The Famous Scott McNealy Tech Bubble Quote

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After the collapse of the 2000 Tech Bubble, Scott McNealy, the CEO of Sun Microsystems made this famous quote:

“[T]wo years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking!”

Zillow (Z) is now in Sun Microsystem in 2000 territory valuation-wise.   It sells at about 28x sales revenue, with 0% profit margins.  Undoubtedly, it’s a great company, and it will continue to grow rapidly, eventually expanding the profit margins … but at the current valuation, it’s almost impossible to imagine that any current long-term shareholders could turn a profit over the next 10 years.

Projecting the Forward Returns on the S&P 500

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“It’s tough to make predictions, especially about the future” – Yogi Berra

It’s often tempting to look backwards as investors. People are lured in by the investment that’s up 200% over the past three years, and want to keep away from the one that’s down 50%, even if the latter is the better investment.

Perhaps this “backward-looking” tendency is part of human biology. We are hard-wired to segregate between what’s “good” and what’s “bad” based on our prior experiences. If we had a bad experience after buying a particular car, we want to avoid that brand in the future. Conversely, if we had a great experience with a product or service, we’re more likely to trust that brand and go back for more. This is generally a good instinct to have; it’s just that it doesn’t always work that well with stock investing.

Buying a stock isn’t quite like buying a washing machine or a refrigerator. It’s true that we might care about the quality of management in the same way we’d care about the quality of a consumer appliance, but there are other factors with stocks. When we buy appliances, cars, or other major consumer goods, there’s generally a competitive market, and all companies are fighting to keep prices down, and gain business. There’s no equivalent with equity investment. To understand stocks, we must evaluate earnings, margins, cash flows, assets, and growth, within the context of a constantly-shifting price.

It’s this constantly-shifting price that can be confusing to many people. Its true prices change with consumer goods, as well, but not in the same way. You won’t find a TV that costs $500 today, $750 six months now, $900 in twelve months, and $350 in two years. With stocks and investment in general, however, prices can change quite rapidly.

What’s more, to effectively value a stock, it requires a lot of research and knowledge. Many investors (even professional ones) either lack this knowledge or lack the will to do the research. It can be even more difficult to understand the “valuation” of an asset class such as housing or US equities (in general), given the vast multitude of factors involved. Given this, it should be no surprise that bubbles do form.

In this article, I want to examine the US stock market and try to predict the future returns for US equities over the next 5-10 years. We’ll use the S&P 500 (SPY) as our proxy for this. My conclusion is that US equity returns are likely to be below-average over the next decade.

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The Central Bank Boom is Creating Huge Risks for Investors

At heart, I’m a value investor. Buying companies with a “margin of safety” is the best way to generate superior long-term returns. However, I always maintain a very close eye on the macroeconomic backdrop. There’s a reason for this: if you look at markets historically, the “big picture” stuff can often undermine valuation. What once looked “cheap” can suddenly look very expensive.

We can find a recent example of this phenomenon with copper producers. In January 2012, Southern Copper (SCCO) sold at a P/E ratio of about 11x. It looked cheap, but only if you completely ignored the macro backdrop. The Chinese Asset Bubble had led to skyrocketing copper demand, causing copper prices to quadruple from levels a decade prior. I wrote about this situation in late ’11 in an article, “Copper Producers Could Still Have a Long Way to Fall.” There, I argued that China’s demand surge was unsustainable and that, in spite of a 20% drop in 2011, copper prices had the potential to fall much further, which could destroy earnings for the miners.

Since that time, SCCO is down about 10% during a time period when the S&P 500 index (SPY) is up about 50%. The “value” case for SCCO was predicated upon the key assumption that copper prices and earnings would hold up and continue to grow. That did not happen, as SCCO’s earnings have declined 30% over the past two years due to waning Chinese demand growth and falling prices. That 11x P/E ratio that looked “cheap” in early 2012 now seems quite high in hindsight. SCCO would’ve needed to sell at a 7.5x P/E ratio in Jan ’12 to have generated the same return as the S&P index.

Of course, this is just a minor example. The most dramatic case for how the “macro” can undermine the “micro” came with the famous Crash of 1929. From a historical basis, the US stock market was not that terribly expensive in 1929. The P/E ratio of the S&P 500 was around 17x for most of the year; slightly above the historic norm, but hardly in stratosphere. The late 20′s market, however, was fueled by easy monetary policies by the US Federal Reserve Bank, which created a massive and unsustainable earnings boom. The boom eventually turned to bust and earnings for the S&P 500 contracted rapidly. By 1932, S&P 500 earnings had fallen 75% from their 1929 peaks.

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Looking at the Crash of 1929 within the context of historical P/E ratios, it’s no more than a minor blip. In fact, the overheated 1929 market doesn’t look much different than the overheated 1959 market. Yet, the ’29 market fell 90% before bottoming out in 1932, while the 1959 market (with a similarly high P/E) fell a mere 10% before hitting bottom. The difference was that the ’29 market was fueled by loose money and surging debt. The Federal government then responded to the ’29 crisis, with a series of flawed policies, including the Smoot-Hawley tariff and one of the largest tax increases in American history.

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Italy: The New “Powder Keg” of Europe?

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In the decades leading up to World War I, the Balkans gained a reputation as the “powder keg” of Europe. Nationalist movements in Southeast Europe were often pitted against the imperialism of the major European powers. The assassination of Austrian Archduke Franz Ferdinand by Serbian nationalists in 1914 would eventually set off a chain of events that would culminate in one of the most violent, miserable, and pointless conflicts in world history.

100 years later, it’s not virulent nationalism or imperialistic expansion that threatens continental Europe; it’s the Euro. By combining the currencies of 17 different sovereign nations into one giant dysfunctional system; trade imbalances, fiscal crises, and asset bubbles have become the norm.

While the markets believe that the situation is improving due to higher GDP growth and falling bond yields, if we dig beneath the surface, we can see that things are still deteriorating rapidly. All it might take is one small triggering event and the eurozone could spiral back into crisis mode.

In 2014, there are several sources of problems, including a housing bubble in Germany, increasing growth struggles in France, and a still problematic Greece. Yet, Italy is the nation that could probably be most accurately identified as Europe’s new powder keg.

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Margin Debt at 5th Highest Level Since 1959

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In December 2013, NYSE margin debt was at the 5th highest level since the data has been recorded.   As a percentage of GDP, it is now at 2.58%, just a hair behind the 2007 peak of 2.62%, and not too far behind the all-time record set in 2000 at 2.73%.

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While the Federal government has tried to restrict lending to middle-income homebuyers with flawed laws such as Dodd-Frank, it certainly hasn’t stopped stock speculators from borrowing.  This is one piece of evidence that suggests in spite of regulatory tightening, quantitative easing and loose monetary policies at the Fed are creating bubbles elsewhere.  In a sense, this is the worst of both worlds, as credit has been increasingly cut off from the middle class, but reckless behavior still thrives off of cheap debt.

Don’t Worry About Being “Right”; Focus on Risk vs. Reward

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“You were wrong!”

How many long-time investment authors have received this comment? I’d wager to say virtually all of us. Sometimes, the commenter cannot even wait a single day to make the declaration. Once, I published an article on a Wednesday morning, the stock fell 2% by noon, and a brash commenter declared me “wrong” by 2 PM, even though my investment timeframe was measured in years, not hours.

My most recent “you were wrong” moment came from an article I wrote back in June on “5 Inexpensive Stocks in an Overheated Market.” I’ll at least give the commenter credit for waiting all of six months to make the declaration, but the amusing part is that even if you ignored all nuance in the article and created an equally weighted portfolio with all 5 stocks on that day, you would have generated a 15.4% return, versus the 11.6% return on the S&P 500. In that article, I mentioned that Genworth Financial (GNW) and BP (BP) were my highest confidence picks. GNW was up 105% in 2013 and 37% after the article’s publication. If that’s the definition of “wrong,” I’ll gladly take it.

It wasn’t all roses for me in 2013. As the market has pushed upwards, I made more attempts to hedge my portfolios. The restaurant sector, in particular, looked overheated to me and I shorted 3 companies in that sphere. Back in May, I decided to write about one of those companies: Sonic Corporation (SONC). My thesis was that franchisee ROE had plunged in the past few years, and that franchisee growth would stagnate, as well. Since I published my first article in the series till the end of 2013, Sonic was up 64%. Somewhere, Nelson Muntz is pointing his finger at me, saying “HAHA!” Yet, strangely, I got the “you were wrong!” comment on Genworth, my big success story, and not Sonic, my big flop.

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