The End Is Not Nigh

Are investors too optimistic? Is this bull about to die in the throes of euphoria? Lately, it seems ever-more pundits say it is—there is too much cheer, and a big fall is ahead. With markets hitting all-time highs, extreme bearish views largely absent, optimism on the rise, and equity mutual funds finally seeing regularly positive net inflows, this theme isn’t surprising. However, in my view, it doesn’t pass the smell test.

First, I see precious little evidence investor sentiment has become euphoric. Sure, optimism is emerging after years of investors fearing a double-dip recession, a potential euro collapse, a US default not once but twice, a debt downgrade, the so called “fiscal cliff” and many others. But budding optimism isn’t unbridled confidence and soaring expectations. Current sentiment doesn’t appear consistent with the latter. If it were, investors would likely be bidding stocks sky-high without regard to earnings and revenue growth—not continually hand-wringing over whether sales will keep pace with earnings, as folks are today. Also, euphoria often brings widespread “it’s different this time” claims, that some newly developed technology—railroads, radio or the Internet—has fundamentally changed the economic landscape to ensure perma-growth and end boom and bust. Today, we have the opposite, with most assuming we’ve reached the end of technology’s power and failing to grasp the implications of developments like the shale boom and 3D-printing.

Additionally, even if sentiment were exceptionally strong, it still wouldn’t necessarily mean the bull market is on the verge of ending. Absent an unexpected negative development ending a bull prematurely (like the advent of FASB 157—mark-to-market accounting—truncated the 2002-2007 bull before euphoria took hold), the recipe for a peak isn’t just high expectations, but deteriorating fundamentals as well. A bull market peak is imminent not just when everyone is dancing, but when the music has already stopped—investors gradually notice and scurry for a safe haven from the impending downturn. This divergence between reality and expectations has characterized many more major market tops than not in modern history, and it’s likely the next market peak will rhyme with previous ones, to borrow from a popular expression.

To demonstrate this point from recent history, let’s go back to late 1999/early 2000, the final stages of the tech bubble. Many know investor sentiment rose to stratospheric heights during this period, but some may not know there were signs the music stopped before the ultimate market peak in 2000. First, the onslaught of tech IPOs, which mushroomed in the preceding years, had created a stock supply glut—an ominous sign, given supply and demand determine prices. But the market kept climbing anyway, thanks to outrageously high expectations for the future—demand later proven unwarranted. The yield curve had been flattening and finally inverted by 2000. Few noticed this classic sign of tough times in capital markets. Leading economic indicators, too, were in a little-noticed swoon. By December 31, 1999,Technology had swollen to comprise 29% of the S&P 500—the US’s largest sector by 16 percentage points over Financials.^[i] Yet many of the firms whose surging IPOs fueled the rise were burning cash. Many had no history of nor expectation for profits and a company history spanning only a few months or years—a shaky history of sales. Without solid cash flow—never mind profits—markets realized these firms would go under or have to raise more cash through secondary stock offerings, further diluting stock supply. The dot-com boom went bust. By the bottom in October 2002, Tech represented less than 13% of S&P 500 market capitalization.^[ii]

Today’s environment is virtually a mirror image—fundamentals are quite strong. Despite some popular social media IPOs over the last few years, total IPO activity has been quite modest, with early trades nowhere near the irrational frenzy for dot-com offerings. Most recent IPOs experienced low double-digit returns in their first few trading days—far lower than the triple-digit norms of the dot-com era. Offerings are also dwarfed by stock buybacks, cash acquisitions, and some private equity deals—overall stock supply is shrinking. Far from social media taking over Tech or the S&P 500’s market cap, most social media firms aren’t even included in this major US stock index. The yield curve is positively sloped and steepening as the Fed continues to reduce quantitative easing bond purchases. Corporate balance sheets are flush with cash, and strong revenue and profit growth enables firms to invest without spending down these buffers. Where an oversupply of tech equipment existed in 1999/2000, today we have pent up corporate demand after several years of underinvestment.

To be sure, investor sentiment is improving, but we’re a long way from a euphoric top. Contrary to what some are suggesting, there is plenty of room for sentiment to improve—and lift markets higher—before this bull ends.