S&P Perpetual Motion

Adam Hamilton    September 1, 2000    2886 Words

 

“There is abundance of evidence to show that dozens of schemes hardly a whir more reasonable, lived their little day, ruining hundreds ere they fell.  One of them was for a wheel for perpetual motion…” – Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, Chapter 2 “The South Sea Bubble”, 1841

 

In Mackay’s eminently quotable opus magnum, he describes the rampant stock speculation in London in the 1720s in wonderful detail.  It was another “New Era”, and investors wanted the moon and were promised the stars by unscrupulous stock promoters.  The very word “bubble” finds it origins from this incredibly intriguing episode of market history, and was a popular term at the time coined to describe small companies that grew rapidly and usually were bankrupt or disappearing in mere days or weeks.  In his book, Mackay takes an inventory of some of the absolutely unreal companies that people were excited about and buying into at the time.  In the equivalent of prospectuses today, the most outlandish claims were made and were swallowed hook, line, and sinker by a gullible and greedy investing public.  Some of the more colorful companies floated include the following … “For trading in hair”, “For extracting silver from lead”, “For the transmutation of quicksilver into a malleable fine metal”, “For carrying on a trade in the river Oronooko”, and what has to be the best prospectus of all time (this company did quite well in attracting capital, amazingly enough!), “For carrying on an undertaking of great advantage, but nobody to know what it is.”

 

Like unlimited wealth, the idea of perpetual motion has fascinated philosophers and inventors for centuries.  Some of the greatest minds of history, including Leonardo da Vinci, spent innumerable years investigating the concept of something for nothing.  The dreams of these great men and women, however, were shattered against the cold hard reality of the physical universe.  The universal physics laws of thermodynamics remain unassailable, continuing to stymie efforts to produce machines of perpetual motion today.  The Second Law of Thermodynamics encompasses entropy, or the perpetual deterioration of any closed system from a state of order to continual states of ever higher disorder.  Every moving part in a machine sacrifices some of the energy input to friction, resulting in heat.  Therefore, as long as friction and the entropy remain unconquerable, the dream of perpetual motion remains a theoretical impossibility.  A machine that provides more useful energy output than energy put into it defies the laws of physics as much as would gravity reversing and dragging everything up into the heavens.  It just is not going to happen!

 

Like the everlasting dream of a wheel of perpetual motion, however, investing and equity markets are also subject to immutable and rock-solid realities that simply cannot be bent beyond a certain point.  All investment success ultimately boils down to immutable fundamentals including valuation and cashflows.  The two great questions of investing have always been… Is a given investment undervalued (or at the very least fairly valued)?  What magnitude of future cashflows streams can it reasonably be expected to spin off?  Like perpetual motion, a future with unlimited wealth where all markets rise forever is a pleasant thought to dream about, but it doesn’t have a snowball’s chance in Death Valley of happening.  Like the rock-solid laws of physics that make perpetual motion an impossibility, equity and investment markets are subject to similar uncompromising fundamental restraints. 

 

With the flagship stock index of the United States, the venerable Standard & Poors 500, vying for new all time highs, we will briefly analyze the current S&P 500 from a fundamental standpoint and attempt to determine if this is the beginning of a brave new era or something else entirely…

 

The S&P 500 is the 800lb gorilla of world stock indices.  It represents the 500 biggest and best companies in the United States, and currently has a market capitalization exceeding a phenomenal $13t (that is $13,000,000,000,000)!  Although the Dow 30 had the limelight up until 1998 or so, and the NASDAQ has become the new popular king of indices, no other index can even touch the breadth and reach of the S&P 500.  Each of the 30 DJIA stocks is included in the S&P 500, as well as 50 of the NASDAQ 100 equities.  The S&P 500, like the NASDAQ 100 and NASDAQ but unlike the Dow 30, is calculated based on the market capitalization of individual component companies.  Market capitalization is calculated by multiplying the number of shares outstanding by the price per share, yielding the total market value of an entire company at the current share price level.  Mega-companies, like General Electric, have a larger impact on the S&P 500 than very small companies 1/500 of this monolith’s size.   The index is calculated relative to a defined base period, so as the companies which make up the S&P 500 increase in value, the index rises to reflect this growth.  With the S&P 500 rapidly closing in on new all-time highs, are the fundamentals sound?

 

The first place to search in order to evaluate the recent incredible S&P 500 mega rally of the last six years is recent S&P history.  One way to detect an anomaly (or determine if everything is sound) is to analyze and compare performance before the period in question (1995 to today).  In January 1959, the S&P 500 closed under 56.  In August 2000, the index closed above 1500.  If this return is averaged over the whole 42 year period, it approximates a compound annual return of 8.23%.  An 8%+ return per year is quite impressive over four decades, and slightly above the long-term equity average.  From 1995 to 2000, the index managed a staggering 22.98% compound annual return, jumping from 465 to 1500 over this short period.  The S&P 500 roughly tripled its historical average return from 1995 to 2000.  One has to wonder to what the extraordinary recent performance of the S&P may be attributed.  Just as a control on this exercise, it is also beneficial to analyze complete S&P 500 returns from January 1959 to December 1994, in order to establish a kind of historical base period to which the last six years may be compared.  In December 1994, the index hovered around 455, yielding a compound annual growth rate over this 35 year period of only 6.01%.  From the perspective of this baseline, the S&P 500 actually nearly QUADRUPLED its 35 year historical average return in recent years!

 

The graph below outlines the real S&P performance since 1995 in red, and shows where the index would be today if it had have grown at more normal growth rates…

 

 

The difference between a 6% or 8% compounded annual return and the actual 23% S&P 500 compound return is quite evident in this graph.  If the S&P had grown at its 35 year average rate (the green line), the index would be trading near 650 today.  The 8% return line (yellow on graph) does not yield much better results over six short years, and would have resulted in an S&P 500 around 725 today.  The odds of 23% returns continuing for the S&P 500 into the next decade are dismally small.  Compound rates of return are exceedingly powerful beasts, and the prospect of 23% compound returns lasting decade after decade is mythical and virtually a mathematical impossibility.  If the S&P 500 had managed a 23% annual return since 1959, instead of 8%, where would the index be trading today?  The answer is an inconceivable 303,057!  (You read that correctly … starting out at 56 in 1959 and growing 23% per year until 2000 would yield an S&P 500 of THREE HUNDRED THOUSAND today!)  The unsustainable incredibly large recent returns of the index become easily apparent when extrapolated to a larger slice of time.

 

With the ever-helpful perspective gained from standing on the giant shoulders of history, the probability that the recent returns are unlikely to be replicated into the future is vast.  If the awesome growth in the S&P 500 did not occur due to the wonderful “New Era” of unlimited productivity and super-technology as bubblevision claims each day, what may be responsible for its performance?  The consensus answer to that important question among thinking contrarian analysts is, without a doubt, two ominous words … CREDIT BUBBLE.  Throughout history, the classic cause of speculative manias is an increase in the underlying money supply that feeds the voracious appetites of the capital markets.  As more money is created, more capital is available to chase speculative investments and prices can rocket to obscene heights.  In Holland in the 1630s, for instance, simple garden tulip bulbs were traded on organized exchanges and some reached prices worth more than a fleet of tall ships and the professional sailors to crew them!  With the universal acceptance of inherently worthless fiat currency backed by absolutely nothing but the good faith of the government that issued it, money supplies around the world have grown dramatically since 1995.  The United States Federal Reserve is the chief hooligan in unrestrained fiat currency growth as the broad M3 measure of US money supply has rocketed from $4.4t to $6.8t since early 1995.  The graph below shows the S&P500 since 1990 graphed against M3…

 

 

The correlation between the S&P 500 and M3 since 1990 is a stellar 0.99.  Even a perma-bull would have to admit these lines look similar!  Although the scales are disproportionate in the graph above, the slopes of the lines are critically important.  As money is created through unrestrained M3 growth, much of this excess capital has found its way into the United States equity markets.  This has fueled a classic speculative bubble, and the consequences are likely to follow the classic historical example… POP!  From 1998 to the present, the effect of the mere slope of the M3 line on the S&P 500 appears to be dramatic.  Although correlation doesn’t necessary imply causation, it is very intriguing to observe the following…  Whenever the slope of the M3 line decreases (the rate in money supply growth temporarily declines), the S&P 500 swoons, sometimes dramatically.  Like a crack addict, a credit-fed equity bubble needs ever increasing amounts of new capital to reach new highs.  As soon as something cuts into that supply of fresh capital, the bottom begins to fall out and the massively overvalued index begins to slide rapidly towards oblivion.

 

If the S&P 500 we are seeing today IS indeed a classic credit bubble and not representative of a dawn of a brave New Era of unlimited prosperity for all, we should see signs of massive overvaluation.  The most simple and most comparable measure of valuation of a mature company is the price earnings ratio.  Ultimately, every investment ONLY has value because it is expected to provide a future cashflow stream to its owners.  As the venerable P/E is readily available and easy to calculate, we can use that as a proxy for cashflows.  Earnings and cashflows converge over the long run.  By dividing the share price by earnings per share, the resulting P/E multiple helps investors gain a concept of how cheap or expensive is a given stock.  A P/E of 1, for instance, is extremely undervalued and indicates that the company will earn back an investor’s entire initial investment every year, for a 100% annual return.  A phenomenal deal!  A P/E of 100 indicates, everything being equal and assuming zero growth, that it will take ONE HUNDRED YEARS for the company to earn back an investor’s initial investment.  This, obviously, is a terrible deal as most humans don’t even live that long.  Any P/E over 50 in a MATURE company is considered vastly overvalued and ripe for an imminent massive correction in price levels.  Historically, the US equity markets have had an average P/E of 13.5, which is considered fairly valued.  The table below shows the ten biggest and most important companies (in index calculation weight) in the S&P 500…

 

 

Is the S&P overvalued?  The simple average P/E of the top 10 companies is an unfathomable 57.1!  ALL 500 companies in the index, using a market capitalization weighted average price earnings ratio, are trading at a multiple of 55!  There are simply not enough superlatives in the English language to describe how utterly ludicrous these current valuation levels in the S&P have become.  In addition, bubblevision is continuing to corral the unsuspecting small investor into the so-called safety of the Big Cap stocks.  In every equity bubble in history, capital entered the markets at the bottom of a great pyramid (small stocks) and eventually flowed up to the apex (large stocks).  When most of the capital is concentrated in just a few stocks, a situation of incredible danger is reached.  If these few companies miss earnings expectations or are caught in a sell-off, a huge plurality of all the capital available in the market can be wiped out in mere hours.  The top 10 companies in the S&P 500 represent a remarkable 27% of its total capital!  The top 25 represent 44% of its capital, indicating the remaining 475 companies in the index only account for 56% of its value!  The concentration of dollars in a couple dozen companies is utterly terrifying from a historical fundamental perspective.  Good working-class American investors are being rounded up and led to their slaughter like cattle.  Growing up in cow country, it rapidly becomes apparent that a roundup is NOT a good thing if one is a cow!  After the cowboys and ranchers roundup their cattle, the inevitable consequences for the cattle include branding, castration, or slaughter.  I can’t imagine any of these possibilities being very pleasant…

 

Although contrarians understand cashflows and study fundamentals, many equity bulls unfortunately do not.  A simple illustration may help, however.  Virtually everyone is familiar with buying a house, and folks have no problem visualizing their annual income.  This house example can be used to communicate the insanity of current S&P 500 valuations…

 

Imagine paying $250k CASH for a house you plan to use as a rental property and not to live in.  Was it a fair price?  The only way we can determine the answer to this all-important question is to analyze the cashflow stream it spins off…  Let’s posit the house can be rented for $25k per year.  This is equivalent of a 10% return or a P/E of 10.  Not too bad of deal, but not spectacular.  Now imagine you can rent the house for $125k per year.  Now you have a 50% return and a P/E of 2 … absolutely amazing, and you probably just made the best investment decision of your life on the rental property.  Easy to understand so far, right?

 

Now imagine the same house can only provide $5k per year in rental income…  This is the equivalent of a P/E of 50 and represents a dismal 2% annual return.  It would take you 50 YEARS to make enough cash to repay your initial investment, and you would not see a profit until 51 years later!  Ridiculous, you say?  Absolutely, but the S&P 500 is currently trading at a valuation 10% higher than even that extreme example, at a P/E of 55.  Unbelievable!  As one final example, imagine paying the same $250k for the house, but being able to rent it out for only $1,250 per YEAR.  It would take 200 YEARS to recoup your initial cost at this P/E of 200, and you would have to be the worst investor in HISTORY to consummate this deal.  Very ugly stuff…  Cisco Systems, the current ultimate market darling, #1 stock in the NASDAQ 100, and #3 in the S&P 500, is trading at a P/E of 191!  It will, barring future earnings growth, take investors 191 YEARS before CSCO even begins to earn a profit for its owners at this valuation.  Even IF CSCO can manage to grow at its current growth rates for the next 50 years, it will STILL not have reached break-even in cashflow terms for folks buying the company this year!  Yet virtually EVERY bullish analyst in the world loudly proclaims CSCO is a fantastic investment opportunity today.  The lack of understanding of simple investment fundamentals that have been true for 4000 years by today’s perma-bulls is utterly appalling.

 

Every investor has an important choice to make.  Each investor must throw down their lot on one of two sides.  The first side consists of over four millennia of historical examples, innumerable experts all throughout history, and rock-solid and logical fundamentals.  The second side is comprised of 5 years of expert testimony, a single two year example, blue-sky dreams, and raw naked greed.  Do fundamentals and cashflow matter, or is perpetual wealth and prosperity finally dawning?  Have we tamed the capital markets and business cycle forever?  Do the laws of physics (and finance) matter, or is perpetual motion (gains) truly now possible?

 

For over a millennium, inventors have unsuccessfully tried to create a machine that can usurp the second law of thermodynamics, reverse the ubiquitous and irresistible force of entropy, and yield more energy than is fed into it.  They have all FAILED.  Will S&P 500 investors be able to work a miracle and reverse the laws of finance?

 

The ancient Latin warning, Caveat Emptor, is certainly apropos for S&P 500 investors today…

 

Adam Hamilton, CPA     September 1, 2000