I wrote a series of articles over the last 14 months called Bubbleville. Putting aside the snark, the articles were simply a plea for sanity and a declaration that what we were seeing was not normal. In a week where the S&P 500 crossed into bear market territory I think it is safe to say that others agree. Today I am going to explore what normal looks like, because the closer we get to normal, the closer we get to the end of this bear market.

Humans suffer from recency bias, a fancy way of saying that we expect the future to resemble the recent past. It helps explain why most economists, policymakers and fund managers told us inflation would be transitory. They found it hard to imagine high inflation because prices had been low for so long. Central bankers believed significant quantities of fiscal and monetary stimulus wouldn’t cause inflation because previous rounds of stimulus during the Global Financial Crisis had not. Crypto investors believed that perilously stacking a series of DEFI ‘innovations’ without use cases onto Blockchain wouldn’t collapse. They believed it because nothing had collapsed yet. Recency bias is why during a decidedly non-normal time so many people came to believe what we were witnessing made sense and would continue.

Take interest rates. We’ve been hearing lots about the level of interest rates. We heard they absolutely wouldn’t go up until 2024. Shortly thereafter we heard it was ‘still plausible’ they wouldn’t go up until 2024. In an effort to streamline RBA press releases, they dropped the adverb ‘still’. We were still using the adjective ‘plausible’ to describe the chances of rates going up in 2022. The point is that rates are going up, they are going up faster than expected and we don’t know where they will stop. And yes, I know about indebted Australian consumers and protecting housing prices. Regardless, I think one way or the other we are going to get back to normal. The average monthly RBA cash rate target since 1990 is 4.68%. If we just look at the period starting since 2000 it was 3.52%. While those average rates seem impossibly high we need to remember that soon the only thing non-normal about the market may be inflation. The average annual inflation rate in Australia since 1990 has been 2.54%. Phillip Lowe just pronounced inflation would be at 7% by the end of the year. You tell me what is ‘plausible’.

Interest rates and valuations are inexorably linked. I like using the Cyclically Adjusted Price to Earnings or CAPE ratio to explore long-term valuation data. By looking back at earnings over a ten-year period we smooth out the cyclicality of business cycles and by adjusting for inflation we can compare earnings across time. Shani and I have pointed out how high the CAPE ratio is in podcast after podcast. At this point I’m even sick of hearing myself say it. At the end of 2021 the CAPE ratio on the S&P 500 was over 38. It had been over 38 at only one other time in history and that was late 1999 and early 2000. When valuations are the second highest ever since 1881, we are nowhere near normal. Despite this year’s decline, the CAPE ratio is still historically high. I am writing this on June 14th after another brutal sell off in the US triggered by another rising inflation reading. The S&P 500 sits at 3,749.63 which gives us a CAPE ratio of just over 29. The monthly average CAPE ratio since the year 2000 has been 26.91 which means another 8 percent fall to reach average. Unfortunately, bear markets rarely stop at average valuation levels and if we zoom out to 1881 the average monthly CAPE ratio is just north of 17.

An astute reader will point out that we have only explored half of the CAPE ratio – the P or price. It is worth exploring the E or earnings. Conventional wisdom tells us that earnings grow over time which will naturally bring down valuation levels if the market stays flat. This process accelerates if the market is falling. And earnings have been rising. In the past decade S&P 500 earnings per share grew at an average rate of 7.7% a year according to the Wall Street Journal. That is really strong. But the source of that earnings growth has been margin expansion. Margin refers to the difference between the revenue a company earns and the amount they keep in earnings. When you have margin expansion you can sell the same amount of goods and services and still grow earnings. Over the last decade we saw profit margins on the S&P 500 go from 9.2% to 13.4%. This is not normal. If we go back and look at the time period between the year 2000 and 2011 the S&P 500 had an average profit margin of 6.2%. Margin expansion has been fantastic for corporations and shareholders but expecting it continue indefinitely is probably a sign of recency bias.

One reason to be doubtful is our golden age of globalisation may be ending. Kicking off in the 1970s, it brought cheap labour and efficiency dividends from just-in-time supply chains. Companies also benefited from cheaper borrowing costs and the stability of a lower inflationary environment. The last great age of globalisation kicked off around 1870 and ended in the trenches of World War 1. Could our age be coming to an end in the shattered cities of eastern Ukraine and hostile rhetoric between China and the West? Will higher borrowing costs erode corporate profits? Will consumers revolt against higher prices and force companies to absorb higher input costs and increased wages? Will our much-delayed attempts to decarbonize result in higher costs? I don’t know the answer to any of those questions. Countless times innovation has solved the most complex problems but that doesn’t change the fact that things don’t look great for continued growth in profit margins.

Reading about the end of globalisation as we know it is not as much fun as listening to Cathie Wood talk about transformative innovation. But remember the companies in her ARK innovation ETF collectively make about as much money as the sausage sizzle at your local polling station. Not caring about earnings is not normal. The fact that 60% of the largest 3000 companies with the highest valuation levels as represented by the Russel 3000 growth index are not profitable is not going to go over too well when normality returns.

Consider this an ode to mean reversion. If this sounds scary, the good news is that a return to normal is not a disaster for investors. It will be a disaster for speculators. It is time to figure out which camp you are in. If it were me, I would be dusting off the old investing playbook. I’m not in the business of offering predictions but it is time to start considering what works when central banks return interest rates to the 3% to 5% range. What works when there is a smaller gap between the valuation levels of growth and value shares. What works when it becomes harder for companies to simply cut costs and increase profitability. Many companies and many indebted Australians are sadly not prepared for this.

I have been guilty of proclaiming we are at an inflection point before and that what has worked, will not continue to work. Perhaps this is a poor way of framing this. What I should have said is that what has worked over the long-term will go back to working. A return to normal is a return to fundamentals. A time when the slow and steady compounding effect of economic moats trumps the desperate immediacy of hype and momentum. When more of your returns come from dividends and less from the perilous climb of ever-increasing valuation levels. Normal means a focus on filling your portfolio with quality. Think companies that are great and are purchased at compelling prices rather than compelling narratives to support sky high valuations. Normal won’t be exciting. But then again, investing isn’t supposed to be exciting.

 

I know this is a stressful time for investors. If you have any questions please feel free to email me at [email protected]