They couldn’t have known

The thing very few people tell you about “overvalued” markets is that, occasionally, the fundamentals arrive to justify them. Later, of course, which is how risk takers are compensated for owning stocks selling at a higher than normal multiple. If there were no chance of this happening, then stocks would never reach these higher valuations to begin with, because no one would pay up for them.

But it can happen. It does happen. At the micro level (individual stocks and sectors), there are hundreds of recent examples one could rattle off.  Amazon, Netflix, Nvidia – you could go back a decade and pretty much never find a moment where these stocks sold at what investors would traditionally call a “reasonable” valuation. Their stock prices soared and then soared again, thousands of percentage points, as the fundamental stories grew up to justify the valuations investors had already been paying.

Not every bet like this works out, but sometimes it does.

This also applies to entire markets. The critics of stock market valuations can’t know what the future holds in terms of fundamentals, They can guess, and guess negatively if they’d like, but they can’t know. It is unknowable. But sometimes the economic backdrop and corporate opportunity set becomes positive enough to justify expensive markets ex-post.

Michael Batnick and I were talking about this recently with regards to the S&P 500, which had made a new record high in the spring of 2013. It was easy to look at the rising valuation multiple and conclude that stocks were expensive relative to history on key metrics like trailing earnings. Mike pointed out that you were buying stocks at that moment, five years ago, at a cyclically adjusted price-earnings (CAPE) ratio that was higher than 87% of all readings for this measure throughout history. The stock market had only been that expensive during 13% of all months.

And then the S&P 500 went up 90%.

No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually. There was a possibility that they would, and a possibility they wouldn’t. There’s no formula for calculating the odds for something like this, given all the inputs and variables.

But earnings grew, floats shrunk, the economy steadily improved, the international economy joined in, gasoline prices eased, the labor market tightened, the Fed began to extricate itself from QE, stimulus from overseas poured into asset prices, a contentious election was weathered, Congress and the White House slashed the corporate tax rate by an unimaginable degree, earnings growth reaccelerated, buybacks reaccelerated.

In 2013, they couldn’t have known.

Just as in the 1980’s they couldn’t have foreseen the birth of the internet and the explosion in wireless and cellular technology in the 1990’s that would transform the world.

Just as in the 1950’s they couldn’t have foreseen the go-go conglomerates and the space-age empire building of the 1960’s that would remake American capitalism forever.

Today we consider the possibilities for things like automation, virtual reality, machine learning, artificial intelligence, decentralized apps and the blockchain. They might be societally transformative and, as a result, under-appreciated based on the multiples investors are paying for technology stocks today. Or, they could be a series of busts, one after another, where profits don’t materialize, innovation hits a dead end, financial backers grow disillusioned or some other exogenous event forces us to rethink everything we currently expect.

We couldn’t know.

So when you hear someone carrying on about backward-looking valuation measures, remember that there is another possibility beyond just stock markets being expensive. That possibility? The fundamentals coming along to make things look as though they were meant to be.


This post originally appeared here on May 14th, 2018.


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