April 2014

 “In 37 trading days, the ongoing bull market would be 1,311 trading days old, says Jim Paulsen of Wells Capital Management. That is a scary date because it was on the 1,311 trading day after the start of the 1982 bull market that the Standard & Poor’s 500 suffered its biggest one-day crash in history on Oct. 19, 1987.”

Seriously?! The market moves on a 1311 day calendar? Is that a lunar calendar or solar calendar? All joking aside, Mr. Paulson’s anxiety is evidence of bubble-thinking....and not so coincidentally this month’s blog is dedicated to bubbles.

During the short lifetime of a bubble, they seem to be wonderful things. They float effortlessly, look pretty, and make us smile. And then they pop....and nothing is left.

Rarely do bubbles pop based on fundamentals. If a company’s stock bubble pops on a Wednesday, it is not usually because something happened to the company on Tuesday night. On the contrary, usually investor perception simply changes....the emperor’s new clothes become apparent to a few....and then to all. Panic then ensues. Once over, the bubble investors move on to the next “sure thing.” Wash, rinse, repeat.

This generation has become acutely aware of bubbles. We now have a large swath of society that remembers the 1987 crash, the dot com bubble, and the Lehman melt down. We have met plenty of investors who exited the markets for good after each crisis—and did not participate in the upside of the subsequent bull markets. Buy high sell low is not a sound investment strategy; however, it is the reality for far too many amateur investors. We can’t blame investors for feeling a bit edgy....especially as markets rise.

Still, there are marked differences between these “bubbles” and now. 2014 does not look like 1987, or 2000, or even 2007. That is not to say there is not a stock market correction in our future. Of course there is. But that is like saying the sky is blue.....accurate, but not particularly


• •

The bigger questions are this:

Are we really in bubble territory?
How would I fare (“Would I at least get my money back!!!”) if a 1987, dot com, or Lehman event hit me again?

Let’s address the bubble issue first. Bubbles are not a function of time. A bubble can form over months—as some dot com stocks showed us in 1999. Bubbles can form over decades---as the 1946-1965 “nifty-fifty” bull-run demonstrated.

Bubbles do not affect the entire market uniformly. There can be fringes of the market that look particularly frothy at any given time. Whether its dot-com, bio-tech, electric cars, or even marijuana, bubbles can spring forth like mushrooms after a spring rain. Simultaneously, staid stocks like AT&T and Exxon can ignore the “excitement” completely.

Bubbles are not a function of percentage gains. If a stock market falls 50% (as it did in dot com and Lehman), a “bubble-esque” 80% gain doesn’t even get you back to even.

In reality, bubbles can really best be identified relative to historical valuations. As investors and consumers, we all seem to have an “internal gyroscope” that helps us determine what something is worth. With respect to Wall Street, history tells us that these gyroscopes are in balance when PE ratios, dividend yields, EPS estimates, and a myriad of other indicators are within “historical norms.”

Unfortunately, investor gyroscopes can occasionally malfunction and irrational bouts of pessimism or optimism will tip toward “tilt.” We tend to over-reward and over-punish based on the prevailing zeitgeist of the day.

With that in mind, let’s do quick comparison of some bell-weather stocks in different sectors during a relatively “benign time” (2006) and see if our bubble gyroscope is tipping toward “too bullish” or “too bearish.”

We believe these charts make a compelling case that the type of stocks we own are not in bubble territory from a valuation standpoint....and we (and you) have been rewarded for following the discipline. On a per share basis, Revenue and Cash have grown and these companies are distributing more money to shareholders via increased dividends.

The fact is, the overall market today is worth a lot more ago. And the reason is simple---the vast majority of the a lot more.

today than it was 5, 10, 15, 20 years companies inside the market are worth

Beyond being careful where we invest, our time horizon is measured in years--- and not in quarters, months, weeks or even nano or milli seconds (the bits of time some high frequency traders are dealing in.) As such, we are not as attentive to speculating as to whether on any given day the “market is too high or too low.” We are not in and out of the market intraday based on short term trends or charts.

With that said, we still prudently play the “what if game” and try to account for risk. That leads us to the next question of, “What are the chances of recouping losses in the wake of the next correction?” Of course it depends on the severity of the correction. For those who bought just before the crash of 1987, it took only 14 months for the Dow Jones Industrial Average to recover.

As you might guess, blue chip stocks in general rebounded faster. Using stocks from our chart, Wells Fargo shareholders were whole within 11 months. Apple shareholders (and remember AAPL was a small momentum company back then) had to wait until 1991 to get back to even. JNJ and Chevron recovered faster than Microsoft.

Recently we have seen some of the froth dissolving. Analogous to gently blowing off the froth that has built up in an overflowing pot of boiling water, some sectors in this market have cooled off. These sectors—biotech, software, electric cars—have seen significant P/E regression that has erased some of their recent large gains.

David Kostin, chief U.S. equity strategist at Goldman Sachs, says there are some parallels to March 2000, but only in high growth, high PE corners of the market:

"The current sell-off in high growth and high valuation stocks, with a concentration in technology subsectors, has some similarities to the popping of the tech bubble in 2000...Veteran investors will recall S&P 500 and tech-heavy Nasdaq peaked in March 2000. The indices eventually fell by 50% and 75%, respectively. It took the S&P 500 seven years to recover and establish a new high but Nasdaq still remains 25% below its all-time peak reached 14 years ago."

Kostin believes that broad market valuations are not as inflated as they were then, and we tend to agree. "Bubbly" corners of the market account for a much smaller portion of overall market capitalization today than then—tech accounted for 14% of overall S&P 500 earnings in 2000 but 33% of market cap, whereas today it accounts for 19% of both earnings and market cap. “Tech” in 2014 is far different than “tech” in the dot com era. The fundamentals are still in place for best-in-class tech companies, but investor perception of value has come down.

While that is good news for the positions we tend to hold, it is still bad news for these high- flying momentum stocks.

This may be why we are seeing the rotation from growth stocks to value stocks...a place we at Talbot Financial have specialized in for quite a while now.

The most stable sector of the equity markets large cap multinationals with fortress balance sheets, low P/E ratios and at least stable or growing top-line revenue. We continue to believe that the risk/reward ratio is most favorable with these stocks. We remain believers in the investment philosophy of Benjamin Graham; we continue to watch the daily “voting” take place on our stock values, while we “weigh” the long-term value, we believe is there.

Happy investing.



View older posts.