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Keep Your Eyes On The Forest While You're Climbing Trees

Lawrence Fuller

January 17, 2020

We all fall in love with our best performing stocks during bull markets, especially those that are undiscovered and not blue-chip names. There is no better feeling than buying a stock for $10/share and watching it double or triple over a short period of time. It makes us feel smart, not to say that we are not, but we should recognize the role a roaring bull market is playing in the performance of our individual names. 

I bought a technology stock for $8/share back in 1998 called Netopia. It was nothing more than a hardware company that manufactured broadband products like modems, routers, gateways and Wi-Fi devices. The stock soared more than ten-fold to $90/share in 1999. I had accumulated 10,000 shares and used margin to make some of the purchases. Analysts kept raising their forecasts for revenue and earnings, as well as increasing their price targets for the company, which made the stock look cheap, but in hindsight they were simply trying to keep up with the rapidly increasing stock price. I felt extremely smart at the time, thinking I had discovered this company before all the analysts.     

What I failed to recognize, as I climbed that tree called Netopia, is that the forest was smoldering, then burning and finally collapsing around me. But I was still climbing up the tree of my brilliant stock pick, never looking down below, convinced that it would keep rising in price. It did not. It was a painful learning experience, but it helped shape my investment discipline and philosophy moving forward. The company was eventually bought by Motorola for $7 a share in 2006, which is right around where I started buying it in 1998.  

I failed to appreciate the impact the macroeconomic environment was having on my Netopia investment on the way up, as well as on the way down. The stock was swept up, up and away in the technology and dot-com boom, during a period of overleverage and mal-investment. Valuations for stocks and the stock market reached heights not seen in our lifetimes, but we convinced ourselves that it was different this time. We focused only on the upside and rarely considered downside risks. We chided the more experienced naysayers for being “missing the rally.”

I see similar trends today, as Wall Street analysts and strategists seem to be chasing stock market performance with fundamental forecasts that are continually reaching to support ever-higher valuations. Forecasts are not based on fundamental developments. Instead, they appear to be influenced by nothing more than the upward momentum of prices. There are lots of “ifs,” to justify targets. If the trade deal results in a reacceleration in global growth… If interest rates remain low… If corporations be to spend again… If the Fed continues to provide the market with liquidity… This is what happened in 1999.

I listened to a money manager yesterday on CNBC’s halftime show discuss her shrewd tactical move in selling one stock that was trading at 37x forward earnings for a better valued one in the sector at just 31x forward earnings. The better valued one was only up 22% last year versus the more expensive one up 38%. She dismissed another far less expensive name in the sector because “it only had 10% upside.” Still, I’ve noticed that several of my sleepy value stocks that have not participated in the market rally have suddenly caught fire, but they are at multiples far below 31x. Everything is now getting swept up in the euphoria.

What we are witnessing today in the relentless rise in stock prices over the past four months is right out of the 1999 playbook. It is a full-blown melt up, which is not being fueled by corporate earnings reports, economic data or the trade deal. It is being fueled by one of the greatest surges in liquidity on record by the Fed. Yet the pundits know this isn’t the foundation to a long-term investment strategy, so they suggest that it must be the market discounting better fundamental news to come. 


Last week Dallas Fed President Robert Kaplan said, “I do think the growth in the balance sheet is having some impact on the financial markets and on the valuation of risk assets…I want to be cognizant of not adding more fuel that could help create further excesses and imbalances.” A rare admission from a former Goldman Sachs banker, but I think the excesses and imbalances are front and center, yet he doesn’t see it. The Fed is too late.

Here is an example-


The IPO market is bleeding red ink, as profitless companies in the healthcare and technology sectors go public. The last time we saw such a high percentage of companies in the red was 1999. This is because investors have the greatest tolerance for risk near the END of bull markets, with the majority of the gains behind them, rather than at their beginning. We only think about the upside, with less and less concern about the downside. Today the mantra is that the Fed will save us from the smallest pullback in stock prices. That doesn’t make a lot of sense, but that’s how financial markets work.

How Epic Is This Rally?

Rallies of 10% or more for the S&P 500 over three-month periods don’t occur very often, and we have just witnessed one close to 12%. According to Datatrek, rolling three-month returns have averaged just 2.2% since 1990, and the standard deviation has ranged between -5.1% and +9.5%. The only times we saw a rally greater than 10% over the past 15 years was when it was followed by drawdowns of more than 10%, as we saw in 2009, 2010, 2012 and early 2019. We had no significant drawdown in advance of this 12% advance.


We did have rallies greater than 10% without a prior decline of 10% from 1990 – 2005. In 1997 the S&P 500 soared 25% in three months, and in early 1998 it happened again with an advance of 20%. The one caveat is that earnings growth was increasing from 7% to 11% in 1997 and from 1% to 20% in 1998. Therefore, we need to see a significant advance in earnings growth just to substantiate the rally we have had so far. Right now, the consensus is expecting growth of 9-10% in 2020, but that will be very hard to come by with economic growth of just 2%. Additionally, we are starting from a forward multiple on earnings of 18.9, which is historically high. 

Valuations are what concern me the most today, especially after the latest rally, because I do not believe S&P 500 earnings will advance significantly in 2020. A best-case scenario is 3-5%, and a worse-case scenario is a continued recession in profits.  

Valuations At An Extreme

We just exceeded the December 2018 peak forward-earnings multiple, but I think it is much higher than 18.9, because I don’t believe the forward-earnings estimates are accurate. It is now as high as it has been since 2000, but strategist David Kostin at Goldman Sachs says not to worry, because a forward P/E of 19 is below the multiple of 23 we had at the beginning of 1999. That’s the kind of senseless logic that keeps investors buying at these levels, assuming that we will see a forward multiple of 23. Don’t forget that if 10% earnings growth does not materialize, the stock market is already at a higher forward multiple than 19.


Other stratigists have argued that stocks are still attractively valued relative to fixed income. The S&P 500’s earnings yield, which is a measure that’s inverse of the P/E ratio, is about 3.5% above the 10-year Treasury yield. That yield was 25 basis points below the 10-year yield in 2000. This seems like a weak argument to me, because the low bond market yields are a function of a decelerating rate of economic growth and central bank bond purchases. How do we know what a free and unmanipulated bond market would be telling us? This was the primary goal of the Fed from the start—push investors into higher risk assets to create a wealth effect.


Price-to-sales valuations are now above what they were in 2000. No one cares, because the Fed has our back.


Enterprise value to EBIDTA is as high as it was in 2000. That’s ok, because it is different this time.


Is The Forest Burning Now?

No, but something is certainly smoldering. If everything was wonderful, the New York Fed wouldn’t be pumping the banking system with tens of billions every day in overnight repo markets in order to control short-term interest rates. The Fed continues to make excuses as to why it needs to extend this temporary program that was intended to get us through the end of the year. Now it claims there will be additional cash needs around tax time. Give me a break. There is a serious problem in the plumbing of financial markets, but the Fed isn’t telling us why. 

I suspect higher interest rates are what instigate a reversion to the mean in the stock market, but it could take a while. The Fed can control short-term interest rates, but it has no control over long-term rates. A weaker dollar in 2020 will also play a critical role in interest rate developments.

Meanwhile, Wall Street suggests you dump your safe and secure bonds for stocks, because they have higher yields. This recommendation assumes that bonds and stocks are the same type of security with the same risk profiles, hence why own bonds when you can earn a higher yield owning stocks. There is a big difference. 



I continue to rotate from stocks that have become fairly valued to expensive into lower P/E multiples that are more defensive. I’m also hedging my stock exposure using option spreads that will protect against a 10% pullback. Lastly, I maintain a disciplined and tactical asset allocation approach that always keeps me invested in each asset class. That way I am prepared for whatever market environment is upon us.

Disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.

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