BUBBLE MONGERING: Surveying Current Market Valuation


I love everything about investing except maybe the fact that I’m actually in the investment industry.  If you saw how sausage was made you probably wouldn’t eat it.   


The allure of a skillfully prepared valuation narrative, however, remains one of the industry’s most enticing, sirenic delicacies. The market is expensive here but valuation is (still) not a catalyst.  Tops are processes, the price signal remains bullish currently and, up through the present, we have continued BTDB’ing (Buying the Damn Bubble) while taking down our gross and net equity exposure since the September 18th, No-Taper announcement. 




It has been hard to escape the valuation discussion the last few weeks as bubble speculation has been ubiquitous alongside higher nominal (& real) highs for domestic equities.   Reviewing a cross-section of market valuation measures (below), the summary takeaway is pretty straightforward – across the balance of metrics, equities are, indeed, moving towards overvalued on a historical basis. 


The problem, of course, is that the overbought-overvalued market narrative is a tired one as moderately elevated valuation has characterized most of 2013 and prices advancing at a premium to profits is not a new phenomenon – particularly in what could (amazingly still) be considered an “early cycle”,  liquidity supported stage of the recovery. 




We use a broad range of valuation and sentiment indicators when contemplating the direction of markets and where our view sits in the context of current prices, consensus estimates, and prevailing sentiment. From an Investment decision making perspective, valuation sits somewhere near the middle-bottom of the our consideration hierarchy. 


So, rather than claiming right to some specific valuation-in-isolation based insight on the immediate term direction for equities, below we survey a cross-section of canonical market valuation measures to provide some historical context for current multiples.    


In terms of how we are managing the current environment:  With fund flows, decent macro, rising M&A activity, bullish price momentum, near universal acknowledgement of the existent “bubbliness”, and the lack of a discrete negative catalyst all supporting equities in the immediate term, we’ll continue to ride the bull until the price signal changes.  Prune & plant within our immediate term risk ranges while holding an elevated cash balance.   


As Keith noted this morning: “This is a raging bull market, until it isn't.”


CAPE/Shiller PE:   At 24.9, the CAPE ratio (inflation-adjusted SPX price divided by the 10Y average of inflation adjusted earnings) is moving into the top decile of its historical range.   Below we’ve broken the historical CAPE ratio values into deciles and looked at average market performance over the subsequent 1Y and 3Y periods.  The mapping of the Shiller PE vs subsequent market performance suggests return expectations should move systematically lower alongside incremental increases in valuation. Historically, 1Y and 3Y returns progressively decline for each decile change in the Shiller PE.   


BUBBLE MONGERING: Surveying Current Market Valuation - CAPE 111813


BUBBLE MONGERING: Surveying Current Market Valuation - CAPE 12M Subsequent Performance 111913


BUBBLE MONGERING: Surveying Current Market Valuation - CAPE 3Y Subsequent Performance 111913


Tobins Q-Ratio:  Longer-term valuation arguments center on the premise that returns on capital should equalize to cost of capital and  market values should normalize to economic value.  Tobin’s Q ratio is not a measure we use to tactically manage risk, but we can appreciate the intuition (why buy an asset when you can “re-create” it for less and compete away existing, excess profit) underneath its application.   


Historically, at extremes, it has served as a solid lead signal for subsequent market performance.   We are sitting just below the 1.0 level currently and approximately 1.0 standard deviation above the long-term mean value – a level that has generally not been a harbinger of positive forward returns historically.


BUBBLE MONGERING: Surveying Current Market Valuation - Q Ratio


S&P 500 Market Cap-to-GDP:  Assuming the collective output of SPX constituents credibly reflects aggregate national production (or serves as a credible proxy for it), the Market Capitalization-to-GDP ratio effectively represents a price to sales multiple for the economy.  As can be seen, on a historical basis, we are certainly entering “expensive” territory as we push towards breaching 100% to the upside.


BUBBLE MONGERING: Surveying Current Market Valuation - SPX Market Cap to GDP


FORWARD/TRAILING P/E:  On conventional LTM & NTM P/E metrics, the market is moderately expensive at present.  Valuing the market on 1Y of (recurrently over-optimistic) forward earnings estimates has its pitfalls and, additionally, any perceived cheapness in current multiples should be discounted to account for mean reversion downside off peak corporate profitability (more below). 


BUBBLE MONGERING: Surveying Current Market Valuation - SPX PE 112013


MARKET COMPS AND PEAK MARGINS:  Operating Margins remain near peak with Corporate Profitability continuing to make higher highs with after-tax corporate profits advancing to a record 11% of GDP in 2Q13 – some 85% above the long-term average at current levels .  Unless you think peak returns to capital provide a sustainable path to aggregate demand growth in the face of negative trend growth in real earnings, trough returns to labor, middling productivity growth and secularly depressed investment spending, then the mean reversion risk for margins remains asymmetrically to the downside.


Topline growth estimates for the SPX (mkt weighted) don’t look unreasonable at +4.8% for 2014.   Expectations look similar across SPX constituents on an equal weighted basis with median 2Y growth estimates reflecting modest acceleration over the next four quarters.   However, the slope on earnings growth (+10.9% for 2014) over the NTM continues to look overly aggressive given expectations for further, significant margin expansion above already peak corporate profitability.  


BUBBLE MONGERING: Surveying Current Market Valuation - SPX Comps 111913


BUBBLE MONGERING: Surveying Current Market Valuation - Corporate Profits   of GDP 111913


BUBBLE MONGERING: Surveying Current Market Valuation - Investment



Christian B. Drake


It’s a Certified Circus At This Point

Takeaway: The Federal Reserve remains the greatest threat to global markets and economies.

This complimentary research note was originally published November 20, 2013 at 08:32 in Morning Newsletter. To learn how to subscribe click here.

"Unlike an inexorable, Newtonian “great machine,” the economy is not a closed system."

-George Gilder

The big picture

That’s a quote from the end of lucky chapter 13 of one of the best markets/economics books of 2013, Knowledge and Power, by George Gilder. I like this book. It’s the opposite of what our central planning overlords at the Federal Reserve think.


Yesterday, at the Keynesian-economics-Club-of-Washington-D.C. event, Ben Bernanke proclaimed his mystery of faith to his head nodders: “the surest path to recovery” is for the Fed to do more (read: no taper).


Right, right. It’s a good thing he’s sure.


It’s a Certified Circus At This Point - bn5

Macro grind

This, of course, is the basic divide between how most of us market-practitioners think about markets/economies versus some un-elected and unaccountable academic theorist does. Core to Fed group-think is certainty whereas what we do is embrace uncertainty.


Markets and economies aren’t some theoretical “great machine” that behaves in “equilibrium.” Markets and economies are dynamic and non-linear. Anyone who has studied history understands that.


I’ve been on the road seeing clients in Los Angeles and San Francisco this week. I’ll be in Vegas tonight and Phoenix tomorrow. No matter where I go, I get the same feedback from market-practitioners about Fed policy – uncertainty.


At the same time, these dudes (and dudettes) backslapping one another at the Fed think that they have this completely under control. At one point yesterday, Bernanke said that his “forward rate guidance is helping the economy.”




Taper, no-taper, taper, no taper, maybe-taper, no taper, change goal posts on taper, don’t taper…


It’s a certified circus at this point.


The smartest investors I meet with have the humility to tell people that they have no idea how this ends. So that’s comforting, right? Not only one of the sharpest clients we have, but one of the best performers in 2013 YTD, summarized that this he-said-she-said-taper-talk thing has given him a tremendous amount of conviction in one position – cash.


“Keith, with all of the illiquidity and policy risk factors building out there, I really like cash.”




After effectively day-trading Yellen’s predictable behavior last week, I’ve gone from 48% cash in the Hedgeye Asset Allocation Model to 60% this morning. But I was at 66% cash yesterday morning, and bought-the-damn-bubble in a few things on red again yesterday.


Day-trading? Yep. I have no problem with that. Do you? #GetActive


I realize its below these uber intellectual types at the “Economics Club of Washington” to risk manage (read: trade) the market risk they are superimposing on us every day. And I kind of like that. Maybe they’ll label me a lower-class-trader, or something like that.


Moving along…


What’s my call? It’s been a fantastic year to be long US #GrowthAccelerating (from 0.14% GDP with the SP500 at 1360 in Q412 to 2.84% GDP Q313 and US stocks at all-time highs), and now, on up days, it’s time to raise cash.


Looking at both real-time market indicators (Russell2000 growth has been making lower highs since locking in its all-time high on October 29th) and high-frequency economic data, it appears to us that the slope of the line on US growth is peaking.


Since what happens on the margin matters most, if and when the US economy slows (from here) to say 2% (or 1.6%, which is now the downward bound in our GIP model for US GDP Growth in 2014), what do you think the top performing Style Factor in US Equities (GROWTH) is going to do?


No worries, you don’t have to guess – that style factor is already starting to do what you should expect it to do – slow. As US equity market momentum slows (on lower and lower volumes), both the Fed and its nodders are going to get lulled to sleep.


Moreover, I think the Fed will cheer on the #GrowthSlowing data as more reason not to taper… and, in doing so, they’ll suck in every last lemming who hasn’t been long US stocks in 2013 to buy the bubble.


How messed up is that? I have no idea on timing, but oh how this “great machine” of Keynesian certainty is going to fall.

Our levels

Our immediate-term Risk Ranges are now as follows:


UST 10yr Yield 2.67-2.81%

SPX 1778-1809

VIX 11.85-13.88

USD 80.48-81.36

Brent 103.68-108.69

Gold 1260-1303


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


It’s a Certified Circus At This Point - Chart of the Day normal

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Fed Carnival Barkers

Takeaway: The Fed is (still) the problem.

So, Bernanke spoke at the Keynesian Central Planning Club of Washington D.C. yesterday...


He basically did more of what we’ve come to expect from him (no December taper... Change the goal posts on tapering targets etc). Surprise, surprise. The Dollar is down again this morning (FYI - it's down -1% on the US Dollar Index since Yellen spoke last week.)


Bernanke thinks the “surest path to economic recovery” is to do more.


He’s sure about that.


That’s the problem.


Incidentally, after failing right at its $81.39 Hedgeye TREND line on “Yellen Day,” it will be interesting to see if the USD can bounce to another lower-high from here. I think those buying dollars in hopes of a December taper are going to be as wrong as those who bought into the idea that “Yellen will be more hawkish than you think."


She’s the Mother of all Doves. Deal with it.


Fed Carnival Barkers - Fed BS


(Editor's note: This is an excerpt from Hedgye morning research. To learn more about our products click here.)

Carnival Barkers

Client Talking Points


So Ben Bernanke spoke at the Keynesian Central Planning Club of Washington D.C. yesterday. He basically did more of what we have come to expect from him (no December taper... Change the goal posts on tapering targets). Surprise, surprise. The Dollar is down again this morning (FYI - it's down -1% on the US Dollar Index since Yellen spoke last week.) Bernanke thinks the “surest path to economic recovery” is to do more. He’s sure about that. And that’s the problem.


After failing right at its $81.39 Hedgeye TREND line on Yellen Day, it will be interesting to see if the USD can bounce to another lower-high from here. I think those buying dollars in hopes of a December taper are going to be as wrong as those who bought into the idea that “Yellen will be more hawkish than you think." She’s the Mother of all Doves. Deal with it.


Oil has completely lost its USD correlation (for now). Our TAIL risk line of $108.69 on Brent remains resistance. We’re short Oil and looking for $103.68 Brent next. Russian stocks lead the losers on weak oil this morning. The RTSI is down -1.3% and back down to -2.1% year-to-date.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Our bullish call on the British Pound was borne out of our Q4 Macro themes call. We believe the health of a nation’s economy is reflected in its currency. We remain bullish on the regime change at the BOE, replacing Governor Mervyn King with Mark Carney. In its October meeting, the Bank of England voted unanimously (9-0) to keep rates on hold and the asset purchase program unchanged.  If we look at the GBP/USD cross, we believe the UK’s hawkish monetary and fiscal policy should appreciate the GBP, as Bernanke/Yellen continue to burn the USD via delaying the call to taper.


WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.


Financials sector senior analyst Jonathan Casteleyn continues to carry T. Rowe Price as his highest-conviction long call, based on the long-range reallocation out of bonds with investors continuing to move into stocks.  T Rowe is one of the fastest growing equity asset managers and has consistently had the best performing stock funds over the past ten years.

Three for the Road


Voluntarily repaying a revolver is not behavior one might expect from a company about to file Ch 11. Sorry $JCP bears. @HedgeyeRetail (Brian McGough)


I haven't celebrated coming in No. 2 too many times.
-Mark Messier 


J.C. Penney reported a larger-than-expected quarterly loss this morning, but the ailing retailer said there will be continued improvement in sales during the current quarter. Shares of J.C. Penney jumped more than 9% ahead of the opening bell.

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