Is it just the same old song? When a bull market lasts as long as this one has, value investors can be expected to start singing the blues. First, cheap equities become difficult to find. Then market leadership tends to narrow. Pretty soon, frustration can test their resolve.

President Trump’s election and his emphasis on domestic manufacturing was expected to stimulate value stocks in the old economy and, in the months of November and December, it did. But the boomlet in value stocks stalled out by February, while new economy equities resumed their ascent.

In early May, GMO’s widely respected founder, Jeremy Grantham, sent a quarterly letter to investors that underscored some of the tribulations that disciples of value legend Ben Graham are experiencing. The very title of his letter, “This Time Seems Very, Very Different,” invoked what many consider the most dangerous words in investing. Coming from a value investor with Grantham’s intellect and certitude, the piece raised eyebrows.

Since 1996, the world has undergone dramatic changes, some good, some not. Medical breakthroughs have extended longevity, but terrorism is now a fact of life, placing the problems of investors in proper perspective.

That said, equity investors have faced a market where the P/E ratio of the S&P 500 has been consistently higher than it was in the 1935-1995 era. “It has oscillated the same as before, but was now around a much higher mean, 65% to 70% higher,” Grantham wrote. “This is not a trivial difference to investors, and 20 years is long enough to test the apocryphal Keynesian quote that markets can stay irrational longer than the investor can stay solvent.”

After the tech bubble burst in 2000, a funny thing happened—the Shiller CAPE (Cyclically Adjusted P/E Ratio) failed “to go below trend even for a minute.” Grantham conceded that, at the time, he missed the full significance. “Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months,” he wrote.

In the past, equity prices as measured by the equilibrium Shiller P/E had remained below trend for several decades after classic bubbles burst in 1929 and 1972. In the last two severe bear markets, the story was different. “It can be very dangerous indeed to assume that things are never different,” he warns.

What has changed? Three factors—lower interest rates, coupled with the surge in corporate profits and profit margins—are the primary driver of persistently higher P/E ratios in Grantham’s view.

Current stock-market skeptics attribute today’s lofty prices mostly to distortions arising from low interest rates resulting from accommodative central bank policy. It’s certainly a factor, but rates were modest in the 1930s, 1950s and early 1960s and multiples weren’t nearly so high.

Moreover, the high-price phenomenon described by Grantham existed for 12 years before the Great Recession, when debt costs were significantly higher than they have been since. Since 1997, P/E multiples have ascended to a much higher level and have failed to revert to the mean the way they once did during business cycles.

One factor is the combination of low interest rates and higher corporate leverage that distinguish the post-1996 era. Before then, interest rates were 200 basis points higher on average while leverage was 25% lower. Were those conditions to reappear, he estimates S&P 500 profit margins would drop 80% of the way back to pre-1997 averages.

Increased corporate power, which Grantham calls “the defining feature” of American history over the last 40 years, is also contributing to corporate profit margin expansion. Viewed from another vantage point, the percentage of unionized workers in the labor force fell from 35% in 1954 to 11% last year. In his view, rising corporate and monopoly power also subtracts from capital spending, GDP growth and job creation.

Since 2000, GDP expansion failed to reach a 1.9% average during either the Bush or Obama administrations, so many have good reason to ask why equities are doing so well. Seen from one vantage point, they haven’t. Eliminating 2000, the year the tech bubble burst, the S&P 500 has returned 5.63% from January 2001 to May 2017 with dividends reinvested. Yet it’s still triple the rate of GDP growth in that period, so it begs Warren Buffett’s question of how long the stock market can keep outpacing the economy. For quite a while, apparently.



When a business boasts abnormally high profit margins, economic theory presumes that new entrants will emerge, undercut established players to take market share and ultimately erode industry profitability. Yet Grantham maintains that many corporate giants possess near monopoly power and fewer businesses are being started as a result.

Against this backdrop of weak growth and productivity, companies that defy the mainstream get rewarded. Increased globalization has lifted the value of brands and the U.S. possesses more global brands than any other nation. Nowhere is American dominance more pronounced than in growth areas like high-tech, bio-pharma, social media and e-commerce, and those companies have driven the post-recession bull market. Yesterday’s global growth brands facing top-line challenges like Coca-Cola and J&J are today’s value companies, displaced by upstart disruptors like Amazon and Alphabet.

For some value investors, the market’s obsequious reverence of disruptors is patently absurd. In their view, the economic variables and names of the players may be different but the script is the same.

Speaking at Financial Advisor’s Invest In Women conference in May, Wintergreen Funds’ founder David Winters noted that 10 stocks he anointed as FANG & Friends (EBay, Apple, Microsoft, Starbucks, Priceline and Salesforce) accounted for more than 70% of the returns in the S&P 500 over the last seven years.

“This has never existed in the past,” he said. Winters conceded that many of the companies he calls the “Terrible Ten” are “great companies.” It’s just that their valuations make no sense.

Part of the reason, he argues, is the ETF rage. While ETFs exist for any style or asset class, many of the biggest claim to slice and dice the universe in imaginative ways. Yet the majority, like SPY and QQQ, end up overweighted with these high-tech growth stocks.
“Active managers have been forced to become Index Lite,” Winters argues. “People have suspended disbelief.”

Markets dominated by a handful of sexy growth stocks certainly have occurred before, often near the end of prolonged runs. The so-called Nifty Fifty captured most of the money before stocks crashed in 1973. A similar scenario played out in the final years of the tech bubble.

Winters told the conference attendees that he lived through 2000 and 2008 and implied the current bull market would end in a similar fashion. Meanwhile, his own value fund was beating the S&P 500 in early May with more than 35% of its assets in tobacco stocks, showing one doesn’t have to follow the crowd to do well.

While growth has beaten value since January 2010, the gap hasn’t been as glaring as some think. Between January 1, 2010, and May 15 of this year, the Russell 1000 Growth Index returned 14.20% while the Russell 1000 Value benchmark returned 12.55%.

In other words, many value stocks have also benefited from the trend toward lofty multiples. Advisors who favor value aren’t nearly as concerned about the issue as portfolio managers who get measured against indexes daily. At Financial Advisor’s Inside Retirement conference in May, Dan Moisand of Moisand Fitzgerald Tamayo and Peter Lazaroff of Plancorp both acknowledged that value stocks often lag for long periods only to display powerful, sustained reversals.

Disruptive innovation is a major reason that growth has outperformed value, according to Rob Sharps, group chief investment officer at T. Rowe Price. It also explains why U.S. stocks have beaten their international counterparts in this cycle.

Five businesses, FANG plus Apple, that Sharps calls “platform companies” constitute five of the top 10 S&P 500 names and look positioned to capitalize on accelerating economic change. They possess “computing capabilities to offer disruptive services such as streaming video and cloud computing,” he says. “This is extending into artificial intelligence, virtual reality and automation.”

From enterprise hardware to retailing to traditional media, platform companies are “draining the profit pools of some industries more heavily weighted in the value benchmarks,” Sharps explains. “I think the auto industry is next.”

In the past, mega-cap companies from the industrial economy like Exxon and GE were often capital-intensive. In today’s innovation economy, disruptors like Alphabet and Facebook don’t require the same amounts of capital, while goods purveyors like Apple outsource manufacturing.

Businesses that require less capital are generally more valuable than capital-intensive concerns, though there is no hard and fast rule here. Amazon’s cloud computing business requires capital, as do its fulfillment centers. “If any of them gets into transportation as a service or autonomous driving, that could be very capital intensive,” Sharps says.

Low interest rates and inflation explain part of the reason that multiples in the U.S. have climbed to a higher level in the last two decades, but Sharps believes that their multiples are deserved. American over-representation in the innovation economy is equally important, if not more so.

Many of the companies in Winters’s FANG & Friends continue to post big top-line gains off of large revenue bases, defying the law of large numbers that will ultimately bring them back to earth. However, viewing them all through one lens is a major mistake. For instance, Amazon has barely earned $5 billion in its history. In contrast, Facebook recorded $3.8 billion in free cash flow in 2017’s first quarter. At Financial Advisor’s Inside Retirement conference, Permanent Portfolio’s CEO and CIO Michael Cuggino called Facebook an example of “growth at a reasonable price” but added he could never come to grips with Amazon’s valuation in light of a business model that treated many tradtional investment metrics, like profits, with little regard.

In Sharps’s view, American primacy in the innovation economy justifies its expensive stock market. “Economies in other parts of the world are more heavily represented in lower growth, cyclical, capital-intensive industries (banks, energy and materials) or have large economies that are not as well represented in emerging areas,” he says.

For his part, Grantham remains convinced that cheaper is better, but he concedes the wait could be a long one. Aging populations in the developed world produce “more desperate 50-year-olds saving for retirement and fewer 30-year-olds spending everything they can earn or borrow.” Slowing population growth will only perpetuate this predicament.

That makes his “best bet” for lower stock prices—the possibility that the Fed and other central banks move to a higher interest rate regime—less likely than many might think. “Changing the [central bank] policy is unlikely to be quick or easy,” he writes. If so, expensive stock prices could be around for a while.


Evan Simonoff is editor-in chief and editorial director at Financial Advisor magazine.