The Rubber Band

“Karma is like a rubber-band: it can only stretch so far before it comes back and smacks you in the face.” – Unknown

As US equities continue their record breaking bull run, market participants have understandably started to question how much longer this will continue for and whether we’re entering bubble territory.

As my colleague John Weavers recently pointed out, there are several reasons why investors should be cautious and selective. But the “bubble” metaphor oversimplifies the current situation in our view.

On headline valuation metrics the US market today isn’t particularly cheap, but nor is it particularly expensive. And at ~16x forward earnings it’s a long way off from the 1999/2000 bubble when the market topped out at a lofty ~60x forward earnings.

Rather than a “bubble” I would describe today’s US equity market as a “rubber band”.

Coming out of the 2008 financial crisis there was an initial post crisis “flight to safety” and a subsequent “hunt for yield” in an ultra-low interest rate environment – the first tugs on the rubber band, so to speak.

More recently high growth technology companies (particularly the FANG/FAAMG stocks) have led the US equity market higher. Apple’s market capitalisation has comfortably broken through the $1 trillion mark – Amazon has also touched this milestone (albeit briefly, at time of writing). The rubber band has been yanked further.

Overlaying all this (the “flight to safety”, the subsequent “hunt for yield”, and the more recent dominance of the FANG’s/FAAMG’s) we’ve seen the rise of passive index ETF strategies.

Such ETF strategies will, by their very nature, generally buy more of stocks that have done well and risen in value, and less of stocks that have lagged and underperformed. This is the antithesis of “buy low, sell high”.

I could write an entire blog post about the merits or otherwise of these passive index ETFs. But instead let me summarise my views by quoting the-ever quotable Howard Marks:

“Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings?  Certainly not.” – Howard Marks, Oaktree Capital, June 2018.

All these factors have contributed to the decade-long outperformance of “growth” and “quality” stocks (companies at the more expensive end of the market). Meanwhile “value” stocks – companies at the cheaper end of the market – have been left behind, underperforming significantly.

Today the valuation gap between the cheapest and most expensive end of the market (the “rubber band”) is looking very stretched. In the past 30 years we’ve not seen it stretch much further.

History has shown valuation is like a rubber-band: it can only stretch so far before it comes back and smacks you in the face.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.