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Today's Investors Aren't Buying the Dip, They're Buying the Flip


Investors aren't allocating capital to investments in companies; they are trying to exploit prices at somebody else's expense.

The Blackstone trade is indicative of today's investment climate that is focused on gaming the system. Investors aren't allocating capital to investments in companies; they are trying to exploit prices at somebody else's expense. Every trade is a flip.

When working on the sell-side during the last bull market cycle, I once heard an equity salesman proclaim that his clients don't buy companies, they buy stocks. He was dead serious. Under Alan Greenspan's uber-easy cycle, the market was dominated by momentum-induced speculators. The goal wasn't capital allocation, it was capital exploitation. This is what happens when the central bank produces negative interest rates. Assets are turned into commodities subject only to the supply and demand of the securities.

Sadly, this is the goal for the current central bank monetary policy. The goal of QE is to foster a negative interest rate environment. The goal is to trick investors into pricing in future inflation expectations to lower real rates. This was the catalyst behind the re-pricing of equity valuation during the credit bubble, and it's the catalyst today. US stocks are not rallying because fundamentals are improving; the market is rallying because multiples are rising.

S&P Multiple

Since the 2012 lows, earnings have grown by a 3.9% annualized rate while the price-to-earnings ratio has expanded by a 21.4% annualized rate. There is more to the story. Because the bottom line is highly manipulated by one-time accounting gimmicks and share buybacks, top-line growth is a better barometer. The operating earnings, or earnings before interest, taxes, and depreciation of assets (EBITDA) are a true indication of a company's growth trajectory. The growth rate of the S&P 500 (INDEXSP:.INX) EBITDA since the 2012 low is 2.6% annualized, however the price-to-EBITDA has grown by 22.5% annualized rate.

Investors often make a bullish case for US stocks by pointing out that the P/E multiple is still low by historical standards. This is a ridiculous assertion. Because valuation is about capital structure (aka the risk curve), equity multiples are a function of credit multiples. You can't compare valuation without the context of interest rates and the cost of credit. Equity multiples are rising because credit multiples are rising because real interest rates are negative.

Credit Risk Premium Vs. Equity Risk Premium

Not only is this methodology flawed, but it's not even correct. Sure, if you look at the P/E ratio at 16.7x trailing 12 months earnings in historical context, it's not overly expensive. However, if you look at the P/EBITDA, stocks are the most expensive they have been in the last 10 years. In fact today's 8.6x P/EBITDA is 17.8% rich to the 20-year average multiple of 7.3x. EBITDA growth is decelerating and the multiple for this growth is the highest in a decade. From the EBITDA line, which is what matters, the market is not cheap relative to history.

Price-to-EBITDA Vs. EBITDA Growth

This is not what you are hearing from the sell side. You are hearing all sorts of ridiculous reasons why this rally has room to run.

Understand the sell side is not your friend. The sell side is not in the business of valuing companies for investment; they are trying to generate a commission for a trade. Their clients don't buy companies, they buy stocks. Sell side theses are not based on what individual companies are worth, but instead by a need to identify the catalyst for the next x% pop in price. In other words, the theses are about buying the flip. This price action provides the illusion of a growth discount, and unsophisticated investors are seeing rising prices and are getting sucked into what they believe is improving fundamentals.
No positions in stocks mentioned.
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