Big and Tall?

November 18, 2013

Whenever you walk past a Big and Tall shop, with its fairly ho-hum styles designed mainly to cover you up, you expect the clothes to be a bit less expensive than the trendier shops with more interesting fare. 

Actually, considering that they offer more fabric AND lower prices, Big and Tall shops are quite a bargain, in function, at least, if not form. Women’s clothing, however, despite requiring fewer yards of fabric, usually costs more. I won’t even attempt to tackle the economics of a $300 bikini here.

Today’s stock market is beginning to look a lot more like an expensive clothing boutique and a lot less like a good place to buy a $300 size 60 suit. Even worse, that dull, yet practical big suit is now up to $400. 

As the stock market continues to rise, we hear experts claiming stocks are not that expensive compared to bonds. They cite modest P/E ratios and record earnings. While the P/E ratio of the market (looking at real earnings, not future expected earnings) is far from a historical bargain, it has been pricier in the past. 

Little time is wasted analyzing how expensive stocks would be if bonds tanked with sharply rising rates, although many also cite rising interest rates and potential bond losses as key arguments for owning stocks.

Welcome to the magical world of investing, in which the only consensus is that with expert strategy and product mix, you won’t be harmed by a largely unpredictable financial slide in which anything with any decent upside will be highly correlated on the way down.

The average stock in the S&P 500 now trades at about 20 times earnings (give or take, depending on the exact methodology) with a dividend yield on the entire index of approximately 2%. As we’ve noted before, it's traded in single digit earnings multiples with yields pushing double-digits . It has also traded at higher earnings multiples and with a mere 1% dividend yield – back in early 2000. The bullish focus on previous higher prices; the bearish are expert historians on all-time lows.

Why do most investors feel interest rates must return to old-timey levels and send bonds into the gutter, yet stocks can’t return to old-timey low valuations? It's a mystery to me. In our book, (actually more of a novelette…) the chance of ten-year government bonds yielding, say, 8% again, is about the same – or even more unlikely – as a greater than 50% drop in stocks.

But once you begin to peel away at the onion, the stock market starts to look like much less of a favorable deal for investors. Mid and small cap stocks are now very popular with investors, unlike back in 1999, when larger stocks, particularly growth stocks, were popular. The Wall Street Journal quotes the P/E ratios on the Russell 2000 small cap index at over 70. The yield is about 60% of the S&P 500's. Vanguard quotes their Extended Market Fund at a roughly 30 P/E ratio and a sub-1% yield (after the fund's low fees are removed from dividends). 

This smacks, at least a little bit, of 1999. Strangely, no one's expecting big economic growth going forward, unlike in 1999, when every company was going to grow earnings by solid double-digits forever. The exception? The stocks the experts like. Of course, those are going to grow really fast, faster than the current high prices take into consideration. Naturally.

The market as a whole looks reasonably cheap because so many stocks have been written off by investors as unattractive, mostly because they are. We’re awash in P/E ratios of 10 and yields over 3%. Even Apple traded like this a few months ago. But there are tons of stocks with P/E ratios of 30, 50, 80 or higher, or no earnings at all yet, just billions in market value. Tesla (TSLA), Netflix (NFLX), Amazon (AMZN). The list goes on and on, and encompasses all industries. Chipotle (CMG) is trading at more than 50 times earnings – a real bargain compared to the stocks I just noted. 

Even if these certainly more attractive – although often riskier – businesses continue to grow quickly, they're going to do it largely at the expense of crummy, supposedly cheap businesses, unless the economy starts picking up steam and goes back to lifting all boats. We’re about to start a near-zero-sum earnings game. Call it a 5% earnings growth trajectory across the market, in which Netflix may grow 20%, but that growth’s going to come out of Comcast or DIRECTV's earnings. 

This isn’t some creed against growth stocks like we had over a decade ago. There isn’t much value in value, either. The Vanguard Small Cap Value fund (VISVX) trades at just below 23 times earnings. Presumably, the value fund owns all of the slower-growing, cheap stocks. How is that going to work out when the growth stocks suck up all of the earnings growth? And if interest rates do climb, just how appealing is a volatile, slow-growing, smaller-cap stock trading at over 20 times earnings and yielding less than 2%, especially if you can earn 6% on a safe bond after rates rise?

There's a risky game going on here. Someday, all of these popular high P/E stocks are going to run out of major upside potential and become low P/E stocks. Apple had what may be the greatest growth story in the history of stocks, and it's barely trading into double digits P/Es now. And why is the average stock in a small cap value fund more expensive than Apple, anyway? Investors don’t think the eventual P/E compression is going to happen on their watch. They'll be onto the next Google by then. 

There are limited options here. Cash should continue to return much less than bonds and stocks, and bonds have little chance of outperforming stocks over any extended period, given current low rates. But this circular logic may mean any mix of the above will lead to underwhelming risk-adjusted returns.

It's entirely possible that many of the investment strategies employed to avoid falling bonds when rates ultimately rise may fall even more than the feared Treasury bond bubble pop. 

Ideally, the current stock market boom will slow down before we get to truly dangerous levels, and the economy will catch up so even "Big and Tall" stocks can grow a little faster, even if they're less fashionable. 

We’re going to run light on stocks in general, particularly small to mid-caps, although not as light as if money market funds yielded 4%. If stock valuations continue to rise, we’re going to cut back more and start getting left behind by a strong bull market. Thus far, we’ve kept a solid upward trajectory with what will prove to be measurably less downside if things turn dark and stormy. 

Out-of-favor investment strategies work best when markets turn down. Bull markets are made up of popular investment themes. It’s been quite some time since we wrote at length about stocks getting pricey and risky. We did it a lot back before the 2000 and 2007 slides. Hopefully, there's no need to sound an alarm this time around, and we're probably early, anyway. It wouldn't be the first time. But right now, it seems like the Big and Tall store's priced like the cool clothes boutique, and the stylish clothes needs to have a storewide 50% off sale.