<September 27, 2024>
As far as seasons go, fall is hard to beat. Not too hot and not too cold. The leaves are changing colors and football season is in full swing. And of course, there’s Halloween!
As a kid I always looked forward to Halloween. Growing up in a health-conscious “no sweets” household, Halloween was an opportunistic time to load up on my favorite chocolate bars and candy. If I played my bag of treats right, my sweet tooth could be satisfied until Christmas!
Another thing I enjoyed about Halloween was the television special, It’s the Great Pumpkin, Charlie Brown. It was and remains a classic. Released in 1966, the Peanuts special follows its cast members as they celebrate Halloween. Some of the Peanuts crew go trick-or-treating, while others attend a party. But not Linus—he does his own thing.
Instead of celebrating with his friends, Linus spends his Halloween waiting in a pumpkin patch for the Great Pumpkin. According to Linus, “On Halloween night, the Great Pumpkin rises from his pumpkin patch and flies through the air with his bag of toys to all the children.” Unfortunately, the Great Pumpkin never arrives, and Linus is ridiculed by his friends. He’s even called a blockhead!
Our belief in full market cycles, including a bull and bear market, is beginning to feel more and more like Linus’s belief in the Great Pumpkin. However, instead of pumpkins, we sit in a patch of T-bills waiting for the return of sensible equity valuations. And rather than bringing a bag of toys, we expect this cycle’s Great Pumpkin (bear market) will bring patient investors the gift of lower prices and opportunity.
From the outside looking in, believing in full market cycles, bear markets, and even recessions, probably looks foolish. To some, we might even look like blockheads! Nevertheless, we continue to believe equity valuations are very expensive, exposing investors to considerable risk. In fact, we consider this stage of the market cycle to be an asset bubble—the third stock market bubble of our careers. The first two bubbles were verified by significant losses, with the S&P 500 losing half of its value during both bear markets (2000-2002 -49% and 2007-2009 -56%).
While valuations support our view that stocks are in another bubble, rarely is today's market labeled as one. This is the case even as equity valuations are near or above past bubble peaks. Given the associated career risk and fear of being labeled an extremist, few professional investors are willing to even say the word. As Linus puts it, “There are three things I’ve learned never to discuss with people: religion, politics, and the Great Pumpkin.” While avoiding talking about an asset bubble may make it easier to participate, it doesn’t reduce the risk of its presence.
Despite bubble-like valuations, most investors are still out trick-or-treating, loading their bags with all sorts of financial sweets. The recent Wall Street Journal article, “Americans Are Really, Really Bullish on Stocks”, provided several samples of investor enthusiasm and overconfidence. The article points out, “Americans have rarely been this giddy about the stock market” with investors’ allocation to equities currently the highest on record. According to the article, “the S&P 500 has hit more than three dozen fresh records this year, on pace for the most in a calendar year since 2021.” In effect, with stock prices breaking record highs and trading near or above valuations of past bubbles, investors are “really, really” bullish.
With investor enthusiasm soaring and valuations in bubble territory, last week the Federal Reserve decided to cut the fed funds rate by 0.50%. Further, through its dot plot, Fed members indicated additional cuts are on the way. There was no mention of asset inflation or asset bubbles.
As the Fed begins its easing cycle, few investors are on the lookout for another bear market, or this cycle’s Great Pumpkin. In fact, as we wait in the pumpkin patch, we’ve rarely felt more distant from mainstream thinking and positioning. Nevertheless, just as we dissented from the popular view that inflation was dead, we continue to believe in the cyclical nature of the economy, profits, and asset prices.
As believers in cycles and analysts of small cap companies, it’s very important that we use normalized operating results when valuing businesses. Although cracks are forming, corporate profits and margins, in aggregate, remain elevated and above normalized levels, in our opinion.
Similar to the credit bubble of 2003-2008, we believe corporate earnings have been inflated by unsustainable debt growth. However, instead of mortgage debt, this cycle is being driven by bulging government debt and spending. In effect, the foundation of the current cycle is being supported by fiscal deficits, debt creation, and the Federal Reserve’s accommodation of both. History has been very clear about profit and market cycles built on debt—they don’t last.
Believing in cycles and timing cycles are two very different things. We can’t and don’t time markets. However, we believe we can spot overvaluation and the inadequate pricing of risk. Until pricing improves and opportunities return, we’ll remain defensively positioned, even if it makes us look like this market’s blockheads. As much as we’d enjoy participating in what looks like a festive Halloween season party, our plan is to remain patient and prepared. As inconceivable as the Great Pumpkin may sound, believing cycles built on debt won’t end, and end badly, seems even more farfetched. We’ll sit with you, Linus.
Eric Cinnamond
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
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Definitions:
Wilshire 5000: The Wilshire 5000 is a market-capitalization-weighted index of the market value of all American stocks traded in the US. It contains 3,403 components as of December 2023 and tracks the performance of most publicly traded companies headquartered in the US.
S&P 500: The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.
Shiller P/E: The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
EV/EBIT: A valuation metric that takes the enterprise value (market capitalization + debt) of a company divided by its EBIT (pretax operating income).
Price to Sales: The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.
Market Cap to GDP: A valuation metric that compares the market capitalization of the stock market using the Wilshire 5000 to gross domestic product of the country. The valuation metric is often called the Buffett Indicator as it’s known to be a favorite measurement of stock market value for Warren Buffett.
Small Cap 600: The S&P SmallCap 600 Index covers roughly the small-cap range of American stocks, using a capitalization-weighted index. To be included in the index, a stock must have a total market capitalization that ranges from $1 billion to $6.7 billion.
Mid Cap 400: The S&P Mid Cap 400 provides investors with a benchmark for mid-sized companies. The index is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.
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