Market thoughts 4Q22- multiples, bills, 1966

Semi-Quarterly-Annually-Centennial Edition

Below is one of my favorite macro charts. It has the really big things I think are worth paying attention to: market multiples, short rates, and long rates, all contextualized by the trailing and forward price return.

“P/D” is just price/dividends

It is about as remedial of a quantitative study as one can do, equivalent to looking at a GF <GO> of historical multiples for the S&P 500 or a ValueLine chart of a stock. It is a reminder of exactly what every market historian tells you about: there’s decade-long periods of flat returns in equities, and then decade-long periods of raging bull markets where all the money is made.

The first takeaway is about as cliché as it gets: the market goes up and the timing doesn’t matter *too* much, as long as your hold period is >10 years you probably won’t lose money.

I still think that’s true today- you probably won’t lose money owning for 10+ years from today, but I would draw attention to the market multiples in 1966. (point E). The market would make new highs in 1968-1969 (point F) before the inflation regime of the early 1970s. Afterwards, we would get to point G- the local highs of the ‘66-’82 period. All told the S&P would have a 16-year period of flat returns from 1966-onward to 1982 (point J). Hate to see it!

I draw this comparison not to predict a 16-year flat market; no individual year is comparable to another, S&P constituents change constantly in quality and growth rate. I am saying that the market in both 1966 and 2022 have reasonable multiples (18x earnings vs. ~4.5% bills/bonds). The 1966-82 period shows that we don’t need a dramatic entry point overvaluation to see a period of flat broad market returns. Incidentally, the top of the tech bubble presented at 28x~ earnings vs. a 6%~ bill rate (point L); a fourteen year flat return from point L onward is not as analogous to today’s market as 1966 for that reason.

Rates, Multiples

I agree with a lot of what Paul Singer wrote in his Q3 letter. I am not as certain as he is that inflation will be persistently high for the next decade, but I do agree with the numerous assertions about asset price headwinds. Singer thinks a 20% haircut to equities after short rates moved from 0% to 4.5% so rapidly is simply not enough.

I don’t really care about the areas of the market that are down 80-90% such as speculative ARKK names and SaaS names without profits; they’re just not that impactful to the S&P’s multiple (numerator or denominator), nor are they reflective of just how powerful and resilient the largest constituents of the S&P500 are. I’d like to think that the people who got into the ARKK game knew their time was up when rates did what they did- although I know this to be less than true.

What can change rapidly is just how these S&P 500 constituents get valued. I’m reminded of the Bill Gates quote from his lecture with Buffett at some college:

GATES: This is an area where I agree strongly with Warren. I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules.

For years this argument has been easily rebutted by the relative growth rates of tech names versus staples names: it’s growth, stupid! Profits at MSFT, GOOG, AMZN, META, etc. have been growing at eyewatering rates for the past ten years, surely they deserve a 20x+ multiples etc.

It doesn’t sound crazy or unwarranted to me that in a world with mid-single-digit bill rates, and product maturity on the horizon for many of these constituent companies, that the S&P could trade to a 12-15x multiple range. There are cyclical elements to these businesses, and they remain under constant pressure to compete for eyeballs or at negative gross margins or bad unit economics etc. Gates is right! I think it’s clear to many (now) that Coke’s business is more durable than Meta’s ads business, especially after the IDFA changes!

I don’t think these constituent companies trade to tobacco company trough multiples or commodity business trough multiples, but it’s not crazy to think they still trade rich at 18-20x. To flip the problem on it’s head- it would sound crazy to me to try to justify these businesses trading up to 25-30x.

Does indexing have to do with any of this?

Maybe, but no. The advent of indexing taking market share from active management doesn’t really affect the marginal price-setting of businesses; index funds are free-riders on the whims of active managers’ and analyst decision making, for better and for worse. Their buying and selling, and the prices at which they do this at, have nothing to with the underlying businesses and everything to do with 401(k) contribution timing and maybe other sentiment, flow-driven technical things that I don’t do much with.

What does this have to with making money?

Nothing- the opportunity set for individual investors has nothing to do any of this. There are still mispriced securities in all market environments and opportunities to make money. It’s only ever oversized funds, unable to deploy into any security without >$1bn of average daily dollar volume, that complain about these market metrics and overall index performance. Good investors will always find something to do until they become one of the oversized complainers, a tale as old as time. I hope to have the luxury one day.

Broader conclusions:

• It’s not crazy to think that the S&P could re-rate substantially lower; it’s also not crazy to think that profits might not grow sufficiently to compensate for this re-rating. Labor, interest, commodity input and other costs might not all be able to be passed on completely. I seriously doubt we’ll see a marked drop in corporate profits overall, but we might see the market trade flat from the local highs of this bear market for a long time.

• None of this affects one’s ability to find mispriced securities. I keep seeing attractive things at attractive prices. However, it’s never been more apparent at this point that larger market participants are too big for the lion’s share of attractive public market opportunities.

  The goals of this newsletter continue to be:

  • Edify and test my own investment theses by presenting them to a wide audience and inviting feedback and criticism.

  • Present investment ideas to a wider audience that otherwise aren’t widely discussed on traditional online investment forums (Twitter/VIC/Bloomberg Anon IB Chat/Discord/Reddit et al.)

  • Present anything interesting I find that has the potential to make money short of operating a pump and dump scheme

  I don’t want to present broad market commentary for the sake of flapping my proverbial gums and putting content in front of subscribers. The broad markets do interest me of course and I am not immune from being a macro observer. I don’t try to make money from these ideas but they’re top of mind when reading through the day-to-day noise and headlines and trying to figure out where we are in a broader historical context.