Crescat Capital Q3 letter to investors on the dangers in the US equity market and the cataylsts for a crash (not just China) below.
US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000. We prove it conclusively across six comprehensive dimensions:
- Price to Sales
- Price to Book
- Enterprise Value to Sales
- Enterprise Value to EBITDA
- Price to Earnings
- Enterprise Value to Free Cash Flow
Brutal bear markets and recessions have historically followed from record valuations like we have today, and this time will almost certainly be no different. Not even positive macro factors like low interest rates, low inflation, or recently improving earnings growth can justify today’s extreme valuation levels. As we show herein, that was the same backdrop that we had in 1929, the setup to the biggest market crash in history and the Great Depression. Optimism over “new-era” technologies are not justification for high multiples today; they are hallmarks of market tops. Artificial intelligence and crypto-currencies feature prominently in current investor enthusiasm, a climate akin to the tech bubble peak. Also, excitement over new pro-business and pro-economic growth policies coming from Washington are poor grounds to rationalize today’s valuations. Again, this is a hallmark of a market top. History has proven that market plunges routinely follow first-year Republican presidents where ebullience over business-friendly government policy runs rampant and only sets the market up for failure. Witness the market meltdowns that followed Hoover (1929), Eisenhower (1953), Nixon (1969), Reagan (1981), and Bush (2001) in their first years. Any real economic boost from Republican tax cuts now before Congress, if such legislation passes, is already more than priced into the market.
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There are many catalysts that are likely to send stocks into bear market in the near term. A likely bursting of the China credit bubble is first and foremost among them. Our data and analysis show that China today is the biggest credit bubble of any country in history. We believe its bursting will be globally contagious for equities, real estate, and credit markets. The US and China bubbles are part of a larger, global debt-to-GDP bubble, which is also historic in scale, and the product of excessive, lingering central bank easy monetary policies in the wake of the now longpassed 2008 Global Financial Crisis. These policies failed to resolve the debt-to-GDP imbalances that preceded the last crisis. Now, central bank easy monetary policies have created even bigger debt-to-GDP imbalances and asset bubbles today that will precipitate the next one.
We are in the very late stages of the global economic and business expansion cycle with investor sentiment reflecting record optimism typical at market peaks, a sign of capitulation in very late stages of a bull market. Crescat is positioned profit from the coming broad, global cyclical market and economic downturn that we foresee. We strongly believe that our global equity net short positioning in our hedge funds will be validated soon For most of the rest of the letter, we delve into our proof of highest-ever US stock market valuations and the reasons that we are calling for an imminent, historic market top.
Below, we show that the median price-to-sales ratio for the S&P 500 today is the highest ever by a wide margin, more than 60% greater than the tech bubble peak.
Now that we have looked at leverage, we look at enterprise value (EV), the market value of a firm that incorporates net corporate leverage to get the total value of a company’s capital structure. Based on the median EV-to-sales multiples for the S&P 500, the market is at record valuation levels.
EBITDA (earnings before interest, taxes, depreciation, and amortization) is a popular valuation measure among investment bankers. We show below that based on median EV to EBITDA, the S&P 500 is at its highest-ever valuation.
Bear with us now as we dig into the necessary nuances of the price-to-earnings (P/E) ratio. It is critical to use cyclical smoothing to accurately gauge market valuations in their current and historical context when using P/E. Yale economics professor, Robert Shiller, received a Nobel Prize in 2013 for proving this fact so we hope you will believe it. The problem with just looking at trailing 12-month P/E ratios to determine valuation is that it produces sometimes-false readings due to large cyclical swings in earnings at peaks and valleys of the business cycle. For example, in the middle of the recession in 2001, P/Es looked artificially high due to a broad earnings plunge. P/Es can also look artificially low at the peak of a short-term business cycle, which can produce what is known as a “value trap” such as in 2007 during the US housing bubble and such as we believe is the case today in China, Australia, and Canada.
Shiller showed a method for cyclically-adjusting P/Es using a 10-year moving average of real earnings in the denominator of the P/E. Shiller’s Cyclically-Adjusted P/E, called CAPE multiples have been better predictors of future full-business-cycle stock market returns than raw 12-month trailing P/Es. Shiller showed that markets with historically high CAPEs lead to low long-term returns for long-only index investors. Shiller CAPEs are fantastic, but they can be improved by including an adjustment for corporate profit margins which makes them even better predictors of future stock price performance and therefore even better measures of cyclically-adjusted P/E for valuation purposes. Below we show Shiller’s CAPE prior to adjusting for the cyclicality off profit margins.
The PBOC also revised its assessment of 2015 off-balance sheet bank debt upward by about 100%. The problem in China is that shadow lending has been growing literally out of control and outside the direction of central planners. We believe this is the largest credit explosion in any major country ever relative to GDP, indicating that China’s banking assets are vastly mismarked, and overstated. In our view, China has an enormous hidden nonperforming loan problem that essentially renders the entire Chinese banking system insolvent, more than wiping out all its equity capital and potentially leaving more than one billion Chinese depositors to bear substantial losses. China certainly was the growth engine of the world for the last few decades, but that growth is about to come to an abrupt halt. At this stage, in our view the China credit bubble is as ripe as it gets to burst.
China is simply in the biggest credit bubble ever, and it translates to the biggest currency bubble ever too given the sheer magnitude of yuan denominated credit when converted to dollars at the current exchange rate. Strangely, the global investment community remains largely oblivious to the scale of China’s twin banking and currency bubbles. We think that currency valuation must be poorly taught in school. There are too many variables for most people to process, so people tend to just focus on just a few. The problem is that it is not as simple as looking at the trade balance and foreign reserves. As we have shown before, in our analysis, we believe China’s reserves are almost certainly fully encumbered given the many years of running a pegged currency against constant capital outflow pressure. In our view, tight monetary policies and capital controls cannot contain the capital outflows without also inflicting punishment on China’s economy and capital outflow pressure including a reversal of foreign inflows will force a big downward adjustment.
Years of Minsky-style Ponzi finance have finally caught up to China. Non-performing loans cannot be refinanced with ever more massive amounts of new credit every year. The marginal contribution to real GDP growth from new credit growth has diminished to the breaking point. History has proven that such is the point at which credit bubbles burst leading to debt deflationary depressions.
Continues in PCrescat-Capital-Q3-2017-Quarterly-Letter