Dear Valued Clients and Friends,
In this week’s Dividend Cafe, we are going to look at a lot of things happening in the world and just ask the question, “Is this indicating that the market is about to tip over?” Some of us have been talking about “valuation concerns” for quite some time, and others have been warning of a big market correction. For those of you who have read Dividend Cafe for any meaningful period of time, you likely know at least part of where I am headed … “No one knows such things, and valuation issues are poor timing mechanisms.” Yes, that’s still all true, and I won’t be saying anything different today in the Dividend Cafe.
But I will be saying a lot of new things, even though they aren’t contradictory to our timeless principles. I may not know when some of the present insanity will end, but I do know why investors shouldn’t be flirting with it, past, present, or future. Today’s Dividend Cafe is going to add to the case for being a little more prudent, a little more informed, and a little less manic. Some may find all of this haunting. We just find it informational. Whether or not you find it actionable, well, that is up to you …
Let’s jump into the Dividend Cafe …
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Why are We Having This Conversation?
First of all, let me tell you why we are not having it. I am a valuation-conscious investor, and I have studied the history of market returns relative to entry points up, down, sideways, backward, and every way one possibly can. And yes, I consider it an empirical fact that, historically, the valuation one buys at entry has been a major factor in returns during certain periods. The S&P 500’s consensus operating earnings estimate for 2026 is $336. I consider this optimistic, but I will play along and presuppose it will happen. I will even play along and pretend it may be higher (you never know). Now, if you are hearing things like $360 or “23% earnings growth,” please understand the apples-to-oranges going on … These other numbers are using one-off, non-operating figures that beg the question, a lot. There are $63 billion of gains in Q1 from just three companies that have nothing to do with operating earnings, and just these three reportable events (all GAAP compliant) are responsible for $30-40 of per-share earnings estimates. But that veers outside of the thing being measured. By any standard we have always used to measure FORWARD earnings of the market (which, by the way, we used to express the market’s P/E ratio by its TRAILING earnings, not forward), the S&P 500 currently has a P/E ratio of roughly 22-23x. That compares to a historical average of roughly 16-17x, though the number has admittedly run higher for several years now.
And all of that is NOT why we are having this conversation.
I have said it a thousand times, and I will say it a thousand more. I am glad to not have an investment strategy that, if accurately summarized, would be: “I am hoping that the P/E ratio of my investments will go from 22x to 26x.” I don’t think that is a very good investment strategy. BUT valuations, especially the price-to-earnings ratio of a broad market index in a time of growing earnings, can be stubborn things. While reversion to the mean is a pretty strong tendency in investing, all sorts of noise can alter, delay, impede, and structurally impact it. I do believe the total market multiple is rich. I do believe forward returns for cap-weighted index investors are lower from a high P/E than from a low P/E. And I believe these things because I believe in math.
But that alone is not a reason to question if we are facing a “top” in the market …
When Vibe Trumps Data
Data is far less predictive in markets than those who studied quantitative analytics in school want to acknowledge. Its descriptive power is magnificent, but drawing predictions from pure data is hard and certainly fallible. And “data” is more than reading a number – it requires interpretation, application, and execution – none of which are sure things. So I do not worry about market “toppiness” right now on the basis of “data” any more than I would be a screaming optimist on the basis of present, verifiable data. All data commands humility, whether bullish or bearish.
And truth be told, I hate the word “vibe.” We hear a lot about “vibes” in our politics, our culture, our general moods and appetites. People tell me all the time they like the “vibe” of a politician, totally divorced from policy, experience, technique, etc., and it drives me bonkers. I understand that “vibes” matter in the context of societal energy and even political movements, but I think most things that can be used to rationalize everything are not helpful at rationalizing anything.
The reason I want to use this week’s Dividend Cafe to call into question the current phase of the market we are in has a lot to do with the “vibes” expressed in a note like this:
“One of the things that makes SpaceX so valuable is how valuable it is. The Cursor acquisition costs materially less in dilution because of SpaceX’s high valuation. SpaceX’s ability to do economically, strategically, and technologically accretive acquisitions is an important component of its value. There is enormous value inherent to a company with a high value particularly when it is controlled by an entrepreneur that the most talented people want to work for and partner with. Value begets value. Talent begets talent.”
This quote comes from Bill Ackman, one of the most brilliant hedge fund managers of our day. His brilliance has been manifested in outstanding, superlative returns, marked by huge wins and huge losses. He is a swing-for-the-fencer and an astute, intelligent, aggressive investor.
And when I hear smart people saying things like something is valuable because of how valuable it is, and value is inherent to a company when it has high value, I worry about the, well, vibes.
The idea that a high stock price used as acquisition currency is less dilutive is true as a matter of basic tautology. The idea that a company using a high stock price to make acquisitions leads to greater value, in and of itself, is (a) Not remotely defensible historically, and (b) The worst kind of begging-the -question. One could look at the highest-profile stock-purchase debacles and not exactly see value creation (ummmm, AOL-Time Warner??). But of course we can find good companies that used a high stock price to buy other good companies and then created value … But is it ipso facto true? I mean, give me a break. That has to be one of the most unserious ideas I have ever heard.
My comments here have NOTHING to do with SpaceX, or Cursor, or any other AI or tech company or M&A transaction, per se. My comments and concerns are about a creeping attitude – sure, a vibe – that is so apathetic to risk and dismissive of reality that the end result has generally been horrifying.
The Evolving Risk Paradigm
Most public equity investors have enjoyed a long period in which technical factors have benefited their ownership. Companies have largely not needed new capital, and new issuance has been minuscule. Companies have stayed private longer than ever. New IPO’s have been minimal. And cash flow has met the capital needs of a very high percentage of S&P 500 companies.
JP Morgan estimates that $1.5 trillion of stock issuance will have to be added to the market over the next two years as companies move to IPOs and secondary stock sales to raise capital. This is a level of net equity issuance that we have not seen in the market since, well, the late 1990’s. It is not a bad thing. Companies need capital because they believe the AI build-out is necessary for their future, and they believe it will be expensive. Equitization is not risk-free, and it is not cheap. Companies meeting funding needs with cash flow have already changed the return (and risk) profile of many stocks. Companies moving to the debt markets further risked up this entire scenario. And now, from cash flow to debt to equity, we have covered the whole enchilada …
If there is market turbulence in the near term, will companies have the lever of buying back their own stock opportunistically if they have already had to equitize to meet capital needs, and committed all of their cash flow to the same?
All I can say here is that some elements of market dynamics have changed, and they have changed both suddenly and dramatically. None of it means a bad ending is assured, but I believe investors ought to consider all of these forces in tandem with one another:
- No debt needed to lots of debt needed
- Retaining almost all free cash flow to spending almost all free cash flow
- Buying back equity to issuing new equity
The stories are plentiful out there. You can’t miss them.
When Good News is Bad News
For me, I consider these two things a cause for reflection:
- This is one of the most successful companies in human history (Nvidia) over a period of time where their revenues are up +62%, +73%, and +85% the last three quarters (each quarter’s sequential year-over-year growth). It is a period where the S&P 500 is up +12% despite a ~9-10% drawdown around the Iran war. And it is a stock that has not moved an inch over this ~8 month period.
- I’ll spare you a second chart, but Broadcom dropped -22.6% the first week of June (it has since recovered a bit of that). What preceded this stock price swoon? The announcement of +143% revenue growth for AI chips in the quarter they were reporting on. Did they accompany that announcement with a dreadful forecast for the next quarter? No, they anticipate +84% revenue growth in the next quarter.
When the two biggest beneficiaries of “pick-and-shovel” AI investment start hemming and hawing despite ongoing record-breaking announcements, it seems worth thinking about. I’ll draw some conclusions shortly.
Sanity Check on Aisle 3
And then there’s this: A brand-new IPO company with $19 billion of REVENUE commanding a $2.5 trillion valuation (with a “t”), the same valuation range as companies like Amazon and Microsoft. I shared last week the behavioral realities at play here.
I am not wondering what this says about SpaceX; I am wondering what it says about the market at large. I am remembering how people defended things that seemed outrageous in the late 1990’s, which later became ex ante rationalizations for events that, ex post, became very, very easy to mock and criticize. I don’t have to struggle to remember it – it seems like yesterday.
Many things are different. There are no perfect parallels. My comment is about the environment, not a particular company or price. And if right now the response is (and I will get them in my inbox, I promise you), “well, if you squint here or there, then this or that, and voila, it all makes sense,” I would suggest that these are the conversations had at the Toppy Bar during happy hour.
Is Warsh a Game-Changer?
Today’s Dividend Cafe is purposely not about the Fed, but there is no way to cover this topic without addressing the potentialities in this changing of the guard. Some people have a portfolio that is far too dependent on the expectation of Fed support than they themselves realize. There are reasons to question the perpetuity of this strategy.
I have used Dividend Cafe to cover the history of the Fed’s coziness with markets for a long time, having spent much of my adult life studying this subject. I am usually looking at this from the context of Fed protection (the Fed’s discomfort with left tail risk market events and effective “put” in such times), but much can be said for the Fed’s occasional role in creating offense for risk assets, too – sometimes too much so. It is not a controversial statement to say that the Fed has played a large role (intentionally so) in protecting risk assets over the years and, at times, promoting them. That has accrued to the benefit of the riskiest, growthiest, frothiest parts of the market on many occasions.
It also has, at times, facilitated serious malinvestment. On the one hand, I don’t think the Fed can be held fully responsible for all the idiotic shiny-object nonsense that has entered people’s portfolios over the years, but on the other hand, excessive easy money can foster an environment of excess. The idea that Fed policy promoted a “punch bowl” mentality of investing is not controversial. How the punch bowl facilitated excess in the dotcom bubble, U.S. housing, and post-COVID absurdities is also not controversial. But where exactly the lines between Fed punch bowl activity and some of the silliest of things in the almanac of investor misbehavior may be harder to establish. Let’s just say that Fed policy can not explain all the moronic things I have seen in my investing career, but many of the moronic things I have seen in my investing career wouldn’t have happened without the Fed’s punch bowl.
The appointment of Kevin Warsh to serve as the new chairman of the Federal Reserve is a big deal. It is not a big deal because “the President now has a minion to do his bidding.” Kevin Warsh is not going to be the President’s puppet. It is also not a big deal because Warsh is “bringing a level of hawkishness the Fed has never seen, and he is determined to go tighten money anywhere and everywhere.” Some will call him a hawk, yes, and some of his actions will surely be hawkish, yes. But I firmly believe the labels of “dove” and “hawk” will be much less useful in the Warsh era, because I think his intentions are outside of these conventional lanes and descriptions.
Will he end up hiking rates? I doubt it, but it is not impossible. One of my favorite macro analysts, who is the closest with the chairman, firmly believes that he will (going so far as to forecast 75bps of rate hikes in the late third/early fourth quarter). But what exactly Warsh does with rates in the next 3-6 months is not super relevant to my point about market toppiness and the aspirational portfolio positioning so many have. Warsh’s iconoclastic edge is not evidenced in a desire to raise rates when some don’t want him to … Rather, it will be seen and felt in:
- A genuine move of the needle away from forward guidance as a policy tool. Warsh believes that the Fed using its microphone to “talk about policy as a means of creating policy” is completely out of control, and he is right. Changing this reduces the Fed’s footprint.
- Most potently and impressively, a pivot of consideration to actual economic data versus questions about how the Fed will react to data. Warsh believes that too much financial activity has been about anticipating what others may think or do, rather than financial actors simply thinking and doing. This has damaged productivity and efficiency, and if Warsh can reduce this “financialization” it will move the needle in the right direction for healthy financial activity, even if froth, speculation, and excess suffer.
- That Chairman Warsh appointed task forces in these five areas is profound. It indicates a possible change of the guard in the way the Fed thinks and the way the Fed does things, which could be far greater than people realize (I am firmly in this camp) …
- Fed communications
- The Balance Sheet
- Use of and reliance on data sources
- Productivity and jobs in this era of transformation
- Inflation frameworks and targeting
- A move away from Phillips Curve models that fear growth as inflationary, and into a framework that looks at capex, the supply-side, and greater productivity as disinflationary forces that invite the Fed to “undo” some of its past errors
I am not here to tell you that “next time there is a global financial crisis or COVID shutdown moment, the Fed will not do anything.” I believe Warsh’s philosophy of central banking would call for Fed interventions in moments like those, but I believe they would be more constrained, defined, and prudent than they proved to be in times past. But significant left-tail risk events notwithstanding, I believe his approach to the yield curve, to term premiums, to price stability, to excess liquidity, and to the host of issues that matter in monetary policy right now is going to prove to be paradigmatically different from what we have seen in recent years and Fed chair eras.
And what does that mean for investors?
I don’t think it means shock and awe. I do think it means a “resetting and repricing of expectations” (h/t Rene Aninao). I think the short end of the yield curve matters more for speculative assets, and the long end matters more for real economic growth and productivity. You may very well see the former shake out the most speculative of shininess, and the long end capture serious attempts to restore price stability. I am optimistic on both fronts.
Let me close this section with a succinct summary:
I don’t think the new Fed chairman is looking to pop a bubble in risk assets, but I most certainly do not think that he cares if he does.
Conclusion
If you got to the end expecting me to tell you where, when, or how this will exactly end, you didn’t pay attention to the beginning. My intention is not to scare, fearmonger, or tease an imminent collapse. In fact, my full disclosure is that I don’t have the foggiest idea exactly what happens next. But I want you to know the pumpers and cheerleaders you see on TV don’t either, and their objectives are to keep a rally going by asking you to play a part in it. And once an investment requires exogenous cooperation to be a good investment, we have a problem.
Very good activity being so priced in already that it creates a flat or negative return is a precursor to a bigger problem. Bubble level valuations are a precursor to a bigger problem. Capital structure changes that are paradigmatically different from those over the past 25 years are a precursor to a changing risk paradigm. And a Fed that is willing to be a central bank and not a market babysitter represents a very, very different risk paradigm.
Don’t take this as a warning to “time the market.” Take it as the exact same thing I have written as long as I have been professionally managing money. There is a better way to do this. To that end, we work.
Quote of the Week
“Forecasting, especially when done with ‘science,’ is often the last refuge of the charlatan, and has been so since the beginning of time.”
~Nassim Taleb
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Enjoy your weekends, continue to take in that stunning Knicks postseason, and if you are like me, try to be polite around those boring you to tears with talk of soccer games you couldn’t care less about. And if you want to get past the U.S. Open, the completed NBA season, or whatever Senegal is doing against Peru in the World Cup, feel free to reflect on dividend growth. It can’t be done without ups and downs, but it can change the nature of the “are we at a top?” conversation in the shiny moments of our day.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
