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Written by: Tim Pierotti
With about two years of headroom left in the dotcom bubble of the late ‘90’s, I was an often wrong, but never in doubt junior salesperson covering small hedge funds at Morgan Stanley. One day, I pitched a portfolio manager named Robert Deaton the idea to short a stock with the main argument being that the valuation was “crazy”. Robert, who was a brilliant North Carolinian with congenial humility listened patiently before telling me something I will never forget. He said, “Tim, the problem is that crazy often becomes insane.” In other words, valuation itself is never the catalyst that causes a bull run to come to an end. Generally, higher valuations correctly reflect increasing optimism in the economy or in an individual stock’s fundamentals. Today, soaring valuations reflect both the non-disprovable consensus belief that AI will sustainably drive higher productivity growth as well as, more recently, the notion that we will see the incoming administration install an unprecedented level of pro-business policy.
That is not to say high valuations don’t matter. Apollo’s Chief Economist, who has been bullish on the economy and risk assets, recently wrote, “A 22x forward PE (Price / Earnings) multiple implies a 3% annual return over the next three years.” Similarly, David Giroux, the legendary T. Rowe Portfolio Manager and author recently said, “Our bottom’s up analysis suggests less than a 5% annual return in stocks over the next five years.” In both cases, precedent is the guide. Historically, when you bought stock indexes at low multiples, expected returns were high and vice versa.
The United States is about 4% of the global population. We generate roughly a quarter of global GDP and a third of global profits. But US stocks now account for more than two-thirds of the MSCI World index’s capitalization. Ask yourself: Is the US stock market capitalization more likely to be higher than 66% in five years or less? I get it. We have Apple, and Google, and Amazon, and a culture of innovation that makes America special, but will the rest of the world not benefit from AI? Will the rest of the world not see a secular lift in productivity? Why is it that markets all over the globe trade at below average multiples of earnings when we are at all-time highs if AI is one of the main drivers?
Bull markets are the manifestation of collective optimism, drawdowns reflect the weakening of that optimism and bear markets reflect collective pessimism. No one can doubt that AI will generate some level of higher productivity growth. Lower taxes and less regulation mechanically drive higher cash flows. The current multiples are obviously not without justification. But none of us know the future and when your starting point is at such a high level of valuation and optimism, the odds of high returns go down and the odds of a rapid drawdown go up.
Remember the old adage. Bulls make money. Pigs get slaughtered.