Bubble Stock Valuations

Snapchat's CEO Evan Spiegel points out that tech stocks are in a bubble and doomed to crash at some point in time. This is refreshing since it comes straight from a CEO of an obscenely-valued tech stock. Mises Institute writer Ryan McMaken reports: Spiegel said the investment bubble is being fueled by an "easy money policy" and low interest rates, which may not last a whole lot longer according to recent economic indicators. Those low interest rates are funneling investments toward stock markets, hedge funds and, yes, startups. John Hussman explains that valuations based upon interest rates are only weakly related to reality in Why Stocks are Not "Cheap Relative to Bonds": If one cares about evidence, the evidence will demonstrate that the most reliable valuation measures across a century of market history are those that implicitly or explicitly adjust for variation in profit margins over the economic cycle. See Margins, Multiples, and the Iron Law of Valuation for extensive detail on this fact. The argument is not that record profit margins need to retreat at all anytime soon, only that history teaches that one should not base equity valuations on the presumption that record profit margins will persist for the next five decades. This is particularly true when we can clearly identify their temporary origin in exteme mirror-image deficits in the household and government sectors. For as much detail on this as one could wish, see An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities, and Profit Margins, Is the Ladder Starting to Snap? Indeed, across a wide range of measures including price/trailing earnings, price/forward operating earnings, the Fed Model, price/book value, price/dividend, Shiller P/E, Tobin’s Q, market capitalization to GDP, and even S&P 500 price/revenue, the ratio-based valuation measure most tightly correlated with actual subsequent S&P 500 nominal total returns over the following decade is the ratio of nonfinancial market capitalization to national nonfinancial gross value added (which I introduced in order to account for the estimated impact of foreign revenues). We’ll simply call this measure “market cap/GVA.” Call it the “Hussman Ratio” if you want it to be completely dismissed by investors here, and to suddenly become a revered valuation metric after all the horses have left the stable. Champ to chump, chump to champ. Bubble-era soundtrack of value investors everywhere. We're near the third peak in a Fed-induced bubble in equities and wondering why the economy can't grow at its historic rate. The answer is simple: you can't create wealth out of an ink pot. That's a lesson many investors have yet to learn even after three major stock market bubbles of the last fifteen years.

Posted in: Wall Street Trading