Stocks rose for the sixth day in a row. With President Trump overseas, attention returns to economics and the news has generally been positive.
One of the headline comments this week came from Professor Robert Shiller, a Nobel laureate, who famously published his book Irrational Exuberance just months before the Internet bubble burst in early 2000. He is also noted for developing a valuation tool called the CAPE ratio, a tool that measures price-to-earnings in a manner that levels out long term trends. Instead of the conventional method of dividing current price by current earnings, Professor Shiller divides the current price by the average earnings of the past 10 years. Logically, given the history of rising earnings over time, a ten year average, more often than not, would be lower than the most recent earnings. As a result, the CAPE number is usually higher than the 15-16 average P/E using conventional math. But, just as P/Es today are high using conventional methodology, they are also high using the CAPE formula.
The comment from Professor Shiller, normally a very cautious prognosticator, that got market attention was the thought that stocks could rise as much as another 50% before this bull market ends. If any asset class is in bubble territory today, he believes it is bonds. It’s hard to believe that Professor Shiller is as confident as he appears to be in light of the high CAPE numbers and the length of the current bull market. To make things clear, Professor Shiller didn’t predict another 50% increase; he simply acknowledged that it could happen within the context of historic precedent.
Let’s go further. Markets behave somewhat like metronomes. Psychologically, they move back and forth between despair at the bottom and euphoria at the top. But, while metronomes move in constant rhythms, markets don’t. They move from despair to euphoria slowly and cautiously, while moving from euphoria to despair rapidly. Therein lies the conundrum. Markets rise slowly. Since 2009, stocks have more than doubled, but they have done so over a period of eight years, a steady climb but not exactly a rocket ship advance. But, if you think back to 2008, stocks fell 50% or more in a space of about 15 months.
There is no science that can predict how long a bull market or an economic expansion can last. As long as there is balance in world economies, there won’t be a recession. As long as there isn’t irrational exuberance, bull markets can continue. Thus, Professor Shiller, in my view at least, is right. This market can keep going up as long as it stays rational in its behavior, and economies don’t show excesses or stress. That could be one more year or 10 more years. But when it ends, it almost always ends badly.
So how long does one stay? The further one gets from the median, the greater the risk. But even though we are above the median today, if you compare current valuations to historic peaks, we have a ways to go. The behavior of markets suggests that P/Es keep rising until they don’t. That may sound like a stupid statement, but it isn’t. As investors move from skepticism, where they are today (until very recently they were still pulling money from equities and buying bonds) toward euphoria, P/Es will continue to rise. P/Es simply don’t decline in bull markets. They rise steadily. They fall quickly in bear markets.
How does one know when the peak is near? The answer normally is when investors start acting stupid or, in Professor Shiller’s terms, irrational. What’s irrational? Buying stocks of companies based entirely on promises without any facts to consider. When new issues come to market for companies built on a wing and a prayer. When merger mania makes no sense. When companies go haywire using leverage beyond any capability to service, let alone repay the debt. None of those conditions is evident at the moment. Neither is recession. How high is up? I don’t know. But I do know earnings are rising and interest rates remain low. The path of least resistance is higher. That is a short term answer to the conundrum we face today. At some point, the near term rewards will be insufficient to offset the risks associated with a widening spread between valuation at the time and normality. We will continue to watch.
Besides Professor Shiller’s comments, one of the other highlights this week was the earnings report of Best Buy. The company trounced expectations and its shares rose by over 20% on Thursday. Isn’t Best Buy a retailer? Isn’t retail near death, courtesy of Amazon and other Internet merchants? The Internet, indeed, has been playing havoc with retail. One only has to look at virtually any department story to see the impact. But let us not forget Newton’s law that for every action, there is an equal and opposite reaction. In today’s world, that opposite reaction has to happen at lightning speed. In the case of Best Buy, it appears it has. The bankruptcy of Circuit City was the wake up call. It has been followed by subsequent bankruptcies of other electronics retailers.
Best Buy succeeded because it found a way to beat the Internet retailers at their own game. The proof is in the 22% growth of its Internet business. It matches price and delivery. In addition, it offers add-on services like in-store pickup, setup and other support. There no longer is an advantage to going to Amazon to buy a large screen TV. Amazon can’t set up your home network. Amazon can’t demonstrate the difference between devices.
Amazon still has its loyal Prime fans that Best Buy won’t take away. Best Buy can’t let down its guard, or it will be defeated quickly. But the lesson of Best Buy is that conventional retailers can win if they offer customers all the advantages of the Internet, plus the advantages a real experience can offer over a virtual experience.
Today, Lenny Kravitz is 53. Stevie Nicks turns 69.
James M. Meyer, CFA 610-260-2220
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