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Finding High Quality Companies 'Today'

We are having a hard time finding high-quality companies at attractive valuations.

For us, this is not an academic frustration. We are constantly looking for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at holdings of investors we respect, talking to our large network of professional investors, attending conferences, scouring through ideas published on value investor networks, and finally, looking with frustration at our large (and growing) watch list of companies we’d like to buy at a significant margin of safety. The median stock on our watch list has to decline by about 35-40% to be an attractive buy.

But maybe we’re too subjective. Instead of just asking you to take our word for it, in this letter we’ll show you a few charts that not only demonstrate our point but also show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, we don’t know either. But this is our point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s demonstrate this point by looking at a few charts.

The first chart shows price-to-earnings of the S&P 500 in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the1999 run-up to the dotcom bubble burst.


We know how the history played in both cases – consequently stocks declined, a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how this journey will look in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it maybe say hello to the pre-dotcom crash level of 164% above average? Or will another injection of QE steroids send stocks valuations to new, never-before-seen highs? Nobody knows.

One chart is not enough. Let’s take a look at another one, called the Buffett Indicator. Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the whole economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a similar story to the first one. Though neither Mike nor Vitaliy were around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first eleven months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: first, “This time is different” (it never is), and second, “Yes, stocks are overvalued, but we are still in the bull market.” (And they were right about this until they lost their shirts.)

Both Mike and Vitaliy were investing during the 1999 bubble. (Mike has lived through a lot of more bubbles, but a gentleman never tells). We both vividly remember the “This time is different” argument of 1999. It was the new vs. the old economy; the internet was supposed to change or at least modify the rules of economic gravity – the economy was now supposed to grow at a new, much faster rate. But economic growth over the last twenty years has not been any different than in the previous twenty years – no, let us take this back: it has actually been lower. From 1980 to 2000 real economic growth was about 3% a year, while from 2000 to today it has been about 2% a year.

Finally, let’s look at a Tobin’s Q chart. Don’t let the name intimidate you – this chart simply shows the market value of equities in relation to their replacement cost. If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then Tobin’s Q is 2. The higher the ratio the more expensive stocks are. Again, this one tells the same story as the other two charts: Stocks are very expensive and were more expensive only twice in the last hundred-plus years.

What will make the market roll over? It’s hard to say, though we promise you the answer will be obvious in hindsight. Expensive markets collapse by their own weight, pricked by an exogenous event. What made the dotcom bubble burst in 1999? Valuations got too high; P/Es stopped expanding. As stock prices started their decline, dotcoms that were losing money couldn’t finance their losses by issuing new stock. Did the stock market decline cause the recession, or did the recession cause the stock market decline? We are not sure of the answer, and in the practical sense the answer is not that important, because we cannot predict either a recession or a stock market decline.

In December 2007 Vitaliy was one of the speakers at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was “When are we going into a recession?” Vitaliy gave his usual, unimpressive “I don’t know” answer. The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from six months to eighteen months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the US economy was already in a recession.

We spend little time trying to predict the next recession, and we don’t try to figure out what prick will cause this market to roll over. Our ability to forecast is very poor and is thus not worth the effort.

An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. This argument sounds so true and logical, but – and this is a huge “but” – there is a crucial embedded assumption that interest rates will stay at these levels for a decade or two.

Hopefully by this point you are convinced of our ignorance, at least when it comes to predicting the future. As you can imagine, we don’t know when interest rates will go up or by how much (nobody does). When interest rates rise, then stocks’ appearance of cheapness will dissipate as mist on the breeze.

And there is another twist: If interest rates remain where they are today, or even decline, this will be a sign that the economy has big, deflationary (Japan-like) problems. A zero interest rate did not protect the valuations of Japanese stocks from the horrors of deflation – Japanese P/Es contracted despite the decline in rates. America maybe an exceptional nation, but the laws of economic gravity work here just as effectively as in any other country.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. How about being patient and not taking the poison at all?

You may ask, how do we invest in an environment when the stock market is very expensive? The key word is invest. Merely buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. We don’t do that and won’t do that.

Courtesy of Mauldin

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I found this interesting (the rise) however I have my own reservations because of the possible change in rates and inflation in 2017.  When inflation rises, interest rates also normally rise to maintain real rates within an appropriate range. PE ratios need to decline to reflect the increase in the earnings discount rate. Another way to look at it is that equities then face more competition for money from fixed income instruments. The cost of equities must therefore decline to keep or attract investors.  Then there is the Rule of 20 to consider.  Rule of 20 equals P/E + long term interest rates (average of 10 and 30 yr bond rates).  If at or below 20 minus inflation -- the market is a buy.  If above 20 minus inflation -- the market is a sell. Today we're at just about 20.  I think I'll keep my cautious side up.  Keep moving up my alerts and stick to only brief swings.  Something tells me it's going to be an interesting year.  All focus on the Fed and inflation.  

During the past week (on February 15), the value of the S&P 500 closed at yet another all-time high at 2349.25. As of today, the forward 12-month P/E ratio for the S&P 500 stands at 17.6, based on yesterday’s closing price (2347.22) and forward 12-month EPS estimate ($133.49). Given the high values driving the “P” in the P/E ratio, how does this 17.6 P/E ratio compare to historical averages? What is driving the increase in the P/E ratio?

The current forward 12-month P/E ratio of 17.6 is now above the four most recent historical averages: five-year (15.2), 10-year (14.4), 15-year (15.2), and 20-year (17.2).

In fact, this week marked the first time the forward 12-month P/E has been equal to (or above) 17.6 since June 23, 2004. On that date, the closing price of the S&P 500 was 1144.06 and the forward 12-month EPS estimate was $65.14.

The Drivers of Change

Back on December 31, 2016, the forward 12-month P/E ratio was 16.9. Since this date, the price of the S&P 500 has increased by 4.8% (to 2349.45 from 2238.83), while the forward 12-month EPS estimate has increased by 0.5% (to $133.49 from $132.84). Thus, the increase in the “P” has been the main driver of the increase in the P/E ratio to 17.6 today from 16.9 at the start of the first quarter.

It is interesting to note that analysts are projecting record-level EPS for the S&P 500 for Q2 2017 through Q4 2017. If not, the forward 12-month P/E ratio would be even higher than 17.6.

Courtesy of Factset

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Don't Be Fooled The Bond Rally Continues

We’ve been bulls on 30-year Treasury bonds since 1981 when we stated, “We’re entering the bond rally of a lifetime.” It’s still under way, in our opinion. Their yields back then were 15.2%, but our forecast called for huge declines in inflation and, with it, a gigantic fall in bond yields to our then-target of 3%.

The Cause of Inflation

We’ve argued that the root of inflation is excess demand, and historically it’s caused by huge government spending on top of a fully-employed economy.  That happens during wars, and so inflation and wars always go together, going back to the French and Indian War, the Revolutionary War, the War of 1812, the Mexican War of 1846, the Civil War, the Spanish American War of 1898, World Wars I and II and the Korean War.  In the late 1960s and 1970s, huge government spending, and the associated double-digit inflation (Chart 1), resulted from the Vietnam War on top's LBJ’s War on Poverty.

By the late 1970s, however, the frustrations over military stalemate and loss of American lives in Vietnam as well as the failures of the War on Poverty and Great Society programs to propel lower-income folks led to a rejection of voters’ belief that government could aid Americans and solve major problems.  The first clear manifestation of this switch in conviction was Proposition 13 in California, which limited residential real estate taxes.  That was followed by the 1980 election of Ronald Reagan, who declared that government was the basic problem, not the solution to the nation’s woes.

This belief convinced us that Washington’s involvement in the economy would atrophy and so would inflation.  Given the close correlation between inflation and Treasury bond yields (Chart 1), we then forecast the unwinding of inflation—disinflation—and a related breathtaking decline in Treasury bond yields to 3%, as noted earlier.  At that time, virtually no one believed our forecast since most thought that double-digit inflation would last indefinitely. 

Lock Up For Infinity?

Despite the high initial yields on “the long bond,” as the most-recently issued 30-year Treasury is called, our focus has always been on price appreciation as yields drop, not on yields, per se.  A vivid example of this strategy occurred in March 2006—before the 2007–2009 Great Recession promoted the nosedive in stocks and leap in Treasury bond prices. I was invited by Professor Jeremy Siegel of Wharton for a public debate on stocks versus bonds. He, of course, favored stocks and I advocated Treasury bonds.

At one point, he addressed the audience of about 500 and said, “I don’t know why anyone in their right mind would tie up their money for 30 years for a 4.75% yield [the then-yield on the 30-year Treasury].” When it came my turn to reply, I asked the audience, “What’s the maturity on stocks?” I got no answer, but pointed out that unless a company merges or goes bankrupt, the maturity on its stock is infinity—it has no maturity. My follow-up question was, “What is the yield on stocks?” to which someone correctly replied, “It’s 2% on the S&P 500 Index.” 

So I continued, “I don’t know why anyone would tie up money for infinity for a 2% yield.” I was putting the query, apples to apples, in the same framework as Professor Siegel’s rhetorical question. “I've never, never, never bought Treasury bonds for yield, but for appreciation, the same reason that most people buy stocks.  I couldn't care less what the yield is, as long as it's going down since, then, Treasury prices are rising.”

Of course, Siegel isn’t the only one who hates bonds in general and Treasuries in particular. And because of that, Treasurys, unlike stocks, are seldom the subject of irrational exuberance. Their leap in price in the dark days in late 2008 (Chart 2) is a rare exception to a market that seldom gets giddy, despite the declining trend in yields and related decline in prices for almost three decades.

Treasury Haters

Stockholders inherently hate Treasurys. They say they don’t understand them. But their quality is unquestioned, and Treasurys and the forces that move yields are well-defined—Fed policy and inflation or deflation (Chart 1) are among the few important factors. Stock prices, by contrast, depend on the business cycle, conditions in that particular industry, Congressional legislation, the quality of company management, merger and acquisition possibilities, corporate accounting, company pricing power, new and old product potentials, and myriad other variables.

Also, many others may see bonds—except for junk, which really are equities in disguise—as uniform and gray.  It's a lot more interesting at a cocktail party to talk about the unlimited potential of a new online retailer that sells dog food to Alaskan dogsledders than to discuss the different trading characteristics of a Treasury of 20- compared to 30-year maturity.  In addition, many brokers have traditionally refrained from recommending or even discussing bonds with clients.  Commissions are much lower and turnover tends to be much slower than with stocks. 

Stockholders also understand that Treasurys normally rally in weak economic conditions, which are negative for stock prices, so declining Treasury yields are a bad omen. It was only individual investors’ extreme distaste for stocks in 2009 after their bloodbath collapse that precipitated the rush into bond mutual funds that year. They plowed $69 billion into long-term municipal bond funds alone in 2009, up from only $8 billion in 2008 and $11 billion in 2007.

Another reason is that most of those promoting stocks prefer them to bonds is because they compare equities with short duration fixed-income securities that did not have long enough maturities to appreciate much as interest rates declined since the early 1980s.

Investment strategists cite numbers like a 6.7% annual return for Treasury bond mutual funds for the decade of the 1990s while the S&P 500 total annual return, including dividends, was 18.1%. But those government bond funds have average maturities and durations far shorter than on 30-year coupon and zero-coupon Treasurys that we favor and which have way, way outperformed equities since the early 1980s.

Media Bias

The media also hates Treasury bonds, as their extremely biased statements reveal.  The June 10 edition of The Wall Street Journal stated: “The frenzy of buying has sparked warnings about the potential of large losses if interest rates rise. The longer the maturity, the more sharply a bond’s price falls in response to a rise in rates. And with yields so low, buyers aren’t getting much income to compensate for that risk.”  Since then, the 30-year Treasury yield has dropped from 2.48% to 2.21% as the price has risen by 8.3%.

Then, the July 1 Journal wrote: “Analysts have warned that piling into government debt, especially long-term securities at these slim yields, leaves bondholders vulnerable to the potential of large capital losses if yields march higher.”  Since then, the price of the 30-year Treasury has climbed 1.7%. 

While soft-pedaling the tremendous appreciation in long-term sovereigns this year, Wall Street Journal columnist James MacKintosh worries about the reverse.  On July 28, he wrote, “Investors are taking a very big risk with these long-dated assets....Japan's 40-year bond would fall 15% in price if the yield rose by just half a percentage point, taking it back to where it stood in March.  If yields merely rise back to where they started the year, it would be catastrophic for those who have chased longer duration.  The 30-year Treasury would lose 14% of its value, while Japan's 40-year would lose a quarter of its value.” 

The July 11 edition of the Journal said, “Changes in monetary policy could also trigger potential losses across the sovereign bond world.  Even a small increase in interest rates could inflict hefty losses on investors.” 

But in response to Brexit, the Bank of England has already eased, not tightened, credit, with more likely to follow.  The European Central Bank is also likely to pump out more money as is the Bank of Japan as part of a new $268 billion stimulus package.  Meanwhile, even though Fed Chairwoman Yellen has talked about raising interest rates later this year, we continue to believe that the next Fed move will be to reduce them.

Major central banks have already driven their reference rates to essentially zero and now negative in Japan and Europe (Chart 3) while quantitative easing exploded their assets (Chart 4).  The Bank of England immediately after Brexit moved to increase the funds available for lending by U.K. banks by $200 billion.  Earlier, on June 30, BOE chief Mark Carney said that the central bank would need to cut rates “over the summer” and hinted at a revival of QE that the BOE ended in July 2012.

Lonely Bulls

We’ve been pretty lonely as Treasury bond bulls for 35 years, but we’re comfortable being in the minority and tend to make more money in that position than by running with the herd. Incidentally, we continue to favor the 30-year bond over the 10-year note, which became the benchmark after the Treasury in 2001 stopped issuing the “long bond.”  At that time, the Treasury was retiring debt because of the short-lived federal government surpluses caused by the post–Cold War decline in defense spending and big capital gains and other tax collections associated with the Internet stock bubble.

But after the federal budget returned to deficits as usual, the Treasury resumed long bond issues in 2006. In addition, after stock losses in the 2000–2002 bear market, many pension funds wanted longer-maturity Treasurys to match against the pension benefit liability that stretched further into the future as people live longer, and they still do.

Maturity Matters

We also prefer the long bond because maturity matters to appreciation when rates decline. Because of compound interest, a 30-year bond increases in value much more for each percentage point decline in interest rates than does a shorter maturity bond (Chart 5).

Note (Chart 6) that at recent interest rates, a one percentage point fall in rates increases the price of a 5-year Treasury note by about 4.8%, a 10-year note by around 9.5%, but a 30-year bond by around 24.2%. Unfortunately, this works both ways, so if interest rates go up, you’ll lose much more on the bond than the notes if rates rise the same for both.

If you really believe, as we have for 35 years, that interest rates are going down, you want to own the longest-maturity bond possible. This is true even if short-term rates were to fall twice as much as 30-year bond yields. Many investors don’t understand this and want only to buy a longer-maturity bond if its yield is higher.

Others only buy fixed-income securities that mature when they need the money back. Or they'll buy a ladder of bonds that mature in a series of future dates. This strikes us as odd, especially for Treasurys that trade hundreds of billions of dollars’ worth each day and can be easily bought and sold without disturbing the market price. Of course, when you need the cash, interest rates may have risen and you’ll sell at a loss, whereas if you hold a bond until it matures, you’ll get the full par value unless it defaults in the meanwhile. But what about stocks? They have no maturity so you’re never sure you’ll get back what you pay for them.

Three Sterling Qualities

We’ve also always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth trading each day, as noted earlier. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity.  This is an annoying feature of corporate and municipal bonds. When interest rates are declining and you’d like longer maturities to get more appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity because issuers have no interest in calling them. It’s a game of heads the issuer wins, tails the investor loses.

Third, Treasurys are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year Treasurys returned 42%, but global corporate bonds fell 8%, emerging market bonds lost 10%, junk bonds dropped 27%, and even investment-grade municipal bonds fell 4% in price.

Slowing global economic growth and the growing prospects of deflation are favorable for lower Treasury yields.  So is the likelihood of further ease by central banks, including even a rate cut by the Fed, as noted earlier. 

Along with the dollar (Chart 7), Treasurys are at the top of the list of investment safe havens as domestic and foreign investors, who own about half of outstanding Treasurys, clamor for them.

Sovereign Shortages

Furthermore, the recent drop in the federal deficit has reduced government funding needs so the Treasury has reduced the issuance of bonds in recent years.  In addition, tighter regulators force U.S. financial institutions to hold more Treasurys. 

Also, central bank QE has vacuumed up highly-rated sovereigns, creating shortages among private institutional and individual buyers.  The Fed stopped buying securities in late 2014, but the European Central Bank and the Bank of Japan, which already owns 34% of outstanding Japanese government securities, are plunging ahead.  The resulting shortages of sovereigns abroad and the declining interest rates drive foreign investors to U.S. Treasurys.

Also, as we’ve pointed out repeatedly over the past two years, low as Treasury yields are, they’re higher than almost all other developed country sovereigns, some of which are negative (Chart 8).  So an overseas investor can get a better return in Treasurys than his own sovereigns.  And if the dollar continues to rise against his home country currency, he gets a currency translation gain to boot.

"The Bond Rally of a Lifetime"

We believe, then, that what we dubbed “the bond rally of a lifetime” 35 years ago in 1981 when 30-year Treasurys yielded 15.2% is still intact.  This rally has been tremendous, as shown in Chart 9, and we happily participated in it as forecasters, money managers and personal investors.

Chart 9 uses 25-year zero-coupon bonds because of data availability but the returns on 30-year zeros were even greater.  Even still, $100 invested in that 25-year zero-coupon Treasury in October 1981 at the height in yield and low in price and rolled over each year maintains its maturity or duration to avoid the declining interest rate sensitivity of a bond as its maturity shortens with the passing years.  It was worth $31,688 in June of this year, for an 18.1% annual gain.  In contrast, $100 invested in the S&P 500 index at its low in July 1982 is now worth $4,620 with reinvested dividends.  So the Treasurys have outperformed stocks by 7.0 times since the early 1980s.

So far this year, 30-year zero-coupon Treasurys have returned 26% compared to 3.8% for the S&P 500.  And we believe there’s more to go.  Over a year ago, we forecast a 2.0% yield for the 30-year bond and 1.0% for the 10-year note.  If yields fall to those levels by the end of the year from the current 2.21% and 1.5%, respectively, the total return on the 30-year coupon bond will be 5.7% and 5.6% on the 10-year note.  The returns on zero-coupon Treasurys with the same rate declines will be 6.4% and 5.1% (Chart 10).

Besides Treasurys, sovereign bonds of other major countries have been rallying this year as yields fell (Chart 11) and investors have stampeded into safe corrals after Brexit.

Finally Facing Reality

Interestingly, some in the media are finally facing the reality of this superior performance of Treasury bonds and backpedaling on their 35-year assertions that it can’t last.  The July 12 Wall Street Journal stated: “Bonds are churning out returns many equity investors would envy. Remarkably, more than 80% of returns on U.S., German, Japanese and U.K. bonds are attributable to gains in price, Barclays index data show. Bondholders are no longer patient coupon-clippers accruing steady income.”

The July 14 Journal said, “Ultra low interest rates are here to stay,” and credited not only central bank buying of sovereigns but also slow global growth.  Another Journal article from that same day noted that central banks can make interest rates even more negative and, if so, “even bonds bought at today’s low rates could go up in price.”  And in the July 16 Journal, columnist Jason Zweig wrote, “The generation-long bull market in bonds is probably drawing to a close.  But high quality bonds are still the safest way to counteract the risk of holding stocks, as this year’s returns for both assets has shown.  Even at today’s emaciated yields, bonds still are worth owning.”  What a diametric change from earlier pessimism on bonds!

The July 11 Journal said, “Recently, the extra yield investors demand to hold the 10-year relative to the two-year Treasury note hit its lowest level since November 2007 (Chart 12). In the past, investors have taken this narrowing spread as a warning sign that growth momentum may soon slow because the Fed is about to raise interest rates—a move that would cause shorter-dated bond yields to rise faster than longer-dated ones.  Now, like much else, it is largely being blamed on investors’ quest for yield.”  Note (Chart 12) that when the spread went negative, with 2-year yields exceeding those on 10-year Treasury notes, a recession always followed.  But that was because the Fed's attempts to cool off what it saw as an overheating economy with higher rates was overdone, precipitating a business downturn.  That's not li kely in today's continuing weak global economy.

Persistent Stock Bulls

Nevertheless, many stock bulls haven’t given up their persistent love of equities compared to Treasurys.  Their new argument is that Treasury bonds may be providing superior appreciation, but stocks should be owned for dividend yield. 

That, of course, is the exact opposite of the historical view, but in line with recent results.  The 2.1% dividend yield on the S&P 500 exceeds the 1.50% yield on the 10-year Treasury note and is close to the 2.21% yield on the 30-year bond.  Recently, the stocks that have performed the best have included those with above average dividend yields such as telecom, utilities and consumer staples (Chart 13).

Then there is the contention by stock bulls that low interest rates make stocks cheap even through the S&P 500 price-to-earnings ratio, averaged over the last 10 years to iron out cyclical fluctuations, now is 26 compared to the long-term average of 16.7(Chart 14).  This makes stocks 36% overvalued, assuming that the long run P/E average is still valid.  And note that since the P/E has run above the long-term average for over a decade, it will fall below it for a number of future years—if the statistical mean is still relevant.

Instead, stock bulls points to the high earnings yield, the inverse of the P/E, in relation to the 10-year Treasury note yield.  They believe that low interest rates make stocks cheap.  Maybe so, and we’re not at all sure what low and negative nominal interest rates are telling us.

We’ll know for sure in a year or two.  It may turn out to be the result of aggressive central banks and investors hungry for yield with few alternatives.  Or low rates may foretell global economic weakness, chronic deflation and even more aggressive central bank largess in response.  We’re guessing the latter is the more likely explanation.

Courtesy of A.GaryShilllingsInsight

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A Tech Bubble, An 'Everything' Bubble Or None At All

One Thursday morning in early June, the ballroom of the Rosewood Sand Hill hotel, in Menlo Park, was closed for a private presentation. The grand banquet hall appeared worthy of the sprawling resort’s five-star designation: ornate chandeliers hung from the ceiling; silk panels with a silver stenciled design covered the walls. Behind a stage in the 2,800-square-foot room, a large sign bore the name of Andreessen Horowitz, one of Silicon Valley’s most revered venture-capital firms.

As breakfast and coffee were offered, the company’s partners mingled with the men and women who endow their $1.5 billion fund. The investors were dressed invariably in business casual, with the top button of their dress shirts noticeably undone. (A mere handful of men stood out in a suit and tie.) Off in the distance, you could make out the faint purr of Bentleys and Teslas ferrying along Sand Hill Road, depositing the Valley’s other top V.C.’s at their respective offices—Greylock Partners, Draper Fisher Jurvetson, and Sequoia Capital, to name just a few—for another day of meetings with founders, reviewing the decks of new start-ups, and searching for the next can’t-miss company.

After some chitchat (Mitt Romney had addressed the group the previous night), Scott Kupor, a managing partner, took the stage to tell the assembled investors what was going on with their money. A16z, as the firm is commonly known in the Valley, had invested hundreds of millions of dollars in some of the industry’s biggest companies—Instagram, Facebook, Box, Twitter, and Oculus VR—along with a number of upstarts, such as Instacart, a grocery-delivery business that had been recently valued at about $2 billion. After the guests found their seats, Kupor began moving through a series of slides depicting the past and present of the tech sector, using data that would help inform the firm’s investments in the future. Each set of numbers had been meticulously researched and culled from sources that included Capital IQ, Bloomberg, and the National Venture Capital Association.

Yet the presentation, which adhered to a16z’s gray-and-deep-orange palette, seemed to have an ulterior motive. Kupor, his hair neatly parted, was eager to assuage any worry about the existence of a tech bubble. While he conceded that there were some eerie similarities with the infamous dot-com bubble of 1999—such as the preponderance of so-called unicorns, or tech start-ups valued at $1 billion and upward—Kupor confidently buoyed his audience with slides that read, “It’s different this time,” and charts highlighting the decrease in tech I.P.O.’s, the metric that eventually pierced the froth in March of 2000. Back then, a company went public almost every single day; now it was down to about once per week. This time around, he noted, the money was flowing backward. Rather than entering a company’s coffers in the public markets, it was making its way to start-ups in late-stage investments. There was little, he suggested, to worry about.

And then, toward the end of his reassuring soliloquy, the ANDREESSEN HOROWITZ sign fell from the wall and landed on the floor with an ominous thud. As the investors looked on, some partners in the Rosewood ballroom laughed awkwardly. Others did not seem so amused.

Kim Jong Un vs. Hitler

While the rest of the country has spent the past year debating gay marriage, policing tactics, Obamacare, and Deflate-gate, the inescapable topic of discussion in Silicon Valley is whether we are in a technology bubble. Marc Andreessen, the co-founder of his eponymous venture firm, is perhaps the leading advocate against the bubble chatter. On his Twitter feed, he has referenced the word “bubble” more than 300 times, repeatedly mocking or refuting anyone on his radar who even hints at such a possibility. One of his arguments, as the slides in the Rosewood ballroom suggested, is the exponential growth of mobile phones, which have fundamentally changed the way we buy and sell virtually everything, from groceries to taxi-like services, and created unprecedented disruption. Also, in contrast to the days of the dot-com boom, many tech companies are creating revenue—in some instances, lots of it.

Andreessen’s points are all valid, but the bubble chatter is still impossible to quell, in part, because the signs are increasingly ubiquitous. When I moved to the Bay Area to cover the tech industry for The New York Times, in the summer of 2011, the Valley was still reeling from the bursting of the last bubble, which led to more than $6 trillion in losses, and sent the NASDAQ on a downward spiral similar to the Dow’s amid the Wall Street crash of 1929. In 2000, some start-up C.E.O.’s lost millions of dollars in a matter of hours. Others saw their entire net worth fall to zero in months. People vanished; commuting times were sawed in half; private investment ossified. At the time I arrived, LinkedIn was the only publicly traded social-media company. A little-known upstart with a catchy name, Uber, had just raised a seemingly staggering amount ($11 million) in venture capital. Postmates, Tinder, Instacart, Lyft, and Slack didn’t exist. Silicon Valley was an actual place, not an HBO show.

But within months I noticed that private money was returning and a cavalcade of start-ups were reshaping the city in their image. Engineers from companies I hadn’t yet heard of began showing up at open houses with checks written out to cover rent for the first few months (a recruiting perk, I later learned). I attended a jungle-themed Halloween extravaganza featuring acrobats, a 600-pound tiger, and other wild animals in order to bolster photo moments that people were posting on a hot new start-up, Instagram. Meanwhile, I was pitched countless apps to find a parking space, or messaging services to tell someone that you are running late. The founders told me their companies were worth tens of millions of dollars. When I asked for their logic, they looked at me as though I were the crazy one. Shortly after the Facebook I.P.O., I learned about a secret group within the social-network company called “T.N.R. 250”; it was an abbreviation of “The Nouveau Riche 250,” comprising Facebook’s first 250 employees, many of whom had become multi-millionaires. The members of T.N.R. 250 privately discussed things they wanted to buy with their windfall, including boats, planes, Banksy portraits, and even tropical islands.

Whenever I even suggested the word “bubble” in my reporting, I became a punching bag. After I scrutinized the ethics (and preposterous valuation) of Path, an ill-fated social network, Michael Arrington, once a nexus of power in Silicon Valley who had invested in the start-up, called me a “pit bull” and said I wasn’t a very noble person. But lately the worries have spread. There are now fast approaching 100 unicorns based in the U.S. alone, and counting. The NASDAQ recently closed at an all-time high, surpassing a record set right before the dot-com crash in 2000. The Shiller P/E ratio, a measure of the ratio of price to earnings, has a number of investors worrying, with The Wall Street Journal noting that it shows stocks are “frothy.”

Lately, in fact, even some of the most aggressive V.C.’s have cowered. Not long after the Andreessen Horowitz presentation, Roger McNamee, co-founder of the private-equity firm Elevation Partners, told CNBC, “We are going to have a correction one of these days.” Bill Gurley, a partner at Benchmark Capital and Andreessen’s nemesis (“my Newman,” as he recently put it, referring to the Seinfeld character), echoed this sentiment on Twitter, venture capitalists’ preferred platform of communication. (Many are staked in it.) “Arguing we aren’t in a bubble because it’s not as bad as 1999,” Gurley tweeted, “is like saying that Kim Jong-un is fine because he’s not as bad as Hitler.” (Gurley declined to comment for this story.)

But the best way to understand the current situation in Silicon Valley is to recall the last bubble. Mark Cuban, who sold his Broadcast.com for $5.7 billion several months before the dot-com bubble burst, told me that there is no question whatsoever that we are in the midst of another one. And as with the last one, there is no question that a lot of people will be devastated when it pops. “The biggest of all losers will be anyone who has borrowed money to invest in private companies,” he told me. “You were stupid. You blew it. You lost. That simple.”

“This Is Hubris”

Perhaps the clearest way to observe the tech industry is through its architecture. When the I-280 deposits you into San Francisco, the view is like no other in America. To the left, waves of thick fog roll slowly off Twin Peaks. To the right, dozens of massive container ships sit like specks on the bay. If you drive farther into the city, toward gilded Nob Hill, the area that once belonged to the robber barons—the city’s original entrepreneurs—is now filled with upscale boutique hotels. But as you enter the city itself, every corner of the sky appears the same: spikes of lanky cranes protrude hundreds of feet into the air, their fishing lines plucking concrete and steel from street level, stacking these beams atop one another.

San Francisco, a city that zones about half of its land for residential use, is on track to increase its office space by 15 percent, with a majority of it presumably allocated for tech start-ups. Travel about 50 miles south to Cupertino and you will see the site of Apple’s new gargantuan glass headquarters, “the Spaceship,” designed by Sir Norman Foster, which will span 2.8 million square feet and house more than 12,000 employees. And then there’s the new, recently occupied Facebook building, designed by Frank Gehry, with its rooftop park and what it claims is the largest open floor plan in the world. Google is currently planning its own updated campus—this one designed by Bjarke Ingels and Thomas Heatherwick— that will include an army of small crane robots, known as “crabots,” which can move office walls, floors, and ceilings and transform the spaces in mere hours.

Yet there may be no greater monument to what’s going on in the Valley than the 1,070-foot edifice under construction at 415 Mission Street. The new, glassy Salesforce Tower is slated to soon become the tallest building in San Francisco, rising more than 200 feet above the Transamerica Pyramid. And that may be a big problem. Vikram Mansharamani, a Yale lecturer and author of the book Boombustology, has argued that virtually every great bubble bursting has been preceded by an attempt to build the tallest buildings. Forty Wall Street, the Chrysler Building, and the Empire State Building were under construction during the onset of the Great Depression. The Petronas Towers, in Kuala Lumpur, were completed in time to inaugurate the Asian economic crisis. The Taipei 101 tower, once the tallest building in the world, laid its foundation right at the height of the dot-com boom.

Some of these buildings, which were erected through money obtained partly from bubble-gotten gains, rode on the assumption that the markets would continue to rise and there would be enough tenants to fill their floors. This trend has historically been true in other industries, too. An inflated art market, according to Mansharamani, is another troubling indicator of overconfidence. (Last May, Christie’s, Sotheby’s, and Phillips broke records by selling a total of $2.7 billion of art in a week and a half.) There’s also a precocious indicator some economists refer to as the Prostitute Bubble, where the filles de joie flock to increasingly frothy markets. (While it’s difficult to substantiate this theory, several bars in the city are well known for this kind of deal-making.) “I think we are absolutely in a condition that you would qualify as bubbly by any stretch of the imagination,” Mansharamani told me. “This is hubris, chest-bumping behavior: Bigger. Better. Wider. Me.”

In more quotidian ways, the mania that presided over 1999 is also back. During 2013, high-tech workers up and down the peninsula were reportedly paid nearly $196,000 a year, on average, and some made several million dollars in stock. Other programmers have their own agents, much like Hollywood stars. Some interns have been paid more than $7,000 a month, which adds up to about $84,000 a year. (The median household income in the United States is around $53,000.) Snapchat has offered Stanford undergrads as much as $500,000 a year to work for the company. Jana Rich, founder of Rich Talent Group, a well-regarded tech recruiting firm, told me that she hasn’t seen such bidding wars since the late 90s. “I’ve seen two of these life cycles, where things are going fabulously well,” she said. “Then we have the bust. We are now, in my opinion, at the height of the demand curve.”

Other tech recruiters noted that every little detail of the hiring process is again up for negotiation, just as it was in 1999, with an increased emphasis on extravagant stock-option packages that could ultimately yield several million dollars. This era also brings the allure of all manner of gourmet cafeterias, exercise rooms, open terraces, and unorthodox cubicles. Sometimes the demands are prosaic: one recruiter told me that an engineer requested closer proximity to the free-snack station. Other times, less so: a Google executive was reportedly paid $100 million not to leave the company for a competitor. Google, or its new parent company, Alphabet, seems to have enough money to throw some of it away.

This euphoria has created a debauched culture that also hearkens back to the last bubble. In 1999, thousands of instantly rich young people would line the city streets and cram into bars and event halls to gorge themselves on the endless flow of multicolored booze and hors d’oeuvres. Every night, it seemed, a blowout was being thrown by companies like Kozmo—a precursor to Postmates or any of the current errand-running sites—that later lost more than $250 million. Some parties had acrobats and fire-breathers. Others gave away gadgets and clothing.

Now a recent “Product Hunt” Happy Hour, where entrepreneurs network with investors, attracted more than 4,000 people, according to the Facebook invite page. At another event, hosts handed out free Apple TV set-top boxes as thank-you gifts. A prominent Facebook employee’s birthday party was orchestrated like an elaborate wedding, with ice sculptures, chocolatiers, and half a dozen women who walked around with card tables hanging off their waists so that guests could play blackjack while staring at their chests. A Google executive’s “40th-and-a-half” birthday party had elaborate acrobatics. In recent years, Burning Man, the annual art-and-music festival in the Nevada desert, has started to swell with venture capitalists and employees from Google, Twitter, Uber, Facebook, Dropbox, and Airbnb. (In 2012, Mark Zuckerberg flew in for a day on a helicopter.) These newly minted rich have eschewed the paltry sleeping conditions for private camps on what has become known as “Billionaires’ Row,” where some spend the night in custom-built yurts with their own power generators and air-conditioning. The most luxurious camps can come with teams of “Sherpas,” waiting on tech elite at a three-to-one ratio.

On any given night a dozen venture firms will host V.I.P. dinners at the city’s five-star restaurants, or on its own Billionaires’ Row, for designers, chief technology officers, or young entrepreneurs to meet and mingle. Some of these dinners even have the promise that a second-tier celebrity, who is now involved in a start-up, might show up. More elaborate affairs involve weekend trips to Richard Branson’s Necker Island or the Four Seasons in Punta Mita, Mexico, or even a pub crawl through Dublin with Bono. All of this exuberance is magnetizing the same diaspora of Wall Street bankers, models, college dropouts, and anyone else with a start-up idea who came to Silicon Valley in the mid-90s. “You know there’s a bubble,” the saying goes, “when the pretty people show up.”

The Domino’s Economy

Engineers and venture capitalists insist that things are different now. In the past, they’ve suggested, people were just trying to get filthy rich. Now they are trying to “make the world a better place.” They are quite emphatic about it, too. Last year, Fortune reported that one of Airbnb’s executives said that he would love to see the company win the Nobel Peace Prize.

Indeed, there are many technologies that are genuinely changing the world—companies that aim to take people into space, or eradicate senseless traffic fatalities, or help people in developing countries by connecting them to the Internet. That shiny rectangle in your hand—the one that you are probably reading this story on—has unequivocally changed our lives in remarkable ways. Hashtags about racism, rape, police brutality, and inequality have offered a potent voice to those who were previously ignored. But the farcical line in the fictional Silicon Valley that people are “making the world a better place through minimal message-oriented transport layers” couldn’t be more true in the real one. All across the Valley, the majority of big start-ups are actually glorified distribution companies that are trying, in some sense, to copy what Domino’s Pizza mastered in the 1980s when it delivered a hot pie to your door in 30 minutes or less. Uber, Lyft, Sidecar, Luxe, Amazon Fresh, Google Express, TaskRabbit, Postmates, Instacart, SpoonRocket, Caviar, DoorDash, Munchery, Sprig, Washio, and Shyp, among others, are really just using algorithms to deliver things, or services, to places as quickly as possible. Or maybe it’s simpler than that. As one technologist overheard and posted on Twitter, “SF tech culture is focused on solving one problem: What is my mother no longer doing for me?”

This, perhaps, is the greatest similarity to what took place during the dot-com bubble, when a generation of companies were created to do more or less the same things. Webvan, the grocery-delivery business, raised $375 million at its I.P.O., in 1999—and reached a market value of as much as $7.9 billion— before eventually going bust. Kozmo, which initially offered free one-hour delivery, ended so abruptly that some employees arrived at work only to discover they had five minutes to retrieve their belongings and vacate the premises. And then there was the parabolic Pets.com, which sold kitty litter and dog food over the Web and raised $110 million from investors before descending from I.P.O. to out of business in fewer than 300 days.

Even if this generation of distribution companies is able to ride the shift from the desktop to mobile—64 percent of American adults now own smartphones—errand running has not proved an infallible business model. Kozmo and UrbanFetch lost so much money on orders and infrastructure that they ended up going kaput. Some more recent start-ups have subsidized their deliveries in a race to gain new users and grow their audience. Even Uber, which is now valued at around $51 billion, is reportedly operating at a loss of almost half a billion. As one prominent author who has written about Wall Street and Silicon Valley said to me, “How long can these companies continue to sell a dollar for 70 cents before you run out of dollars?”

For now, they may have a little while longer. The Federal Reserve’s decision to carry out multiple rounds of quantitative easing, in which the central bank stimulates the economy by buying securities, has flooded the system with cash. (“The whole world is awash with money,” says Christopher Thornberg, an economist who is best known for predicting the 2007 housing collapse.) Private-equity firms, not to mention China and Russia, now have the ability to help venture capitalists fund massive rounds of financing to prop up billion-dollar start-ups that have little in the way of revenue. Last year the Government of Singapore Investment Corporation led a $150 million round of funding for Square, the mobile-payments company. Tiger Global Management, a New York–based investment firm, took part in a $1.5 billion round for Airbnb. Collectively these start-ups have helped promote a culture of FOMO—or “fear of missing out,” in Valley parlance—in which few V.C.’s, who have their own investors to answer to, can afford to ignore the next big thing.

And this is where it gets particularly murky. These are private companies, with private balance sheets, and the valuations they ascribe to themselves aren’t vetted in the same way by the S.E.C. or public markets. These start-ups, in other words, can command much higher, and at times fabricated, valuations. One successful venture capitalist told me that he recently met with a unicorn that was seeking a new round of funding. When he asked the C.E.O. why he had valued his company at $1 billion, he was told, “We need to be worth a billion dollars to be able to recruit new engineers. So we decided that was our valuation.”

Another well-known venture capitalist told me a related story. When Instacart raised $220 million, this past winter, V.C.’s who had wanted to get in on the round were allowed to look at the company’s prospectus only inside a secure office. Investors were asked to refrain from using their cell phones at the meeting and banned from taking any pictures. The company claimed that these measures were taken to prevent anything from leaking to the press or competitors, but this venture capitalist said it felt suspiciously like the company was trying to control how much time investors could spend mulling over the company’s revenues and margins.

Indeed, contrary to Kupor’s argument at the Rosewood, it is this later-stage investing—with its shortage of regulation, tremendous envy, and Schadenfreude—that worries many bubble-watchers. “We basically doubled the number of unicorns in the past year and a half,” says Aileen Lee, the founder of Cowboy Ventures, who has herself become a mythic creature in the Valley after coining the term. “But a lot of these are paper unicorns, so their valuations may not be real for a while.” Others, Lee acknowledged, may never see their balance sheets add enough zeros to justify the title. They will be given a new sobriquet: “unicorpse.”

The problem with being a unicorn, indeed, is that there aren’t many exit strategies. Either you can go public, which is inadvisable without a lot of revenue, or you can sell, which is difficult given the paucity of companies that can afford to make such an offer. So, for many, the choice becomes fairly simple. You continue to raise more and more money, or you die.


There is, however, one crucial difference between what’s going on now and what happened 15 years ago. On the eve of the dot-com crash, as 1999 rolled into 2000, few wanted the party to end. Tech I.P.O.’s had become a daily amusement, often doubling, and sometimes growing exponentially on their first day of trading. (One even popped up 978 percent before settling down at an unreasonable 606 percent before close.) As a result, gas-station attendants, college students, bankers, teachers, and retirees were all cashing in on these gargantuan returns. People who picked the right horse, which seemed like pretty much any horse, were able to sextuple their net worth in a single day—at least on paper.

Now countless people from all over want this to be a bubble and they want it to burst. There are the taxi drivers who have lost their jobs to Uber; hotel owners who have seen their rooms sit vacant as people sleep in Airbnbs; newspapers that are at the mercy of Facebook’s algorithms; booksellers and retailers who have been in an unrelenting war with Amazon; the elderly, who can’t keep up; the music industry; television producers; and, perhaps most of all, San Franciscans, who would rejoice in the streets if their rents fell from totally insane to merely overpriced, or if they could get into a decent restaurant on a Monday night. The bloggers who cover the technology industry would write a thousand jubilant think pieces saying “I told you so” to the venture capitalists who sneer and scoff when anyone comes close to mentioning the word “bubble.” As one prominent tech reporter told me, “Frankly, wiping that smug look off Marc Andreessen’s face—I can’t wait for that.”

Andreessen declined to speak to me for this piece, but his argument against the bubble is well documented. It is based, in part, on the fact that it hasn’t popped yet. (“Where’s the kaboom?” notes his Twitter bio. “There was supposed to be an earth-shattering kaboom!”) But timing these things isn’t easy. As the British economist John Maynard Keynes is said to have observed, the market can stay irrational longer than you can stay solvent. And calling these things early is a part of the process. Patrick Carlisle, chief market analyst at Paragon Real Estate Group, in San Francisco, has studied the great financial collapses over the past 30 years and said nothing ever happens when you think it will. “People started to talk about bubbles in 1998 and ’99, and said it can’t go on,” he said. “But it went on for another two years.”

The real difference may be that the biggest tech companies—Apple, Amazon, Facebook, and Google, among them—are indisputably now part of our social fabric. So perhaps this bursting won’t be as big and sudden and cataclysmic as the last one. Instead, things could simply slow down like a large tractor with a small hole in its tire. Maybe the “kaboom” will be a number of smaller, quieter pops—more like a correction—set off by something seemingly unrelated, whether it’s the collapse of Greece’s financial system, the fall of the Chinese stock market, or, God forbid, the election of Donald Trump. Meanwhile, according to CB Insights, start-ups have died at an average of one per week in 2015. Many wondered if we were getting the first intimation of the kaboom in August, when the Dow fell 1,000 points in the initial moments of trading hours.

But in whatever form this pop happens, some worry it could be worse than the last time. When the dot-com bubble burst, the Web was still in its infancy. Now, according to a McKinsey & Co. report, by 2011 Internet-related consumption and expenditure exceeded that of agriculture or energy. As Noah Smith, the noted financial writer, explained in July, the danger is not that we’re in a tech bubble but rather that we’re in an “everything bubble,” in which any one of these events could be the domino that makes it all fall down.

Ironically, whenever the kaboom happens, and in whatever form it takes, the people who are most protected will be the V.C.’s themselves. Most of them learned their lesson from the last bubble, and this time around have set up deals to ensure that if a company goes under, or has to sell itself for parts, any leftover money will go directly into their coffers—to “make them whole,” as the saying goes in the Valley, ensuring the investors get back what they put in. This doesn’t protect the hundreds of thousands of people who now rely on a paycheck from the errand-running start-ups or taxi disrupters. Nor does it help the mom-and-pop businesses that have bought into the hype of Zynga, Yelp, or Twitter, and invested their savings, which continue to plummet.

But don’t worry. This time is different.

Courtesy of Vanity Fair

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Are Profit Margins Sustainable: RBC

Stock markets have enjoyed a banner half-decade, forcefully reclaiming the ground lost to the financial crisis, and then some. This vigorous performance has occurred thanks, above all else, to two key enablers: surging earnings and recovering valuations. On the surface, there is nothing especially questionable about either. Earnings naturally rise as economies grow, and valuations recover as risk aversion fades.

However, a closer examination reveals a significant vulnerability within this cozy equation. Corporate earnings growth has been, in a sense, too good – persistently outpacing both revenues and the economy. This has driven profit margins to multi-decade highs.

Worryingly, profit margins have long been assumed to be mean-reverting, arguing that these juicy gains may eventually have to reverse. Such a scenario would necessitate an eye-watering one-third decline in the S&P 500. With stakes as big as these, a clear sense of the downside risk is imperative. This report evaluates the seriousness of the threat by seeking to understand the forces that have propelled profit margins higher, and their likely direction in the future. In so doing, we find that a large number of previously favorable profit-margin enablers are on the cusp of reversing, including the advantages of low borrowing costs, deleveraging, soft wage growth and deferred capital investment. The decline in these drivers suggests that profit margins could suffer.

Fortunately, there are a number of under-appreciated structural forces that continue to support high (and in some cases, even rising) profit margins, including globalization, automation and a compositional shift toward higher-margin sectors.

Grab a cup of coffee (maybe two), sit back and read the full RBC PDF here.

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