Memo 3: Paper Wealth
They Mistook Leverage for Genius – Steve Eisman
Excited to be back with Memo 3, and so thrilled this is picking up steam. The encouragement is great to hear and the feedback is beyond helpful – keep it coming! Subscribe if you haven’t already and please feel free to send this around if you’re a fan!
Last week we spoke about the 2010s’ macro policy, how it was accommodative of weak economic conditions and broken economic policy. The Fed kept rates low to keep the economy limping along. To be fair, we can (and should!) debate whether they had a choice. Should the Fed have pushed rates – that certainly wouldn’t have helped our feeble economic recovery. To what extent should the Fed cover for failed fiscal policy – the Fed is supposed to be Independent – that usually means Trump shouldn’t be able to call these guys up and tell them to cut rates to keep the markets strong ahead of an election. But if our government deals the Fed a shitty hand is our central bank really supposed to be blind to the economic condition that results? Is the Fed really independent in this case? I would argue no - the Fed has already compromised its independence to clean up our politicians’ economic mess for the past decade, but even still, the path to hell is paved with good intentions.
With its Jelly Doughnut monetary policy, the Fed created a rift between economic conditions and market conditions. While the economy grew at 2ish %, our markets experienced one of the most lucrative booms in history. As the politicians would say, Wall Street beat out Main Street. In the midweek memo we illustrated just how levered our economy is to rates.
In this week’s memo I want to explore just how inflated the market has gotten as a result of Fed Policy. As a note / disclaimer, I started working on this memo ~two weeks ago, and since then I have shorted the market in a several different forms - in my opinion all of the below has only become more timely.
First off, investing is all about two things: fundamentals, and valuations. Now these are very fancy words, but I like to think of fundamentals as just cash an investment produces. If you make a loan, this may be the interest you earn, and if you own a business, this might be approximated by the profits the business generates (of course it’s more complicated, but not that much more complicated). Valuations are just a question of risk and required returns, or said less technically, what would you pay today for the fundamental performance an investment is expected to generate in the future? That makes investing a practice of predicting fundamentals and applying a valuation that results in an appropriate return, given the risk profile of an investment.
Every asset class presents its own fundamentals / value profile. Bonds carry fixed coupons – their returns are largely predetermined, but Bitcoin has no cash flow – your returns are fully dependent on the next person’s faith in the currency. An industrials company may have a long operating history, consistently growing income at 3% annually, but a venture business may still not have a fully-baked product, let alone a history of profitability, making growth quite difficult to forecast, and future earnings even more difficult to value.
The best investors play to their strengths – some might use data to predict fundamentals, some write algorithms to arbitrage valuations, some will leverage relationships to secure proprietary deals with favorable pricing, or some might hire teams with deep industry expertise to understand complicated businesses. Some people are really just out there gambling and when they are, it’s import to know the difference. What kind of investor are you?
No matter what kind of investors we are, it’s critical to be conscious of when we’re betting on fundamentals and when we’re betting on valuations. Fundamental earnings tend to be far more predictable and in the case of a business, within a management team’s control. Valuation on the other hand, is more subjective and usually up to the whim of the market’s herd mentality. An investment that you buy based solely on someone else being willing to assign a higher valuation (i.e. Dogecoin) will inherently be much more risky than an investment based on an informed forecast of future earnings growth of a company. In the industry, we call people who buy based on fundamentals investors, and people who buy based off valuations speculators.
So now let’s get to the heart of the memo and answer this question for our markets. How much of our markets’ returns can be attributed to fundamental performance (growing profits) vs. valuation increases (higher multiples)?
The below table shows both earnings and valuations of the stock market in 2006, the peak before the ’08 crisis and 2019, the peak before COVID.
If you invested $100 in 2006, you made $127, a 6.5% annualized return. Of that return, earnings grew 34%, while valuations expanded 69%. In other words, your returns were driven 1-part by our 500 largest companies performing better and 2-parts by people being willing to pay more for those companies’ earnings. Or put even less kindly, if you bought the S&P 500 over those 13 years, you were 1-part investor and 2-parts speculator. Why is this a problem? Well, if you applied 2006 valuations to 2019 corporate performance, the S&P 500 would decline 41%. Before our eyes, markets have turned from a way to invest in businesses and their profitability, into a game of the Old Maid (per the link recommended for ages 4 and up) where we speculate on the valuations others are willing to pay.
Now let’s control for interest rates:
Netting out nominal interest rates (i.e. your opportunity cost) from required returns at each time controls for ~90% of the difference in valuation (0.4% / 3.3%) – now I’m no statistician, but that’s pretty good! The Fed cut rates to 0% and investors got desperate for returns, kicking off a cycle of speculation. Your high multiples and low returns don’t hurt as bad when your opportunity cost is zero… but rates also aren’t zero anymore. In fact, I could have (and have) made this argument for the past 5 years – friends joke I’ll have called 5 out of the last 2 recessions, but this time is different because the Fed is on a mission to raise rates.
Where are we today? From 2019 to 2021 earnings grew 31%, but the stock market grew 47%, meaning valuations increased an additional 13% to 23x earnings / a 4.3% required return. But before we go any further, just exactly what are these “record” earnings? The chart below bridges us from 2019 to 2021. To a small extent this growth was inflation and to an even smaller extent it was GDP growth. What about the rest - I would venture a bet this is mostly one-off business and pent up demand that carried over from 2020, when earnings were just $100. How much of this will carry over to 2022? Exclude these other gains, and the S&P ended the year still trading at 27x earnings, again – ~50%+ downside if we return to 2006 multiples.
I need to caveat that this analysis — really estimation — is super rough and highly imperfect: these multiples aren’t perfect measures and don’t always capture the whole story. I still think that we’re directionally right here in calling for a valuation reset. The title of this memo is Paper Wealth because as I hope I’ve shown, so much of the wealth created over the past decade has been detached from tangible economic growth and productive activity. Rather this wealth has been created out of thin air through valuations gone wild, which could revert at any moment. This is going to make for a very challenging investment climate, but if there’s a silver lining, a valuation reset should also recalibrate market with economic conditions. For the past 15 years we’ve watched valuations reach unconscionable levels, while speculation displaces investment. If a correction is what it takes to stop people from lighting money on fire to speculate on tasteless NFTs, well I could only call that cathartic.