S2N Spotlight
In response to the valuation methodology I presented in yesterday’s letter, a highly successful businessman offered me a challenge. He pointed out that my approach relies on “E” (earnings) as a foundation, yet today’s earnings figures are often skewed by varied accounting standards, sometimes to the point of being nearly meaningless. It’s possible, he noted, for a company to report zero earnings while actually generating billions in cash. His argument being that the E reported today and the E reported 30 years ago are not the same E, making my PE valuation method useless.
I appreciate being challenged by those with deep expertise, as it provides invaluable opportunities to learn and identify potential blind spots in my approach.
My first response is that he is 100% correct. Today reported E is in a shambles. Analysts spend most of their day trying to work out the true earnings and come up with a variety of acronyms to present a clearer picture. He has provided me with lots of reading to get a better handle of the state of E today.
My second response is that I am very much the kind of guy who loves deductive reasoning and simple heuristic models, so the PE model is very attractive to me, and I am unlikely to just throw it away without a fight.
My third response is that if I am going to be intellectually honest, I need to embrace the fact that he may be right and the model is useless. With this approach in mind, let me try and address the question of whether fundamentals do matter.
I am a big picture kind of guy. I am not into the work that fundamental analysts do, searching through the financial accounts to see if an entry is going through the income statement above or below whatever line the accounting standards have introduced. I would rather write an if statement based on a universal rule and get the answer by the click of a button; this approach doesn’t help if the rule is nuts.
Having coffee this morning over looking the beautiful Bondi Beach, I was wondering to myself how I could approach this without getting my hands dirty. This is what I came up with.
I plot the S&P 500 price adjusted for inflation and transform it into a log scale. The log scaling is very important, as I want to create a picture that makes the index value irrelevant. I prefer not to explain it here and bore you with what that means. Just note the index price spacing to get the picture.
I now draw a regression line from beginning to end to measure the average slope of the yearly returns. After taking inflation into account, the S&P 500 has grown by 2% per annum since 1860. Please note that I have not referenced earnings once so far. I am allowing the index to do all the talking. As with any regression, you will have points above and below. We are now getting to the exciting part. The current performance of the S&P 500 is way above trend.
What can we deduce from the fact that the index performance is way above trend? There are only 2 ways to answer this. One is that the E being reported is much lower than what is actually being earned, and therefore valuations are not actually so overvalued. The other answer is that E is growing so fast that the higher valuation, i.e., PE, is justified.
The problem I have with the second response—that earnings are growing above trend—is that, at a macro level, earnings are ultimately tied to economic growth. By the way, this is one of the reasons I like the Shiller PE, as it takes 10 years of earnings into account. You simply cannot have sustained above-average earnings growth if the economy itself is not growing above its historical trend. While individual companies may temporarily outpace the economy through innovation or market dominance, the aggregate earnings growth across the market cannot exceed the broader economy’s growth indefinitely. Earnings, in the end, are a reflection of the wealth and productivity generated within an economy. We are definitely not currently experiencing above-trend economic growth.
If we consider this relationship, the current high PE ratios imply either a belief in a new era of accelerated economic growth or a significant overvaluation. Thus, while the valuation framework may seem outdated to some, it is grounded in the reality that earnings growth, however you want to define earnings, cannot outpace economic growth over the long term.
In this light, I remain convinced that PE ratios have a valuable role in long-term valuation, as they help anchor us to the fundamental limits imposed by the economy’s growth. While today’s “E” may be obscured by various accounting adjustments, the PE ratio ultimately reflects a relationship with the underlying economy that, in my view, remains valid.
Some of today’s most well-known proponents of the Shiller PE or CAPE methodology, as it is known by some, are Jeremy Grantham from GMO, John Hussman, and Mebane Faber. I want to include Ray Dalio, as he recently shared research with CAPE models for many of the countries he is allocating capital to.
I learned about some newish VC valuation methods that I am eager to research further. I guess I will share in another letter when I get round to it.
S2N Observations
Quite a few people are referencing the number of new all-time highs the S&P 500 has made this year. Here is a chart I created; as you can see, we have been here before.
While creating the above chart, I thought I would make one for Bitcoin as well. So far, nothing special, which might suggest that there is plenty more to come – yikes.
I have to admit that I cannot fully get my head around the divergence in Bitcoin and Gold’s performance.
I came across this news headline: “US Government to buy 1 million Bitcoin over the next 5 years” to augment its foreign reserves. I dug further and watched an interview where this quote originated from. It was a fund manager postulating. However, it might be something that could be a reality. Clearly something is going down.
JP Morgan’s Bitcoin fund now has more assets than its Gold fund. I will leave you with a quote from someone on the internet. I am a believer in Bitcoin, by the way; I am just a bit more cautious than some of the fundamentalists. I see it as an experiment that gains traction with each day.
Gold is the money of kings,
Silver is the money of gentlemen,
barter is the money of peasants,
debt is the money of slaves,
bitcoin is the money of fools
S2N Screener Alerts
Gold had a -3 Sigma day yesterday, the 3rd this month. This is rare stuff.
Performance Review
For those who are new to the letter, the shading is Z-Score adjusted so that only moves bigger than usual for the symbol are highlighted.