market, has been above its pre-1980 average of ~15x for over 23 years! It is reaching a sufficient duration that some are beginning to ask whether this change is cyclical or secular. Because of the length of this cycle, many professionals within the market, have now only invested in a time when multiples have been expanding. For example, the last PE cycle peaked around 1965, therefore, to have been investing in the last multiple compression cycle, an investor would need to be at least 70 years old! (1965 and 18 years old at the time, equals a birth year of 1947)
The following chart depicts the cyclically adjusted price-to-earnings ratio (blue) over the last 136 years. This ratio was developed by Robert Shiller and is calculated by taking the price and dividing it by the trailing 10 years average earnings, adjusted for inflation. The orange line is the rolling 10 year moving average of this ratio.
Historically, the ratio has been highly cyclical, with peaks and troughs being roughly equal from one cycle to the next. However, the last cycle which peaked in 2007 (based on the rolling 10 year moving average) has been rather unique. For starters, the peak was 50% higher than prior cycles, at ~30x vs. 20x in the peaks of 1905 and 1970. Secondly, and perhaps more concerning, is that it looks to have troughed at around 22x. Not only is this more than double the previous trough levels (<10x) it is higher than the previous peak levels!
Therefore, you can’t blame people for beginning to question whether this is a secular change or just a longer cycle.
To try and understand the drivers behind this cycle, one needs to consider what has changed over the last 35 years and whether they are likely to be repeatable or remain favourable. My (non-exhaustive) list of some major changes that have occurred over the last 35 years are:
- Decline in interest rates from over 12% to less than 3%
- The internet & associated business models
- Explosion in the percentage of assets managed by a computer or under a passive mandate
- China going from 10th to 2nd in terms of global GDP
- The advent of the leveraged buy-out
- Increase in global productivity
Interest rates go from all-time high, to all-time low
Interest rates are discussed daily, but I still believe people fail to grasp the materiality of the move in interest rates that we’ve witnessed over the last 35 years. They reached an all-time high of 15% in the early ’80s, before declining all the way down to the record lows of sub 2% achieved in recent years.
The following chart overlays the long run interest rates (inverted) against the CAPE:
As you can see, the low point in price-to-earnings ratio’s, coincided exactly with the peak in interest rates (which makes theoretical sense). The decline in rates since this point has correlated very closely with the expansion seen in equity multiples.
This has led many (including Buffett) to argue that, given the high correlation between PE multiples and interest rates, if interest rates remain extremely low, PE multiples can remain extremely high. While I agree with the logic behind this (driven by the lower discount rate for calculating the NPV of a security when the risk free rate is low) I also think the level of current interest rates is too often taken out of context. For example, interest rates were below 3% from around 1935 until the early ’50s. During this period, the CAPE ratio averaged 13x – less than the long run average!
Therefore, while there is definitely a correlation between interest rates and the valuation of equities, I think too many people are using the current rates to justify irrational valuations, given rates this low have been seen before and did not coincide with 30x PE multiples.
One of the most prominent impacts the internet has had on the stock market, is the influence it has had on the business models of some of the major index constituents. Several of the largest companies in the world, such as Google, Facebook, Amazon, Netflix, eBay, PayPal, etc. would not exist if it weren’t for the Internet.
What’s also interesting is that many of these businesses require very little capital, have extremely high profit margins and afford highly visible revenue streams. These traits are coveted among investors and are often associated with companies that deserve to trade on higher multiples. However, even if we take this assumption to the extreme, it does not support current valuations:
- Assume “high quality” tech companies account for 50% of the S&P 500
- Assume they deserve to trade on 30x CAPE
- Assume the “rest” should trade at long-run average of 15x
This implies a “new normal” CAPE of 22.5x – still well below the current level of 30x+
Passive & Quantitative revolution
In the early 1990’s, less than 5% of total assets were invested via passive strategies. Today, that number is approaching 50% and it does not look like slowing. The structural impact this could be having on earnings multiples and the price discovery process are too long to be discussed in this blog, however, the impact is likely to have been a steadily rising equity market. This is because, if you have fixed supply (number of stocks/available liquidity) and an increasing demand, which is price agnostic (passive), then price is likely to move higher (in this case, earnings multiples).
The Leveraged Buyout
A leveraged buyout (LBO) is a transaction where a company is bought via a combination of debt and equity, such that the company’s cash flow are used as the collateral to secure the borrowed money. The first LBO is thought to have occurred in the 1950’s, however, they became mainstream in the 1980’s due to the dramatic increase in available financing provided by junk debt investors – Michael Milken & Co.
Based on my analysis, PE firms need a spread of around 4% between the cost of debt and the equity yield on an investment to hit their 20% IRR targets. See an earlier article I wrote on leverage, interest rate differentials & ROE’s for the math behind this.
Therefore, when LBO’s became mainstream in the early ’80s & interest rates were above 10%, PE firms needed to acquire firms on multiples less than 7x (10% + 4% spread equals 14% equity yield, or inversely, a 7x multiple). However, with interest rates now sub 5%, PE firms can increase the multiple they pay to around 11x (5% + 4% spread equals 9% equity yield). Given the proliferation of money that has moved into this asset class over the last 20 years, I believe it has been a key contributing factor to the steady increase in multiples. For example, the average PE transaction was made at around 6-8x EV/EBITDA in the early 2000’s, however, these days it is often in excess of 12x
From 1996 through 2007, productivity in the UK (measured as output per hour), increased 28%. However, in 2016, the output per hour remained at levels similar to the peak achieved in 2007:
If the trend from 1996 until 2007 was continued until 2016, it would imply an output per hour value of 118 – creating a 16% shortfall. Now maybe it could be argued that the last 10 years have been impacted by the GFC etc. and this may be a fair point. However, what if productivity growth has slowed?
Stock market returns are driven by earnings over the long run. Earnings are driven by revenue growth and margin expansion. If productivity growth has slowed, that means margins will struggle to expand as costs move linear with revenues. This means that the long run earnings growth could more closely resemble GDP as opposed to GDP+ as it has in the past.
As is the case with most macroeconomic indicators, they can be read in many different ways – hence the one-armed economist joke… The point of this post is not to predict where markets are going, but to point out that the last 30 years have been extremely favourable for economic growth and stock market returns:
- We’ve had interest rates fall from record highs, to record lows
- Lowers the discount rate for equities – i.e. allows higher multiples
- Lowers the hurdle for LBO’s due to cheaper cost of financing
- Makes it easier for less fiscally strong companies to survive
- We’ve had near interrupted multiple expansion for the majority of most financial professional’s careers
- We’ve had a dramatic increase in global productivity
- We’ve had a huge demand source from the growth of China
How many of these are repeatable for the next 30 years? Of course we are likely to see further innovation, which should drive productivity growth and introduce new business models like the Internet did. It’s also probable that another economic power-house will pick up the slack now that China’s growth is slowing – although, with a greater portion of the world now urbanized, this can only go on for so long. And finally, interest rates can only go so low. While they might not go back up in a hurry, the tailwind they’ve provided over the last 30 years is likely over.
Therefore, the next 30 years could be very different to the last. Whether earnings multiples prove to be in a new paradigm, or return to their cyclical past, I’ll leave up to you.