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- [00:00]
A
We're excited to announce the launch of a new podcast, the Jim Paulson Show. We have followed Jim's work for most of our careers and have always respected his balanced and data driven take on markets. We are really excited to launch this new monthly show where we'll get Jim's take on the major issues impacting both the economy and markets. We have included this episode in the Excess Returns feed, but if you want to keep receiving new episodes, you can subscribe to the Jim Paulson show on all major podcast platforms or our YouTube channel using the links in this episode. Description thank you for listening. We hope you enjoy the new show.
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B
Something has changed the the the range of valuation and I don't it's not likely to go back anytime soon. If it does, it'll be shocking because something else is driving this into new ranges. Now if we were we were to adjust that valuation range, one thing is interesting. It it suddenly comes into a consistent range all the way through. We no longer have this new valuation range. We have the same valuation range. If you're a stock investor, we have recession once every two years or three years like clockwork. Now in the last 25 years we're down to 10%. We've been riding the red risk return frontier and we're about to shift to the green. We are starting to move up. Monetary stimulus and fiscal stimulus is staying pretty high. So we could run in this cycle on red and then shift to green during the balance of the cycle or at least for a good period of time. And that would be a boon for investors.
- [01:31]
C
Jim, it's great to have you back. Our audience always enjoys these discussions with you and today what we thought we would do a little different. I guess we're going to do a deep dive into market valuations where we stand today, how valuations compare to history and what the data tells us about maybe some of the broader investment landscape that we're looking at. And then trying to think through and talk through a little bit, you know, what might be the drivers of some of this higher than average, at least historical valuation, which I think that's going to be sort of a good interesting discussion to think about what could be contributing to that. But like all of the shows with you, this is going to have a number of charts and what you're going to have a lot of charts and not one single metric as the audience will see, but you know, kind of looking at things across multiple perspectives and indicators to try to help our audience sort of make sense of where valuations stand today all of these charts always come from your substack pulse and perspectives. That's paulsonperspectives.substack.com Some of your research is free, some of it is behind a paywall. But we certainly encourage our audience to go and sign up and sort of be on the lookout for what Jim's, you know, putting out there, which is great research. So, so thanks Jim for your time as always. Be before we, we get into the, the valuation sort of discussion, we thought it'd be good just to think about. You know, it's been about a month since we've talked. There's been some interesting developments in the market. We have the government shutdown, we have the Fed, the lowered rates yesterday by 25 basis points, Nvidia hit $5 trillion market cap. So there's a lot of things going on and we just thought, you know, to start we'd like to get your sort of thoughts on some of the developments that you're paying attention to and what you think investors should be paying attention to in the here and now.
- [03:29]
B
Well, first, thanks Dustin and Jack for having me. I always enjoy coming on and visiting with you guys and appreciate the exposure a lot. Any old analyst hack always likes to get an idea or two out. So I appreciate it. You know, there's, I guess, I know some of those are hot, hot things at the moment. A lot of that stuff I'm not too worried about, I guess like the Fed and the, but there's two things I guess on that I might just throw out that people maybe keep a little thought on. I think the biggest thing that is that I'm still just drawn to and comforted by maybe is just the amount of fear and pessimism that exists. And I, I really think this is the biggest positive force for this entire bull market has been a perpetual huge wall of worry and it just won't go away. And I think, I think that's, that's the biggest thing driving the bus here. You know, consumer confidence is still at an all time record low or within an eyelash of that measured by, you know, University of Michigan sentiment, the CNN Fear and Greed index right Now, I think said 42, which is in the fear category below the median of 50% even though the market's at a record high or very close. The Fed is scared enough to ease that. That'd be my takeaway. You know, they're, they're fearful finally and that takes a lot, when they were so, you know, fixated on inflation that they're scared enough to ease gold is, you know, since we last talked has exploded to new record highs. And not just exploded, you know, completely atomic bombed upward. And you know that to me is the quintessential fear asset. You know, gold is, gold is the SAF or whatever worries you at night and it's exploding. Higher Money Market Funds, $7 trillion Percentage Possible Personal income, it's rocketing higher. Close to record highs overall. And then we got all these little one off things which I find interesting. Jamie Dimon comes out last month. You know, it says he sees cockroaches that are infiltrating the financial system across the globe. Very, very frightening comments. Bill Gross says that a 4% 10 year looks really ridiculous. Given government debt, it should be four and a half to 5%. Andrew Ross Sorkin comes out with the book 1929 and goes on 60 Minutes to suggest that this is where we're headed again. And it's, you know, I'm sure it's coming out. The reason it's coming out because we're coming up on the 100th year anniversary and you know, it's it that's, that's been thrown out there. We still got a steady diet of trumpetility, you know, you take your pick. It's all, every month there's something new. You know, now we're bombing drug kingpin boats off the open seas, we're raising tariffs on China and we're sending troops into cities, you know, on and on. And then I think, I think probably the biggest thing that's kind of affecting investors the most is this chronic and constant comparison for many quarters that this market is very much like the dot com market with AI stories and everything else. It's very comparable. You know, that's enough to scare any good old veteran investment guy. That was a three year collapse, 50% decline in the S and P and much worse than a lot of the most popular tech area tech sectors. So I think there's, I'm not, I'm not necessarily as fearful as these things suggest but I love the fact that there's a lot of fear. I think by the time this bull market is finally done we will have a lot less advertisement of its demise going on and a lot less warnings about it. And I think it's comforting to me when I still see kind of this month this much going on. Second point I'd say is probably sometime in the next few weeks, probably before we meet again, we have set up a situation that's going to create perhaps a lot of volatility and that is we're going to start re releasing economic reports. That's the point. And right now we're all kind of out in the blind and that what that does is we're not totally out of the blind but it sets up a situation now where the VIX could really explode for a few days as we start re releasing and people re gearing their thoughts on where we think we are. I don't know. I don't know the answer to that. I mean we don't know if we pick back up or we've continued to weaken or inflation's gone up or has it or there's going to be a lot of questions that will be looked at consensus opinion form. Now we're not totally the blind and I would suggest that investors watch some of the non governmental releases. There's really quite a number of them. You know, you got ADP conference born, University of Michigan, National Home Bearer association, the mba, a lot of the regional Fed, Philly Fed, New York Fed releases are still coming out. But I'll tell you what I'm watching the most is I'm watching some market action which kind of tells me, I think where, where some of the momentum is in the economy. Two big ones I'd point out, look at the relative performance of the S and P cyclical sectors and they are just dying. They're down 4.2% since we closed the government. Okay. And the end of September, the relative price of the cycle sectors, that's materials, industrials, consumer discretionary and financials within the S&P5 to the overall 5 is down over 4% since the end of September. That's a pretty big collapse. I don't think that happens unless the economy is weakening. That there's a lot of investors with big money bet on that there's some economic weakness going on there. The other thing I'd point out as I watch an index of inflation sensitive equities, there's actually an ETF for that BIFN nf, I should say binfo and that that one is down two and a half percent on a relative basis since, since the government releases closed. That's, that's, the latter is pretty closely associated with CPI movements, annual safari inflation, the former with the Citigroup Economic Surprise Index. Even the GDP now numbers, it's pretty highly correlated. And I both are saying weakness is where I'm looking at. But there's a real chance that there's going to be a lot of you know, up upsetting with that overall could be from when they do come out, the last thing I'd say is, you know, watch kind of. I, I, I do see some broadening going on in the stock market. I mean, we still have a lot of the media attention on AI and tech, but you know, there's a lot of broadening going on. We're seeing Micros and smalls, IPOs, low quality doing, doing a lot better. International stocks doing a lot better. We haven't seen large cap value really turn yet overall, but we're seeing also a pretty big decline in some of the defensive sectors like low vol investing on a relative basis. So I think in the undertow, the market sort of reacting to easing. I think it's starting to react to easing. We got the money supply going up. Yesterday's report, they're going to quit qe, which means money supply is going to increase even at a faster pace. You got the funds rate, you know, coming down. You got bond yields coming down, you got the dollar that's been coming down. And you're starting to see that show up in broader participation in the stock market for the first time. I think that's a good sign. It's like the start coming out of recession, start of a new bull. So those would be some of the things that I'm kind of watching a little bit and probably most interested about. We're all going to get a retrofit at some point on the economic data when they decide to reopen the government.
- [11:33]
C
So that's a solid and thorough overview. And to your point, you made about, you know, a lot of investors. And I think this will kind of get flushed out as we get into this valuation discussion. You know, a lot of investors look at today and they compare it back to the late 90s.com boom and bust because valuation levels are somewhat similar. Maybe not as high depending on what you look at, or maybe even higher depending on what you look at. But before we start working through these charts, you know, I wanted to ask, how do you think about using market valuation overall in general? Like, how do you personally, where is it useful and where is it not useful? So for example, we know that valuation can't be used particularly as a timing tool, right? But when you think about market valuation, how do you think about the way investors should be thinking about it?
- [12:28]
B
It's a great question, Justin, and I don't have a great answer because I'm still thinking through all that issue myself. To tell you the honest to gosh truth, I this is a guy that 43 years ago cut my teeth In a value shop, value stock shop. And that's where I learned and it was, it was all about value. I think I've told the story where I started that I didn't look at any stocks that sold at a double digigit multiple. They had to be single digit multiples or less. And quite frank when I started. Multiples have been single digits for a decade by that point. And, and so it was all about value. And so I, I came from that point to kind of over the years kind of embraced other methodologies including growth and other things that we just didn't really buy much of in my first shop. And so you're talking about a value guy, you know, deep in his roots. But I've, I kind of divorced myself from it because I, I just kind of believe, given what's happened and we'll talk about that. With valuations kind of going off the rails from any kind of, of range or normalcy, I think it's led a lot of people to make bad decisions about their investments. It's probably caused too much conservatism for too long a periods of time. All on the basis of this has to crack. This is way too high and it's cost a lot of money. I think we're still in the midst of a change that's going on in the valuation universe and until that shakes out a little more, I, I'm not going to trust it a lot and we'll kind of get into that. But you know, where, where does that leave you? That's the question. I think that there's, I think I want to look at, you know, what's the environment around the market, is it hostile or, or supportive and spend more time there than on where the mark where the. Trying to figure out where the market, if it's fair value or, or less than fair value. I'd like to spend more emphasis on where is Senate. You know, as I, as I started the show today with. Is there really an outcry in exuberance today? You know, there's, there's generally some high correlation between valuations and sentiment. You know, exuberance come with high valuations and low valuations often come with passive influence. Um, I don't see high, high exuberant attitudes today, whether it's debatable, but I, I certainly don't. And so I, I think those two things, I look at supportive or hostile environments and I look at sediment surrounding them. You know, you think about sentiment, a bear market is taking sentiment from an exuberant level down to something much less. That's really what a bear is about. It's readjusting sentiment. And you can have values wherever they are. If sediment gets too high, there's risk even from low valuations. Like I said, when I started, we had low valves for a decade or more and I could tell you we had bear markets from very low valuations. It didn't matter. So I, I, I, I'm kind of, I, I wouldn't say divorced. And I'm not saying they still don't have some value. Like I said, it's not timing value, but it certainly is longer term. They, they do still provide some input. We'll visit a little bit about that. But I, I'm kind of think you ought to focus a little bit more on some other aspects and still have where you are and value in your head. And I, I think most people have a sense of, you know, where values are by, by, by historical standards. Everybody kind of knows. It's more a question of how much weight you're going to put on those in your investment philosophy. So the short answer is I don't really freaking know what the engine could be. I'm, I'm flying like everyone else.
- [16:31]
C
That's okay. People can, people can make their own, you know, as they listen to you and see these charts, they can make their own decisions and see where the road takes them. I think that that's part of, like the learning process as an investor. This first chart, Jim, is, you know, the CAPE ratio is one of the things that a lot of people point to saying, you know, it's much higher now than it has historically been. But I think it's very interesting what you've done in this chart with charting the old valuation range versus sort of the newer valuation range with the CAPE over the last maybe 20 years or so. So I'll let you talk to it.
- [17:06]
B
Yeah, yeah. This is just The Cape Shiller PE multiple going back to 1900. On this chart. I, you could take it back to 1870. It's in that same range really from 1870 up through the 90s. The, it stayed in that very normal same valuation range roughly around 6 or 7 to the 21 area, something around that range. I grew up with a 7 to 21 in my head and largely because of this history and the, what I have on there, the red dotted lines are essentially, essentially the 90th, 50th and 10th percentile range since 1900 up till 1994. And you could carry that back into the 1870s. It would hold Almost all of the history of valuation and you know, a key ingredient evaluation is it's only useful if there is a range guide. It's kind of like looking at something and saying is it heavy or light? Unless you have a scale, it really doesn't do much for you. And what we have had here is a broken scale of judging what's high and low valuation. Because what's happened in the last 30 years, at least for the KPE, is outside of about what, six months since 1994, we have been at the 90th percentile or higher of the previous hundred years of valuation. Think about that for a minute. It's, it's, it's quite amazing. And so you could, in 1994, when it broke above 20, you, you could have correctly said, oh, this thing's extraordinarily expensive. Well, it, it maybe was, but it's basically been the same position now for three decades now. If, if it, if you have one blow off in the dot com like we did there, where it went up to 45 times in dot com, the bubble and greed spans irrational exuberance. You can kind of, okay, I understand that we got it, we got out of control, we got ourselves back in control now and we're going to be okay. But no, this, this is now three decades and counting. Something else is going on here. Something has changed the, the, the range of valuation and I don't, it's not likely to go back anytime soon. If it does, it'll be shocking because something else is driving this into new ranges now. A lot of people have, you know, we've, we've adapted to this in many different ways. You know, some people start ignoring a lot more of the history before 1990s and just look at the last 30 years and that's okay, that's some reasonable semblance of, of new valuation, if you will. But I'll get to in a minute. The problem with that is this valuation range is actually continuing to drift northward. It's not like we jumped up to a new range and static again like I show here with the green dotted lines. It's not static. These all should be tilting upward. If you do it on a rolling 30 year basis. I don't know, it's still advancing higher and higher, so that's even got problems associated with it. But certainly to suggest, you know, that we're, we're selling at a level today that's, that's higher than we were at points past is to me a little value. And what this just asks more than anything is what the heck is going on here? Why have we had this sudden change?
- [20:32]
D
I've seen these cape charts a million times, but this is the most unique way I've seen it presented. Because this idea of the old 90th percentile has become the new 10th percentile. Probably explains this whole thing better than any other way I could explain it.
- [20:44]
B
Yeah, I think that's kind of what, what's happened here. And it's, it's quite amazing when you think about it how fast that changed overnight. And then I, I even thought it would come back after.com and it really has. And that's, that's where at some point along, you know, it hasn't been that long for me either, but a decade or more where I've just finally said, hey, something else is going on here.
- [21:05]
D
And when you think about all the like 7 to 10 year forecasts that the various shops put out based on this idea of mean reversion, you can see why they can be so different. Because the people that are assuming mean reversion back to the original, you know, 14 are going to call for horrendous returns that have been for a very long period of time that's been completely wrong. And then people have been calling to reversion to a new mean have been wrong too, but wrong by a lot less. So you can just see as you look at this how much this impacts those types of things that we see.
- [21:31]
B
Right? It does. And you, you know, and no one's right or wrong really. We don't know for sure. I mean the fact of the matter is, to your point, Jack, we went back to 14 in the, in the heat of the 09 crisis, right. We, we made it back there. We didn't spend very long there, but we did make it back there. This next chart, I, I just want to, I, I'm just trying to get at the fact that this, this isn't just a phenomena that's occurred among the largest 10% of the stock. It isn't just the tech stocks. This is a phenomenon that goes way beyond that. This data comes the Kenneth R. French database which goes back to 1950. And what they, what they do, this is annual data through 2024. But what they do is they take all the stocks on the New York Stock Exchange, NASDAQ and AMEX exchanges back to 1950 and look once a year at the PEs trailing price to trailing twelve month PEs of all those stocks. And then these are just the deciles. So that top blue line is the top 10th percentile based on valuation, based on PE. And the gray line at the bottom is the cheapest PE, 10, 10% of the stocks. And what I want to point out is basically let's go back to the end of the 60s, which prior to getting into this environment that was kind of the high watermark evaluations was the, was the growth run of the 60s leading up to the Nifty50 surge in the early 70s before it all collapsed. The last big great growth market, if you will. But, and so just compare it back to there and you got to go down blue, orange, gray, yellow, blue, maybe even green. You got to get down to like the 70th percentile before you find something today that's valued below where it was at that previous peak. And for the most part, most, most of this percentiles, even the yellow there, they've been the same today roughly at the 90th percentile valuations the same today as it was or back in 1990. Same thing with the yellow, you know, kind of the 50th percentile. They went up in the 90s and they've kind of been at those record levels ever since. You got to get to these maybe bottom two or three, the gray, the brown and the dark blue at the bottom that really are still below the old record highs. So there, there are the cheapest stocks out there, maybe somewhere between 10 and 30% are still back down to relatively low valuations today. But much of the 70% of all the stocks out there have kind of went up and stayed up over this period of time. So this is a broad based valuation thing. It's not like there's just a concentration of new era companies and the rest. This is pretty broad based where all valuations have kind of gone up in, in price and stuck, if you will, at higher levels.
- [24:28]
D
This, this surprised me a little bit. And then I would have expected maybe the blue line to have separated itself. It has separated itself some of the other lines, but given what I thought about the market, I would have expected maybe even more of that and, you know, less of this going on as you move down. But so this was, I, from that.
- [24:41]
B
Perspective, actually this is on a, this is on a log scale, Jack. And so the vertical distance is the same percentage amount. And so that if you look at the blue to the orange, the one below it, they really have been about that same distance even going back to the 50s and 60s most of the time. And most of those have been, when you look at it, it's not like there's been a too much spread a little bit to your point. But if there is, it's more like the top 70% versus the bottom 30 spread out. But most of the rest have kind of moved in their same ranges but just with each other. And I do think it's a broad based, this is just another way to look at some of that same information. But I, I'm kind of looking at the, the red bars. Look at those percentile or decile PE valuations, but they look at it only from the range from 1951 to 1994 and they say if, if I look at it over the whole period of time from 50 to 90 or to 2024, where do those, where do those percentile ranges come in? If, if I just look at where PEs were from 51 to 94, well you can see that they're all very low. Even top decile values or, or, or first decile values. We're talking, you know, 31% to 44% over the entire range. The flip side of that, if, if I just look from 1994 to date, you get the green bars, 1994 date with basically valuations across the spectrum are all 60% or higher percentile range. So again, just another way to say that not just the S&P 500, but the entire US stock market has done a big, big upshift in, in values PE valuations over the last 30 years.
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D
And on this next chart we're looking at the S&P 500 specifically in the percentiles.
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B
Yeah. Now this one I'm make a little different point. This goes back all the way to 1870 with the Shiller data on PES. And it's basically the S&P 500P ratio. And this is not Cape Shiller. This is just another way to look at it. This is the trailing twelve month PE which a lot of us have used and still use to some degree on the blue line. But what I've done there is that the green line and the purple line and the red line are trailing 30 year averages and then represent what would be on the green line, the 75th percentile at that point, the red line, the 50th or, or me median and the purple line, the 25th percentile of PE valuations over the previous 30 year period. So one way to do this, say rather than have this fixed range over the entire period from 1870 to date, what if we change, allow the valuation range to change a little slowly on a 30 year rolling year basis. Okay. This is what you'd get. But what strikes me the most is that middle bold red line. Now, I started right at the start of the 1980s and the history going backwards and my history going all the way into the 90s was basically the middle valuation range of the stock market was around 14, maybe, maybe 15, maybe 13, but it was around 14 most of the time. So you kind of had 7, 14 and 21. That's what I used to use bottom, top, middle. And 14 was gold for, for kind of an average valuation. But then look what happened starting in the early 1990s, mid-1990s, it just started to chronically drift higher. We have gone now over the last 30 years from 14 to almost 20 times earnings. The multiple of 20 times earnings in the last 30 years are very close to that is equal to the upper end of the valuation range in the previous 100 years prior to the mid-90s. It's now the average valuation of the stock market. And herein lies the problem of saying, okay, we've had this adjustment, now we can use this new range. Well, not if it's still drifting up. You can heck, five years, 10 years. Where is that red dot going to be? Is it going to be 23? Is it going to be 2510 years from now? In 2035, is the average valuation going to be 25 times earnings? You know, think about that. It's really hard to use these valuation measures until this settles into a normalized range again and again, really trying to figure out what's driving this thing higher.
- [29:16]
D
It's interesting because to your point, people usually when they look at this data, come up with two conclusions. Some people will say, all right, we're going to revert back to the long term mean. Some people say, no, we're going to revert back to the mean of the new regime. But you're bringing really a third point in here, which is the means going to keep going up. So we might not be reverting back to either one of those.
- [29:32]
B
I know. And it's just hard. It makes it hard to know what to use to judge whether value is high or low. And I, I think we've all been guilty of probably getting in trouble because we had some rule that we used that, you know, it got high on us and we cashed out and then we got run over a lot of the times. And I, I think, I think that's why I've kind of not abandoned it, but put down the list of what's important to me until I get some sense of the scale is sort of fixed again. And I know what the new range is.
- [30:06]
D
So the next logical question from the range being higher is why is it higher? And these next charts, we're gonna, we're gonna get at that. And you know that that really gets at the heart of the will they stay higher? Is maybe what are the reasons and are there justifiable reasons? So right in this first one, you're getting at something that you, that we've talked about in previous podcasts, which is, it's kind of shocking when you see it in front of you in a chart like this. But this idea that we've had less recessions.
- [30:28]
B
Yeah, by quite a margin. This goes back to 1880 and just looks at the recessionary risk, I think over the previous 30 years. This is a roll only if you could speak German with a rolling R. You got it. And that's, It's a rolling 25 year moving average of the frequency of recessions. And you can see if you go back to World War II, you know, 1940, a little bit before that, we had recession of, you know, pretty close to half the time in this country, you know, a lot of the time, once every two years. Think about that. If you're a stock investor and we have recession once every two years or three years like clockwork. Now in the last 25 years, we're down to 10% in recessions. And I, if you think about it, we, we had a one month recession in the last 15 years. One month recession in the last 15 years back to 2010, we had a recession lasted one month in 2020. And the only reason we had that wasn't because of endogenous cyclical forces in the economy. It was because of an entire exogenous event health crisis. If we didn't have that, we wouldn't have had a recession for over 15 years. Now if you certainly we all know that cyclical stocks, we, we always had to take their price to trailing 12 month earnings with a grain of salt because it was the rule of thumb you learned as a young investor was when the cyclical, the cyclical stocks were best to buy when their pes were astronomical and when they were good, that was too late for good cells. And that's because they have cyclicality involved in their earnings in a big way. Well, if, if you have recessions all the time, you just can't afford to pay up on that earnings stream if it's not very reliable. Right. But if you could have recessions and earnings continue to advance, they become More reliable, more predictable. Guess what? You pay higher and higher multiples. That's the reason why growth stocks get higher multiples than cyclical. And what we've essentially done by, by taking the recession risk out of the equation is we've increased the valuation you can afford to pay on more predictable earnings in a big way. You go from once every two to once every 10 years. That's a huge reduction in risk and a huge increase in the amount you can afford to pay for it. And I don't, you know, you can argue, are we going to suddenly have more recessions? Possibly, but I kind of doubt it overall.
- [33:06]
D
Well, that kind of gets to the question I want to ask you, which is, do you, what do you think the reason for that is? Are we just getting better at managing the business cycle?
- [33:12]
B
Well, I, I think I would put a couple things in there, Jack. I think that I, I think that if you go back to the 1800s and night early 1900s, you can certainly sort of see the, and this is interesting given today's, the debate today, you could see that we radically took down the recession risk this country. Once we introduced the Federal Reserve and once they had a few years to get their feet on the ground, I think their idea that we could use a policy official to support the economy, I mean, literally prior to that, prior to 1913, we just let the sucker rip. It was free market capitalism maybe. And there was no, there was no, nobody trying to moderate or help the cycle. Well, the, the 30s, or excuse me, 1913 Federal Reserve act was at least an attempt to do that. Now it didn't really even start out that way. It started out more with bank regulation than it did with really introducing support for the economic cycle. But, but I think that's one big piece of it that really brought that down a lot after World War II. And it wasn't just fiscal, but it also became monetary policy. I mean, Herbert Hoover, the president that grew up not too far away from where I grew up in Iowa, he, he decided to tighten fiscal policy basically in the Depression. You know, that was before we realized that that mattered and more or less. And so we do realize that. And you could see the difference that that's made. That's certainly been a big part of it. I think, I think some other things have been innovation cycles and I might come back to that a little bit later. But I would argue that companies that go in to innovation, if you have a big enough part of the economy that that can really shut down cyclicality for a period or recessionary. Impulses. Because when you introduce a new product that almost everybody in the marketplace has to have, it's just going to grow for a period. You can't hardly shut down. That growth regardless, has no sick count. Eventually as it becomes more mature, becomes cyclical again. But if you, if you have introduced innovation in here that's large enough, it can kind of run it right through cyclical recessionary risk. And I would argue of late we've had not only big innovation, but rapid and perpetual renovation. I think that's part of the reason that we're not seeing as frequent of recessions and then the last one more frequently. I would argue that particularly since the 2009 situation, and maybe just take the last 15 years, it's hard to have a recession when no one is really, when everyone's on their best behavior. So if you look at the debt to income ratios in the household sector, they've been falling steadily, that ratio since 2000, 2009, just steadily after rising during most of the post war era, it's been falling steadily. Corporate or debt? Corporate debt to corporate profit. That ratio has been falling for more than 10 years steadily. And what that tells me is that some of the things that get you in trouble, historically getting out over your skis, too much debt, not enough cash, not enough strong balance sheet that that almost mandates a recession has been lessened and eliminated almost by people being more conservative. I don't know if that'll persist forever, but it's been a, a play of it of late. So I would, I would put those three things, that's just my guesses and I don't know if it'll stay this low, but I think in the near term, like right now, I think one of the reasons we haven't had a recession already is some of those same forces, particularly the good balance sheets and the high levels of liquidity that people hold, the conservative nature of people and their attitudes because they're scared and fearful that something's going to happen. So they don't over expand, they don't overspend, they don't over hire those things keep a recession away. Recessions need vulnerabilities and unless you create some, it's hard to have. So I think all those play a role, but it matters big. I'm much more willing to pay higher, higher percentage PS on an economy that's only recessing once out of every 10 years. And this shows up as you say, this next chart, Jack, with, with a high correlation to the frequency of bear markets, as everyone knows there's not a perfect correlation, but there's a high correlation and we generally have bear markets when we have recessions. And you can see that in here that they have somewhat of a similar type of chart. You know, if you're going to have less, less bear markets, you can afford to pay higher, higher p amount of higher valuations than you could have when they, when they occurred more frequently. So that certainly played a big role.
- [38:13]
D
In this next chart. You're getting at the trailing twelve 25 year stock returns versus this recession frequency.
- [38:19]
B
Yeah, and the only reason I throw this in here, it gets off the stair a little bit, but just shows a little possibility left in this thing yet. You know, the, the red line there basically is that, is that frequency of recession on an inverted scale. You can see it's going up, which means the, on the right side scale, the recession risk going down 10%. Then on top of that just the trailing 25 year stock market return. And there's been a fairly good correlation. It, it diverged there in the 80s and then caught back up again. It's diverged now. And I don't know if we continue to have 10% recession risk. I wouldn't be shocked if we have 12% annualized returns at some point here in the Future on a 25 year trail basis simply because that, that seems to be at least going back as far back as 1900. You know, kind of what has happened with stock returns overall. They, they tend to go up when recession risk goes down.
- [39:17]
D
And in this next one we're getting at household and corporate cash to gdp. So what do you think the big takeaways are from this?
- [39:22]
B
Yeah, I, I just think, you know, one of them, as I said, less recession, less bear market risk leading to valuations. I think another one is just liquidity. And if you think about it, you know, think about what the liquidity was of the stock market in the 50s and 60s compared to what it is today. Far greater liquidity. Far more people are involved in the stock market not only in this country, but around the world than ever were before. And we're liquid liquidifying it the heck out of things. We're flushing the entire economy with massive amounts of liquidity. And really a big chunk of this kind of started bottomed out in the early 90s and it's been going up ever since. This just shows the total liquid asset holdings of households and corporations as a percent of GDP from 1948 to date. And you know, basically until you more recent years, you didn't really get up that much above, you know, 60% or so. Well, we've been in the last few years now riding at 75% or more, basically cash to GDP ratio. And, and that's a huge boon for, for stock and financial assets in general. You got all this excess cash. Are you going to do it? You're going to invest some of it, right. Some of it goes to savings accounts, but some of it finds its way into equity markets. And just having greater liquid markets, I think leads to higher valuations or less risk. And I do think we've had a much more liquid global stock market than we used to have.
- [40:57]
D
This next one gets at profit productivity, which we've talked about in some of the other episodes. But this would be a good argument, I think, for higher evaluations. Right. If we're making more profit per employee, you would expect valuations to be higher.
- [41:07]
B
Yeah, and that's all this is showing. This just goes back to 1940. And the blue line there is the Shiller PE again. And the red line is real corporate profit per job in the United States. And I think what's telling about this is just that real profit per job went nowhere from 40 to the early 90s. You just traded sideways the same profit productivity per job, and then suddenly it's exploded and literally it's gone, you know, basically up from 0.5 to 1.5. It's triple. Profit productivity in real terms has tripled in the last 30, 35 years. Why wouldn't you expect that the valuation of the stock market would go up a lot too? You know, if, if you, if you've got employees that suddenly you think about the one thing that matters for stocks, the one thing that matters for corporations. It. It's not even so much do I have laborers that can produce more widgets every hour. It's more about what do they do for my bottom line. And if they triple my bottom line in real purchasing power, man, that's really valuable. And that's what this, that's kind of what the Cape Shiller P multiples telling you. Do you think that red line's going to dissipate tomorrow? I don't think so. I think it's up there. It could trend sideways again, but it's up there because of technology. It's up there because of innovation. It's up there. We're making labor more profit productive because of its mix with capital.
- [42:35]
C
I mean, it almost seems like what, you know, AI could even fuel up more. That could be an argument for, you know, this thing continue to go I hadn't really.
- [42:44]
B
You're right, Justin. I. You're right. And that's sort of the headlines of the day. Just, they don't say it that way. But, you know, AI is leading to less people. I mean, we just had all these layoff announcements this week. A lot of those, Amazon, a lot of those are. People are kind of quoting a little bit of AI. And so that's certainly going on now. This next chart, I just had some fun. I mean, you wanted fun with valuation. This is one. And what I'm doing is taking the KP multiple and dividing it by the red line in the forward chart, binding my profit productivity. Now, there's nothing in the CFA manual that says this is good or accurate or anything or in my economics textbook, but it's just one way to look at it. I think it's a way to say, look, you know, if we were to adjust that valuation range, one thing is interesting. It suddenly comes into a consistent range all the way through. We no longer have this new valuation range. We have the same valuation range, which is sort of an attractive feature evaluation, which I pointed out. And it also shows that the dot com was an utterly ridiculous, irrationally exuberant run in the stock market. Kind of shows that the 60s got pretty exuberant. But it doesn't really say that since dot com and since the great financial crisis and since the. The pandemic health crisis, that we've had irrational exuberance of this. It says valuations are really reasonably priced today. At least it challenges your thinking. And quite frankly, this part here, from 2010 on, when it's really been low, doesn't that jive with some of the other information we keep hearing off Main Street? People aren't very excited about their futures in this country. They're pretty darn pessimistic. You got. CEOs have been warning about how bad the economy is for quite some time. You got. I mean, in some ways this valuation critique sort of fits the narrative of the day. Much more so than this idea that we're at all time record highs or close to anything like dot com. But hey, this is just a figment of my imagination. That's about all it is. But I just thought it was interesting.
- [45:03]
D
Well, I'll take it in the video. I'll take the original one, the first slide we did, and put it alongside this one right now, because I think that's. It's really interesting to look at those two next to each other, because that whole problem that we had in the first slide is now gone.
- [45:13]
B
When you look at it, it went away. That's one, one way to take care of it. Which is interesting and I, I just think I would have taken this back further by the way, Jack, but the data on, there's not data on profit prior. That's the problem with it.
- [45:25]
D
So in this, this next slide, we're looking at the forward multiple. So what are you taking from this?
- [45:29]
B
Well, the reason I want to visit just a minute about this is because I think this is one of the defaults that we've all gone to in terms of this new valuation range. When I started in the 80s, there was no forward model, there was no data on forward, there was no forward earnings estimates, there was nothing like that. That really didn't come around until the late 80s where the people started to collect some of this and estimates and forecast. And since then it's become kind of the, I would argue it's probably the valuation multiple of choice in more recent years. Not. So no one wants to use trailing. And you know, we used to debate a lot is a trailing 12 months ride or should we have a 5 year average or a 10 year weighted average of earnings to appropriately measure value? That's kind of gone now because people basically use this price to forward earnings more in this chart. You know, it still has stayed at least since 1990 because that's all the further back we go, which is convenient since the valuation range blew up right, right at, right before this. But we don't have any data back there. And what we do know is we got a stable valuation range and values look very high today. In fact, they're pretty close to 2,000. But I do think there's an issue or problem with this and I personally believe that this is basically more a measure of sentiment than it is evaluation and it also isn't that good. So if you go to the next chart, this, this next chart looks at the forward one month average annualized stock market returns from the, from each quintile of the 412 month P multiple from the previous chart. So when you have lowest quintile pes, you got about, you know, just shy of 12% annualized forward returns. Sounds pretty good. The problem with it is from the highest quintile pes, you still got about, you know, 9 to 10%. Not, not much different. In fact, the, the second quintile, lowest pes that give you a lot better returns and even there's nowhere on here that just washes you out. I mean, and as I said, the highest pes do you do pretty well. So I don't really think the 4pmultiple gives you a lot of edge if you're basing your judgment on it. And yet a lot of us do base our judgment on that. The other thing that bothers me is I think it's just a sentiment measure. If you go to the next chart, what I did here, the red line is just the conference board bulls less bears investment survey among consumers. Are you bullish and are you or bearish and taking the percent bullish list those bearish and just looking at the 12 month growth rate of a 6 month average, 6 month moving average and I've laid that on top of the forward 12 month EPS, the annual growth rate in that which is the blue line and they're essentially the same chart. That is to say that when people get bullish, forward multiples go up, people get bearish, forward multiples get down. And I think it has a lot to do with, with people. Bullishness goes into earnings if you will, one way or the other. And essentially what you're doing is basing your valuation approach on essentially sentiment. Now that's not necessarily bad because sentiment is a, is a decent measure of risk and reward in the stock market in the future. As we all know, when people get really bullish, returns tends to diminish and when they get bearish they tend to go up future return. So it's not horrible. But I don't think we should kid ourselves that the forward price earnings multiple is a true valuation guide or some kind of independent metric. It's really a sentiment measure. Just another one of these next few.
- [49:31]
C
Charts you're getting into looking at like technology communications and then mid and small and value and growth. So let's kind of work through these here.
- [49:40]
B
Yeah, okay. Just I, I think this is getting more to current situation a little bit and I, there's this real concern about the division of the S P500 into new era and Old Era. I, I think it's there, I, I share that, that view and this kind of brings us up. I went back and just recalculated the underlying trailing 12 month price earnings multiple for the newer two new era sectors which is in red and Market cap weighted them appropriately relative to the other nine sectors in the S&P 500 and market cap weighed their PE trailing PE, which is the blue. And no doubt there's been a huge division in the valuation of these two parts of the stock market. Technology has gone way up. Now you can't compare this back to dot com because when I look at trailing on communications and technology, particularly communications back into that period, the dot com, they went away, earnings went negative over there. So multiples went through the roof with negative earnings. But it does give you a sense that this has been a very concentrated bull and we've driven the valuation of, of this new era sectors to pretty darn high levels at 36, 37 times earnings right now. But as you can see before we leave that chart, the rest of the market, the blue line here is not all that badly priced. So 9 of the 11 sectors of the S&P 500 market cap weighted are, are not expensive. They were a lot more expensive at the top of the last bull market in 2021 for example and they're not radically different for where they were in much of the 2015-2020 period. If you go on to some of these other ones, I just, I just want to show that there's a lot of this market that's still relatively cheap on a basis. So this is the price to trailing twelve month P ratios for the S and P mid cap and blue and the S and P small cap in red. They're really reasonably priced both of them. They have not, you know, been driven up to very high level. This isn't a relative pe. Relative pe they'd be down in the dirt super cheap because of the impact of the valuation overall from tech. But just on absolute basis they look pretty reasonable. If I go to the next one, this is looking at a few other aspects of the S P. Just the S P you can see the red one is the growth index of the s and P500 which includes mainly those tech stocks and communications. That's up a lot. But then if you go beyond that, look at low volatility in gold. Look at the equal weighted S P equal weighted index in green or, or the S P value index in blue. None of them I, I don't think show much, you know, excessive valuation at all in this market. I would say a big differential between this and dot com. I, I think is there are other differentials too but the biggest one that there wasn't any earnings of new era back. A lot of those companies didn't have any earnings today. We do have earnings on this new era part of our economy but the other big difference is I don't, I think a lot of the rest of the stocks on a relative basis were cheap but they weren't as cheap on an absolute basis today. They've stayed pretty reasonably cheap overall and that's kind of what I wanted to.
- [53:09]
C
Bring out with these we had before we move on to this next chart, Jim just we had recently on a guest that was talking about the capex build out by the major tech companies and he was kind of making the point that you know, these companies are kind of moving from like an asset light business model into like asset heavy and sort of looking at other backpass boom and busts with the railroads and also the telecom build out in the Internet and just sort of saying that like the, the makeup of those companies is kind of changing as they invest, you know, hundreds of billions if not eventually trillions of dollars into the so it's just interesting to think about that in terms of like the growth like these, the growth is to your point is these companies are great companies minting money. The Mag 7 They're awesome businesses but you know their businesses are kind of changing a little bit with like this, this big build out. So it's just going to be interesting to see how that plays out with like that cohort of stocks that have been darlings and leaders and delivered in spades, but they're now spending a boatload of money on these, on this big infrastructure.
- [54:21]
B
So anyways, just it's a great point Justin. I, I, I, I thought I can remember when there was the after dot com, there was the build out of fiber optic by the telecommunications company, really telephone companies at the time and they all buried their fiber optic cables down the rail beds across America and much those never did pay off for a lot of those companies. They ended up going bankrupt, they get bottled up, whatever. And that was a change in kind of what they did and how they did it. And I think here you make a really good point that they're changing their stripes a little bit of their business. I have written recently over the last year, a couple of years about the economy and we talked about the last time commie split between new era and the rest. The rest is cyclically related to policies and the like. But this new era part really has divorced itself from those cyclical concerns, including policy. If you, if you got a product that everyone needs, what do you care if rates are 10% or 0 or the money supply is strong or weak or fiscal? It doesn't matter. They're going to grow right through that. But to your point, to the extent that they're changing their stripes, their business from more service based contracts to heavy capital investment, they sort of take themselves closer to like an industrial concern a little bit. And one of the key things I think to figure out as we go forward here is we know what drives the old economy cycle. We don't really know what drives the innovations. We don't know the warning signs of the innovation cycle. That's a tightening and it's going to go down, or vice versa. I think we're still learning about that and trying to understand it, but I think to those that could find leading indicators for that, I think it's going to pay off big, because I think that's going to be a big thing to think about. My, my, my feeling right now and has been for a while, is that I think tech's going to underperform over the next year or two. I don't think it's going to collapse, but I think it's going to underperform. But I do think, as you point out, there's some interesting things going on as they change their stripes and make themselves acceptable in other ways.
- [56:42]
C
So we got two more on the valuation here. Let's go to this next one.
- [56:47]
B
Yeah, this is real quick. I just, I, I just thought this was interesting. There's 72 separate industry groups. If you break out the S and P, I just took from Bloomberg back to 1990 and I, I just looked at the percent each month of all 72. What percent of those are trading at a below average relative PE that is below the 50th percentile over the entire period from 90 to 2023. And this is kind of the chart. And you can see we've got currently, you know, more than 70% of those 72 industry groups are selling below average relative PEs right now. Now, that's testament to the concentration of the bull, but it's also testament to, there's quite a bit left over on, at least on a relative basis, that's pretty cheap. This is not like you were sitting, for example, necessarily at other, other times in the past. We've got a lot of relative cheapness out there.
- [57:43]
C
So to give the audience just a little inside baseball, Jim, we talked about this episode and Jim sort of pulled some charts from all his substack articles and sent, you know, a bunch of those over and then we pulled those. And I got to be honest, when I saw this chart, Jack, you remember what I said? I was like, I have no idea what, what this chart is showing, but whatever it is, it's awesome because I just, I just thought it was like, I, I don't know, like this boomerang thing. I was like, oh, my God, this is great. So I'll let you talk to it, but it's a cool, it's a cool looking chart for sure.
- [58:13]
B
No, I think it's just the colors. I think it's the colors.
- [58:15]
C
Yeah, that too.
- [58:16]
B
I didn't use Viking, Viking purple though in there. I should have.
- [58:19]
C
Yeah, you should have.
- [58:20]
B
I got Packer Green. That's not good. Well, I, let's just look at the red one in the middle. And, and what this is, is it's called a risk return frontier. And all that does is it looks at different stock and bond combination portfolios. And if you start here, down on the, on the, on the downside of the, of the boomerang there, the, the dot there, that's 11% standard deviation and 6% portfolio annualized total return. Read off the bottom and left scale. That dot represents a, a portfolio that consists of 100% bonds and 0% stocks.
- [59:00]
C
Okay.
- [59:01]
B
If you go to the other end of that red boomerang, the one that's 14% deviation and 12% returns, that represents 100% stock portfolio and a 0% bond portfolio. The ones in between I believe are 10% increments. So you go 90, 10, 80, 20, 70, 30, 60, 40. The 6040 dot over there is on 9% risk and 9% returns. That's the, the minimum risk stock bond portfolio that you can achieve based on historical stock bond returns. So that's what we're looking at. It kind of is the trade off. You know, if you start with an all bond portfolio, it makes sense to add some stocks because the inverse correlations, low correlation allows you to not only raise your return but simultaneously lower your volatility. And this is a standard financial sort of construct. It's been around forever showing the trade off and risk and reward between stocks and bonds. If you want max returns, you want all stocks, but you got to accept higher risk. Okay, so I, the reason I start with the red because what I did is I looked back to 1948 and I created four different risk return frontiers based on the pol economic policy regime that existed during those months. So the red one is the environment we've been in during much of this bull market that is high fiscal juice and low monetary juice is the red risk return frontier. And I would argue that we've been oscillating across that boomerang if you will, for most of this bull. There's still you get better return for stocks than bonds and higher risk. But the question, the reason I bring this up is I, I, I looked at four different ones. Fiscal low monetary high is the blue one. Fiscal High monetary high is the green one. Fiscal low monetary low is the yellow. And it's interesting, they all are different. Sometimes they shift up, they shift down, sometimes they elongate, sometimes you don't have as much risk, trade off, whatever. But what I really wanted to bring home was I think we've been riding the red risk return frontier and we're about to shift to the green. We are starting to move up. Monetary stimulus and fiscal stimulus is staying pretty high. So we could run in this cycle on red and then shift to green during the balance of this cycle or at least for a good period of time. And that would be a boon for investors. All bond portfolios go from returns on average, at least historically, from about 6 to about 9. Stock returns go from about 12 to about 17. Risk also go up to some degree. But my point is, is that going from a fiscal high monetary low to both high could be a real boon of in the last half of this bull, if you will. And I think that's kind of where we're shifting. I don't really see fiscal coming down a lot near term. And I think you see monetary starting now to accelerate and that that'll affect both stocks and bonds in positive fashion, or at least it has historic. Is that.
- [62:18]
C
Yeah, that's great. No, that's a, that's, that's an excellent overview of that chart and all of these charts. I'm. I know Jack and I, and our audience is super happy that we were able to go through all this with you. I think it's, it's sort of important stuff to think about. Like, one of the things that I'm sort of trying to wrestle with is I'm interested in your take on this, like to your point about there being less recessions and you know, maybe that there, there just seems like maybe there's less risk. And so if you would think that there's less risk, you would think that maybe like the risk premium would come down over time. But if anything, stocks have given like a higher return. So those two things sort of seem a little bit at conflict with me. And I'm kind of wondering like how, how you might respond to something like that, like in thinking about that, because it should be like more recessions, more risk, investors need to be compensated for that risk, so the return should be higher. But it almost seems like it's going the opposite way here. Do you know what I mean?
- [63:19]
B
Yeah, I hear what you're saying, but I think that you also kind of look at where bonds are today. I think Bonds are in a perhaps different situation as well, to some degree. I mean, if you were. Let's just compare the comparison to 1980 today where you'd look at bond yields being as high as they were and the odds of bond yields going down fairly good, probably, particularly if we ever addressed inflation, that would have been killing us for a decade. And there was great returns possible from stocks. So the excess returns over that period of time for stocks would not be necessarily, you know, all that, all that great. I think that today is almost the opposite of that situation where bond yields are relatively low by historical standards, which is in the back of, of people's minds, so they perceive a greater risk of, of higher rates, you know, at some point coming. I mean, a lot of people have talked about in recent years, the great bond bowl is over. Well, of course we hit zero yields. It had to be over. But the real question isn't, is it over? The question is, are we ever going to see that bear again? And, and I think that's, that could be playing to some extent with, with the, with the risk reward potential between stocks and bonds overall. One other thing, I don't have the chart in here today, but I've run this at times past and that is that there is a real big toggle switch historically. If I go back to 20, 19, 26 and look month to month at the excess returns of the stock market relative to the 6040 portfolio. Okay, you with me? If you are at a 4% yield, above a 4% yield, the differential is not that great. There's still a differential in favor of the all stock portfolio, but it's not that great. But once you get below 4% yields, the excess return from the all stock portfolio skyrockets. And we're right on that cusp of the, of the toggle switch. Well, we've been running this whole bull with not great difference, but we could fall now if yields go below 4% or go to 3, where the stock portfolio soundly beats the 60, 40 in a much bigger way. And I've written about that in different pieces here.
- [65:51]
C
Yeah, yeah, we'll have to pull that one in the future too. So just in kind of wrapping it up here, any final closing sort of takeaways, thoughts that you want to sort of share with the audience?
- [66:02]
B
Well, I, I think the only other thing I'd say, and I've kind of alluded to it, is that when I look at today's market, I, I really don't, I don't see where this is.com Redux or anything. Again, we got companies, as you mentioned, Justin, that have good, profitable businesses today. We, we've got companies that are probably even more innovative than they were back in the dot com era. In many ways, the speed of innovation and I don't think the valuations are anywhere as close to that. The, the size of tech within the economy is about 20% today, and the size of it makes up about 20% of real GDP today and it comprises about 8% of the economy. Tech spending in dot com, it comprised about 8% of the overall change in real GDP and it, it made up of about 2% of the economy. So we have, we have tech that's four times larger really in terms of size today than it was then. It should have an outsized impact today, which it is because it's much larger than it ever was. Here's the kicker though. Back then when tech made up 2% of the economy and I think something like 8, 8% of the stock market, it comprised 40% of the stock market's return. Today, tech comprises about 40, 45% of this bull return, but it comprises 30% of the stock market weight. So we're talking about 30% weight versus 8% weight, much bigger weighting. That's. And it's comprising about the same amount of decay. So in retrospect, the tech, I think is at far less risk today of collapse than it was in 2000. And I think that's a key thing you have to make a decision on. Do you think there's collapse risk for new era or do you think there's just underperformance risk? And I still think the latter.
- [68:08]
C
Thank you very much, Jim. We've really enjoyed this discussion. We will see you in late November, probably before Thanksgiving, so.
- [68:16]
B
Well, that's good. Well, we're, we're going to get past the spooky here.
- [68:20]
C
Yeah, yeah, yeah. We'll get past the scary part of tomorrow, so. All right, thanks. Thank you for tuning in to this episode.
- [68:27]
A
If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excessreturnspodmail.com no information on this podcast.
- [68:45]
D
Should be construed as investment advice.
- [68:48]
A
Securities discussed in the podcast may be.
- [68:50]
B
Holdings of the firms of the hosts or their clients.