Too Great Expectations

This article has been excerpted and edited from our quarterly newsletter to clients dated February 14, 2025.

You know there’s too much speculation when stock market participants, who’ve become obsessed with rapid trading, including zero-day options (highly speculative leveraged instruments with same-day expirations), are having to attend Gamblers Anonymous meetings.

Market return expectations are at a high and borrowing to invest has surged, which is unusual when borrowing rates are unfavourable.  A similar phenomenon occurred during the ’99/00 tech bubble and near the markets’ peak in 2007.  Strategists are also sanguine, expecting above-average double-digit stock market returns again in 2025.

The expectation for U.S. tech stocks earnings growth for this year is way above the actual trailing 5-year growth rate of 11%, whereas historically there’s little deviation.  Either IT earnings are about to take off or expectations are clearly out of whack.  At 27x forward earnings, the tech market is expensive historically, but assuming 11% earnings growth, more in line with history, the resulting multiple—above 30x forward earnings—is sky high—a level only previously achieved in the dot-com bubble.  Yet the amount flowing into tech-sector ETFs is at an all-time high market share compared to all ETFs.

S&P 500 earnings are expected to grow in the teens this year.  While earnings growth could exceed the historic annual 6% average rate, already high profit margins suggest a possible reversion to the mean, which would compress growth.  And a recession would likely cause negative earnings growth, at least in the short term.  

The North American stock markets are trading at a premium to our estimate of underlying Fair Market Value (FMV); however, most appear complacent, believing a bull market will persist.

Everything’s Expensive

Long-term U.S. interest rates have been rising, because of heightened inflationary expectations and additional issuance of bonds while demand wanes.  Mortgage rates have ticked back up too. 

While inflation rates have declined, prices remain high.  As an analogy, the running joke is, you’re put in a room and told it’s 100 degrees but not to worry because it won’t rise any further.

Prices for most shares leave us with similar discomfort.  Both public and private market valuations have risen too high.  Though valuations could become even more extreme if animal spirits heighten further and liquidity expands.  If sources of liquidity eventually wane, look out.

Elevated expectations have resulted in elevated share prices.  We prefer getting in on the ground floor—there’s less room to fall with more obvious upside.  Most may soon be disappointed by stock returns that are unlikely to meet such great expectations.

The Bigger They Are

U.S. stocks now represent about 70% of the Morgan Stanley World index, despite the U.S. being 4% of the global population, 26% of global GDP, and 38% of global markets’ corporate profits.

Within the U.S. indexes, the level of concentration has eclipsed that observed at previous market peaks in 1973 and 2000.  The top 10 S&P 500 companies represented 40% of the index as of year end, the highest concentration ever.  Interestingly, over the last nearly 70 years, the top 10 S&P 500 companies have underperformed the rest by 2.4% per year.  

Furthermore, when the S&P 500 reached its current valuation level historically, though it’s rarely traded so high, all subsequent 5-year returns were negative.

Typically, in any given year, about 48% of stocks in the S&P 500 outperform the index itself.  Previously, in years when markets were highly concentrated, the underperformance was even more pronounced.   And when more than two-thirds of stocks lagged the index, it marked the end of market concentration for such periods.  In the last couple of years, just over 70% of stocks lagged the index, an unusual occurrence, and once again likely setting the market up for an end to its over-concentrations.

The top 10 companies are remarkable businesses.  They’ve experienced clear growth in an environment when growth is hard to come by.  These highly profitable juggernauts have grown by significant rates, especially in relation to their sizes.  But the expectations built into their share prices may be unachievable.  These have been capital light businesses; however, the AI race has most spending daunting amounts compared to their historical capital expenditures and current cash flows.  Each is currently trading at or above our FMV estimates and each has its own issues.

Apple’s growth is slowing, and iPhone growth should slow to low single digits.  While still growing its revenues by low double digits, Microsoft could experience cost pressures from cloud competition and its AI buildout.  Nvidia is growing dramatically but it’s so dominant that competition is gunning for the company’s market share, and the AI race may have front-loaded demand.  Amazon’s revenue grew by 12% but it was shy of 13-15% expectations and costs were generally higher than expected.  Alphabet guided to low double-digit revenue growth but its search business is susceptible to AI and ad-based business vulnerable to a lower rates and volumes.  Meta Platforms, like the others, is also spending significant amounts of capital to achieve market share in the AI space, which should materially lower free cash flow.  Neither Tesla’s revenues nor its costs met expectations, and it remains the most overvalued of the mega caps, while it loses market share to BYD.  The cars better drive themselves because the stock price already appears to be.  While Broadcom exceeded expectations, its business is also vulnerable to AI competition.  Berkshire Hathaway and JPMorgan Chase continue to meet expectations but both trade at full valuations.

On a trailing-12-month basis, these top 10 S&P 500 stocks are trading at a price-to-earnings ratio of about 47, way above the average stock valuation.  They trade at 27x forward earnings, versus 17x for the S&P 500 when it is calculated on an equal-weighted basis.  The average stock isn’t cheap either though.  The median price-to-earnings ratio for the Value Line Index (1700 equal weighted North American stocks) recently hit the top 10% of its historical range.

What to Expect When You’re Expecting (a Recession)

A couple of pages complete and we’ve barely touched on our continued concern about a U.S. recession.  Our Economic Composite, TEC™, alerted to one which has yet to occur, though it has alerted to recessions that have recently occurred in other major developed countries.

We monitor the business cycle for peaks because, since 1965, 2-year rolling losses of 20% or more have always been preceded by a peak in the cycle and were also accompanied by additional market volatility.

The U.S. economic cycle has been prolonged, likely by excessive stimulus.  Still exceeding 6% of U.S. GDP, the federal government budget deficit remains at unusually high levels.  Though this stimulus has buoyed the consumer and assisted in keeping unemployment low.  The U.S has now experienced a record 49 consecutive months of job growth.

TEC™ is driven mainly by the inversion of the yield curve.  Short-term interest rates were higher than longer-term interest rates for a record 20 months, and only recently did the yield curve  un-invert—10-year U.S. Treasury bond yields once again exceed T-bill yields.  This un-inversion (a normalization) is also significant because it has typically occurred only a few months prior to every recession.

A recession is precipitated by liquidity drying up because central banks are tightening, which is occurring in the U.S. and elsewhere.

While governments provided reams of excess liquidity over the last few years, another source of short-term liquidity has come from the ability to borrow Japanese Yen (an undervalued currency), at extremely low interest rates, and invest the proceeds in higher yielding instruments (just about anything).  This should cease soon, since Japan has begun raising rates.  Higher rates should prop up the depressed Yen, hurting borrowers (those short Yen) and forcing these major hedge funds, in this massive carry-trade, to cover borrowings or buy Yen.  To do so, they would sell USD, which should constrain liquidity—fewer USD and less overall investment activity.

Don’t be perturbed if you had to reread the previous paragraph—it was rewritten more than once.  Please don’t swear off our letters either.  Some economic issues are clearly complex and don’t worry, there’s no test at the end.

Even if the DOGE (government efficiency) program is successful at cutting one-quarter of projected expenditures, about 1.5% of GDP, it could initially be detrimental for the economy, assuming most cost cutting would be personnel related.

Tariffs, though hopefully short-lived, are taxes on foreign goods and induce stagflation—slowing   trade (even the fear of which could crimp corporate expenditures) while boosting prices.

Realistic Expectations

Over time, most returns from stock indexes come from earnings growth, with a bit from dividends.  In the last 50 years, the nominal (including inflation) growth rate of the U.S. economy was about 5% annually.  Over the same period, margin expansion enhanced corporate earnings growth to a slightly higher 6.5% per year.  And the S&P 500 in the same time frame, ignoring fees, returned about 9% per year with an additional 2.5% from dividends.  Since the market was at a low valuation 50 years ago and a high one today, market returns outstripped the combination of earnings growth and dividend yields.

The overwhelming driver of more recent returns has predominantly been much higher valuations.  In 2024, market returns exceeded earnings growth in nearly every developed market.

As value investors, we expect most of our returns to come from multiple reversions, as our stocks rise toward our FMV estimates.  While we also prize earnings growth and dividends—an integral part of our valuation analysis—they are just part of our return expectations.

Stock indexes today are high and vulnerable to valuation compressions.  As valuations revert, it should subtract from stock index returns.  Furthermore, the S&P 500 yields only 1.3% today, about half its historical yield.  Even if the economy were to continue growing by 5% nominally, and dividends add another 1.3%, that doesn’t leave much room for upside in the short term if overall valuation levels revert from their highs.

For example, the Nasdaq 100, excluding the dot-com bubble, has traded on average at 19x next12-months earnings.  The forward multiple now is 27x.   If, however, we use the annual earnings growth rate over the last 5 years of 12%, it implies a forward multiple above 30x (again, compared to 19x normally).  Frankly, we’re not sure why others aren’t as concerned.  Is it a result of FOMO, complacency, ignorance, or a dramatic upswing in earnings that we’re missing?

When U.S. investors’ allocation to stocks have been this high, it has coincided with a peak in the market.    Valuations this high for the U.S. markets imply a flat return over the next several years.

Insider likely agree, as selling in the U.S. remains high with recent data showing 5 insider sales for every buyer.  Nearly the most sellers to buyers in 35 years.  Meanwhile, market timers (newsletter writers) are exuberant about stocks and gold, while detesting bonds.  They’re invariably wrong when they’re so extreme.  And their readers, retail investors, are invested in leveraged long-based ETFs way in excess of inverse (short) ETFs.

Secular and Cyclical Trends

The markets remain vulnerable to slackening economic growth (both internationally and domestically—from higher unemployment and a weakening consumer), a further rise in long-term interest rates, and oil price increases.  China, a material engine of world growth for the last several years, could struggle with protectionism, rising debt, overbuilding, and poor demographics.

Poor demographics—aging populations and low fertility rates—are a problem in most developed economies.  Over 2 births per woman are required to sustain population levels.  South Korea is running at 1.1, having been only 0.7 in 2023.  China and Japan were at 1.7 and 1.4 respectively last year.  And immigration isn’t helping in these countries.  In fact, China has net migration.  Canada and the U.S. aren’t much better with birth rates averaging 1.4 and 1.7 respectively in the last couple years.  Immigration helps but both countries are looking to be limit immigrants.

Money supply aggregates have been contracting.  Lenders are skittish, so the velocity of money— how quickly it moves around the system—is falling too.  This stifles growth.

The resulting disinflationary effects should allow interest rates to fall; however, despite true inflation easing (e.g., declining real-time rents though leases still show higher figures), inflationary expectations have increased from concerns about labour costs, energy prices (including electricity), raw materials, and transportation.  While the increase in inflationary expectations could continue for a few months related to temporary price increases from hurricanes, fires, tariffs, and bird flu, we believe secular disinflationary forces remain in place, namely lower population growth, technological advances, and debt-suppressed growth rates—debt is too high everywhere.

Global capacity utilization has fallen to levels associated with all previous recessions in the last 60 years.  Factories aren’t as full.  A sign of moderating growth.  China has slipped well below its average utilization, resulting in outright deflation and should lead to lower prices elsewhere too.

Albeit down from recent highs, the ISM Services level at 53 (from the ISM Report on Business surveys), is still indicating expansion.  The U.S. economy is expected to grow by 2.9% this quarter.  Unemployment is only 4%.  The current picture is still rosy.  And the markets refuse to sell off, even in the face of tariff threats and other Trump administration uncertainties.  It’s as if the markets are ignoring the President.  A t-shirt kind of summed up the markets’ attitude, “I Survived the Tariff War of February 4 to February 4.”

Our Strategy

We continue to hold a partial hedge against market declines for our Growth accounts by shorting an S&P 500 ETF (or holding an inverse long ETF) and/or the Vanguard Total World Stock ETF.

Despite our concern about a recession, we are constantly analyzing quality businesses, those with competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets; however, their share prices must be undervalued relative to our FMV estimates.  On a bottom-up basis, we are finding fewer opportunities than usual since most companies are fairly valued or overvalued.  Yet another reason why we remain defensive.

The U.S. stock market is over twice as expensive as foreign markets.  It’s no wonder that we’ve been finding more investment opportunities outside of the U.S.

Lowered Expectations

A MADtv skit from years ago parodied dating, where the participants had better than anticipated outcomes because expectations were set so low.  On the contrary, U.S. and Canadian stock markets have set the expectations bar way too high.  Outcomes are more likely to disappoint.

Indexes are overly concentrated in companies whose performance has been outstanding.  This has been reinforced by a piling on effect from overly optimistic animal spirits, driving stock prices too high.  Interestingly, Research Affiliates recently wrote a paper illustrating that buying companies that were kicked out of the index (talk about low expectations), would have resulted in a doubling of the index return over the last 30 years.  It’s not merely about the underlying fundamentals but also the embedded expectations that govern prices relative to proper company valuations.

Because investors often lower expectations too far for certain individual companies, we search for compelling opportunities where shares price are, in our analysis, temporarily detached from our estimated values, providing potential undervalued entry points.  Our criteria include high-quality, preferably non-cyclical, more predictable businesses.

Our expectations are already lowered for general market returns.  When expectations are this high, our fear of losing overcomes any fear of missing out.  We still see a high probability of an economic downturn and remain defensively positioned for that reason as well, and we continue to hold some cash and hedges that should protect our portfolios when everybody else’s expectations are lowered.