Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 377

The future is always clearest once it is in the past

For stock market transactions to occur, there must be a buyer and a seller. Consequently, there must always be divergent, and even polar opposite, views despite generally similar information being available to both sides.

You decide which side of the fence you are on

But ask the question about whether the market is expensive or cheap and you stir up a hornet’s nest of opinion. And reaching a conclusion on the affordability of the market is often interpreted as a prediction about its future direction. Argue the market is expensive and one is forecasting a crash. Conclude the market is cheap and you must foresee a rampaging bull run.

Of course, it is entirely possible that the market remains cheap or expensive for a long time. Therefore, a comment on whether it is cheap or expensive is not a prediction about anything. Today, I intend to demonstrate why the market could be cheap and why it might be expensive. I will leave you to decide on which side of the fence you sit and to draw your own conclusions about what happens next.

How big tech prices can be justified

Many of those who point to an overvalued market cite the extreme valuations for some technology companies. Apple, Facebook, Amazon, Microsoft and Google – commonly referred to as the FAAMGs – collectively represent 25% of the entire S&P500’s market value, and the market value of US tech stocks is greater than the capitalisation of all European exchanges. Meanwhile, Apple’s market capitalisation alone is now on par with the market capitalisation of the entire US small cap index, the Russell 2000.

Much of the market’s 2020 rally has been driven by a stampede of investment into these five giant technology companies. In the absence of these five, the S&P500 would be about flat so far this calendar year.

In terms of measuring their popularity, over the last six years, while the famous five’s profits have increased by US$80 billion, their market value has increased by more than US$5 trillion – a multiple of over 62 times. Investors have simply been willing to pay a lot more for each dollar of earnings that these companies generate.

Perhaps this is because while every economic contraction produces challenges for many businesses, there are others that win. And the FAAMGs are indeed winning.

I looked at the returns on equity for each of the FAAMGs for the last five years and discovered something universal. As these companies grew, they became more profitable. In 2016, Microsoft was earning US$20 billion on US$76 billion of equity, or a return on equity of 27%. In 2020, Microsoft’s equity was a little more than 50% higher at US$110 billion but the company earned more than double its 2016 profits at US$44 billion. It therefore recorded a return on equity of 40%. Improvements in profitability, as measured by return on equity, similarly improved for the remaining four of the FAAMGs.

If I gave you a choice of purchasing a bank account with $10 million earning 27% interest or a $15 million account earning 40%, which would you prefer? You will always take the bank account with more money earning a higher return. It is no different with companies and when it comes to equity and returns on equity, too much of a good thing is wonderful (with apologies to Mae West).

As the profit and return on equity has risen these companies have become more valuable. And its unsurprising during a period of low growth and ultra-low interest rates that more valuable companies should also become more popular. Such assets are scarce, and history shows scarce assets always become more popular when growth and interest rates are low.

Of course, investors need to be mindful that popularity can be fickle.

The booming stock market therefore is at least partly due to the popularity of five very large but very profitable companies. While some value investors who predict an immediate crash and an emerging crisis could be right, they must also understand the same conditions also explain the concentration of money into those companies and business models that are actually winning.

IPOs come out of the woodwork

Booming stock markets tend to attract IPOs because the right time to list a company on the stock exchange, and sell out or sell down, is when investors are applauding their listing. Indeed, the appearance of today’s conga line of IPO’s is cited by many as a sign that temperatures are rising and therefore so should investor nervousness.

I have some sympathy with this idea. Experience tells me that we should be tempering enthusiasm when the most popular and oversubscribed IPOs are for companies with no profit and in some cases no revenue.

But the IPO wave has been rolling on for some years. Indeed, there was a bumper crop of IPO’s in 2019 and investors will recall the IPOs of Lyft, Uber, Peleton, Pinterest and Zoom. This year’s crop of listings which includes Snowflake, Unity and Palantir are different however in that they have much shorter histories and less time has passed between private equity capital raisings and an IPO. Snowflake has also seen its value more than triple in six months between the last private equity funding round and its price on the market today.

In Australia there may be a similar level of enthusiasm for the unprofitable. Sixty-three companies in the All Ordinaries index gained 20% or more this reporting season compared with only two companies that were down as much. But what some analysts point out is that out of the top 10 performing stocks in the All Ordinaries index, none made any free cash flow for the period. And of the 20 best performing stocks, only four made any free cash flow at all.

Such unbridled enthusiasm for loss making companies always gives me cause for concern based on the three similar scenarios in history I lived and invested through.

The overall market level is not a bubble

When I instead look at various models for estimating the fair value of the aggregate market, I reach a more sanguine conclusion. Australia, like the US, has experienced a similar expansion of price to earnings (P/E) multiples as a function of ultra-low interest rates and the migration out of cash and into growth assets.

Ultra-low interest rates helped the Australian Treasury sell 31-year Government bonds at around 1.9%. If we add on the equity market risk premium (ERP) of, say, 3%, we arrive at an earnings yield of about 5%. The inverse of the earnings yield is the PE ratio and if we then divide 100 by five, we arrive at a PE of 20 times earnings. At the time of writing, the forward PE for the ASX200 is currently 19.8 times, suggesting it is about fair value, even without factoring in growth. If long term growth is 2.5% (and yes, that may yet prove ambitious) the fair multiple of earnings could be materially higher than 20 times.

So perhaps the market isn’t expensive at all.

The US Federal Reserve has also articulated and demonstrated a desire to do ‘whatever it takes’. Indeed, central banks are aggressively buying an unprecedented range and quantum of listed and unlisted assets and securities. The consequence is the frustration of the traditional price signals that tell investors which businesses are weak and should fail.

What about the zombies?

And that brings me to the final point - the wave of zombie companies that some analysts are citing as a justifiable source for unease.

A zombie company is one that is unable to pay its interest expenses from its EBIT (earnings before interest and tax). The number of zombie companies listed around the world has been rising as a proportion of all listed companies in most western democracies and it has many investors worried.

Among the Russell 2000 – the US small caps index – the proportion of companies unable to meet interest on debts from profits for at least the last three years has risen from 10% in 2017 to 15% today. During the GFC, the proportion of such companies in the Russell 2000 was 16%, so today’s number is almost on par with the experience during the GFC. A similar jump in the walking dead is evident elsewhere almost everywhere. The share of US listed firms more than 10-years-old with an interest coverage ratio of less than one for three years in a row is 19%, in Germany 15%, in the UK 8.5% and in France it is 17%. But while the numbers have been rising steadily it should be noted Japan’s proportion of walking dead is almost double the US at 36%.

Time will tell

There are solid arguments suggesting the market is not expensive and equally solid arguments suggesting it isn’t cheap. The future is always clearest once it is in the past.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

RELATED ARTICLES

Diversification is not a free lunch

Five reasons fund managers don't talk about skill

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.