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Crash Prone Bubble Valuation

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Donald Trump makes a lot of controversial statements. One he made happened at the 3rd Presidential Debate, where he said:

We are in a big, fat, ugly bubble. – Donald Trump (September 26, 2016)

Check out the video below at around the 1-minute mark to see and hear it for yourself.

Valuation Approach

To test his assertion, we need to find a way to measure bubbles. One reliable way is valuation. There are many approaches though. The most common ways of valuing companies are based on profitability (e.g. price-to-earnings). Another way is to base the valuation on the underlying assets. This latter approach uses the balance sheet, which includes figures for assets, liabilities and shareholders’ equity.

Price-to-Book

This balance sheet approach to valuation is focused on shareholders’ equity, which is not a market derived number. It is instead based on accounting figures. To distinguish the difference, it is commonly referred to as book equity. Investors would understandably prefer not to invest in a company at a price-to-book (“P/B”) of much more than 1.0-times. Such a low valuation though is virtually impossible to find amongst the universe of high quality companies I seek to invest on my clients’ behalf. Quality comes at a price but not any price. As you will see, paying too much has ramifications.

valuation, price-to-book, P/B, stocks, NYSE, NASDAQ, AMEX, crash, bubble, Trump

The median P/B valuation in 2014 increased to 2.4-times, which is placed at the 92nd percentile looking back 91 years. The only other time that was more expensive occurred during the Tech Bubble.

Bubble Level

As shown in the graph above, the median P/B valuation of U.S. companies listed on the NYSE, AMEX, and NASDAQ stock exchanges have risen over time. This is most evident by the yellow-dotted, upward-sloping, 91-year trend line. (I will likely discuss the sustainability of this trend in the future.) In the first 6 instances when the median P/B valuation was +1 standard deviation or more above trend (red dotted line), the U.S. stock market crashed each and every time, and normally within 3 years. Four of these instances were the bursting of bubbles. They include:

  1. The Roaring Twenties (i.e. 1920s) stock market bubble that preceded The Great Depression,
  2. The Nifty Fifty Bubble of the 1960’s that Warren Buffett famously exited before it crashed,
  3. The Tech Bubble that imploded in 2000, and
  4. The Subprime Mortgage Bubble that preceded the Global Financial Crisis.

I am bringing this to your attention because a 7th instance has arisen.

Deja Vu?  

In 2014, the median P/B valuation increased to 2.4-times, which is placed at the 92nd percentile looking back 91 years. This was also more expensive than what was observed in the years leading up to the Global Financial Crisis. It is also second only to the Tech Bubble. More recently, the median P/B remained elevated at 2.4-times in 2015 and moderated to 2.3-times in 2016. The moderation in 2016 should not be looked upon as air being released from what may prove to be stock market bubble. After all, the median P/B also moderated in 1999, the year before the Tech Bubble crashed by almost 50% over 2.5 excruciating years.

Whether or not you believe valuation is a good way to measuring asset bubbles, please consult an investment fiduciary before making any investment decision.

Meritocracy Capital Partners Inc. is a boutique investment management firm & portfolio manager that aligns itself with its clients. We build trust & accountability by providing a fee structure driven by performance and by having our money invested right alongside our clients’ money. As a result, we treat our clients’ money like our very own.

How could you be better served? If you have any questions, then please reach us on our Contact page.  

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