What inning is the market in today?
Being asked a question framed incorrectly is frustrating as no matter how you answer, you’re ultimately doomed from the start. Such is the case when asked “what inning” the stock market and/or economy is in. Absent an early rainout, one always knows how many outs are left during a baseball game. If a pitcher is throwing a no-hitter in the 7th or 8th inning, sports networks will highlight the status to keep sports fans engaged. Interested viewers can follow with anticipation knowing exactly how many outs are needed before completion of the feat. It couldn’t be more different in the financial markets as we can only track the progress of equity markets in hindsight.
So why do so many investors and observers feel like we are in the “late innings”, and is this actually true?
The reliance upon investor heuristics are likely a root cause of this characterization. As Kahneman states in 2003, “…heuristics are cognitive shortcuts or rules of thumb that simplify decisions. They represent a process of substituting a difficult question with an easier one…” Right now investors are locked into a number of heuristics that make them believe we’re in the late innings including the following few:
Years since the last recession: This one is easy to spot. Investors see it’s been nearly a decade since the last recession and say, “ten years is about time for the cycle to turn”. The fact that we’re nine years into a recovery and baseball analogies are flying around make it easy to think the ballgame is almost over. There’s not a magic number of years that’s predictive of anything. This narrative evolved last week as we were bombarded with stories about today’s market being the longest bull market in history.
The yield curve: Ahhh, yes. The yield curve has been flattening for the last few years at a rapid rate (true), and investors are beginning to sound the alarm bells that this is indicative of a looming recession (probably false). The fact that an inverted yield curve has preceded the last few recessions has investors, pundits, and economists on high alarm. Even Federal Reserve Bank of Atlanta President Raphael Bostic pledged to oppose hike inverting the yield curve. At the risk of saying that this time is different, this time is a bit different in terms of the structure of the yield curve. Among the differences include the absolute levels of rates, the explicit telegraphing of Fed policy, the potential impact of the Fed’s balance sheet in terms of volatility selling and stock impacts, and relatively benign inflation levels relative to past cycles. Does a yield curve flattening (or inversion) have a causal effect on the economy? I do not think so. While it can have an impact on the real world economy in areas such as bank net interest margins (NIMs) in practice NIMs which are driven by deposit costs and loan/securities yields that are usually very different than the 2s10s treasury spread. The fact that we’re seeing so much attention paid to the risks of a flattening yield curve (likely a healthy thing), including from the Fed shows how we’re likely overthinking this subject.
Valuations are elevated: Whether you’re looking at the valuation of Series A VC rounds, PE buyout multiples, credit spreads, or equity market multiples, valuations on average do not appear cheap. Yes, we can make arguments that forward looking S&P 500 P/E multiples are reasonable, but by and large aggregate valuations are elevated. I know this, you know this, the sell side knows this, and the buy side complains about this. Many things have worked in favor of corporate earnings the last decade including benign wage pressure that have allowed corporate margins to stay wide, lower tax rates, and large tech pushing their weight globally. As shown below, based on history the S&P’s NTM P/E is ahead of the 10yr average and ahead of most time periods. The table (via Goldman Sachs) on relative valuation versus 10yr average shows we’re more expensive in terms of EV/sales, EV/EBITDA, P/B, FCF Yield, and P/E. While this may help foretell lower future returns, it tells us nothing of the timing or path of future returns, and cannot be used as an accurate method to time stock prices.
One of the issues with these three things (and others I haven’t mentioned) is that they’re widely known and accepted. It’s easy to sit back and say, “If X, then we must be in the late innings”. Is my point, therefore, that we are still in the early innings and stocks have much further to go? No, that’s not the argument. Nobody knows the end of the cycle (myself included), and attempting to predict it isn’t a productive use of time. We just must not fall victim to easily available heuristics.
Elongation of the economic cycle
In ecology, forest fires are a natural part of the ecosystem. Fires allow dying or dead material to be removed from the forest, enriching the soil, and allowing more productive growth to ensue. While this analogy of the financial crisis may be imperfect, the fact remains that many excesses of the financial system were removed in the aftermath of the crisis (sorry Fed haters and TBTF readers!). Maybe more importantly, the psychological scarring has caused investors to look for the next financial crisis at every turn. Yes, time causes us to slowly forget the pain of the great financial crisis but it still exists.
Indeed it is plausible that the economic cycle lasts longer than most participants think will occur. Residential fixed investment is historically low, excesses from oil/shale were flushed out in late ‘15/early ’16, a healthy private sector surplus exists, and the consumer looks to be in a very strong position at the moment. Moreover, we haven’t seen such pro-cyclical fiscal stimulus like we’re seeing with the recent tax reform. From a psychological perspective, animal spirits are alive and well with some combination of greed and fear of missing out permeating the minds of investors from mom and pop to lagging hedge funds.
Clinging to bearish narratives is always intellectually more palatable, but it’s important to at least dismiss common heuristics when evaluating whether the market is in the “late innings”, and take a clean look at the unique economy we currently live in today. Does this mean we ignore high valuations and press on being bullish? In money management there is no sense in ever being bullish or bearish, instead we deal in probability of outcomes and use those to form prudent portfolios. In the case of today we must take a multitude of things into account when constructing portfolios (including current valuations), but resist the temptation to cling to heuristics that tell us that we’re in the “late innings”.