Alambic Insights: Is this what Euphoria Feels Like?

by Albert Richards
CEO and Founder
Alambic Investment Management LP

Imagine if we had circulated a note at the end of 2016 predicting that 2017 would be punctuated by the Dow reaching for 25,000, volatility hitting all-time lows and crypto-currencies infiltrating every conversation. We would have been wildly sage pariahs!

Like many other thoughtful market-watchers, we considered the 8-year bull market, stretched valuations, political uncertainty and inevitable interest rate hikes to be reasons for caution. Beta prevailed in 2017, however, adding more than 30% to indexed portfolios and further stretching valuations. At the dawn of 2018, although the reasoning that inspired caution at the start of 2017 remained valid, a chorus of pundits trumpeted further prospects for growth and some speculated of an impending “melt up.”

As value investors, when prices move against us, in the absence of new information, our conviction is strengthened. Our popularity may wane as others capitulate, but our resolve has never been stronger. February’s technically-lead sell-off was a “correction” in name only as the Russell 2000 Value Index lead the Russell 2000 Growth Index on the way down and lagged on the way back up, knocking valuations further askew and “correcting” very little aside from some mis-conceptions about the safety of exchange-traded, short volatility products.

While it is possible that the trends of 2017 could continue through 2018, we believe markets are very expensive relative to history on a broad range of measures. Additionally, while some are talking about the market being in a “pre-bubble” phase, or suggesting that a “melt-up” may be about to occur, we don’t believe this hype does investors any favors. Bull markets are born in fear and die in euphoria, and it’s looking a lot like euphoria out there. The numbers presented below suggest that we may already be well into the final melt-up phase of this aging bull market.

Is This What Euphoria Feels Like?

Given that bullishness seems to be everywhere, we believe it’s appropriate to ask, “is this what euphoria feels like?” Our analysis suggests cause for heightened concern about market exposure. According to the American Association of Individual Investors, as shown in the chart below, equity allocations popped above 70% in December to levels last seen in October of 2000 while cash allocations dropped to 13.0% – lower than any time since December of 1999.

Over the past several years, “buy the dip” has been a remarkably strong strategy, demonstrating that investors have been perceiving market dips as opportunities to buy more equities, rather than cause for concern.  Even the mini-market-correction in early February was attributed to the unwinding of short-volatility products, rather than a sudden bout of investor nervousness (ask us about the Morgan Stanley Equity Research Report on this).  Indeed, investors took the opportunity to jump further into the market, precipitating the record-breaking rallies of the following week.  The chart above shows that individual investors have taken on extraordinary levels of equity risk and are becoming very fully invested.  Hence they could easily be spooked and have little cash to buy the next dip.  When buying the dip finally fails, it could fail spectacularly.

One could argue that equity allocations aren’t that different from the 2003-2007 period.  But higher allocations to cash in that era demonstrated a healthy appreciation of risk (helped by a reasonable return being earned by that cash).  Today, without the counterbalancing  “cash caution,” we wonder how long this rally can continue.

While we find both cash and equity allocation levels disturbing, we believe that the spread between equities and cash is an even more telling indicator of the level of euphoria in the marketplace, as this is essentially a measure of greed minus fear (a third allocation element, bonds, is essentially midway between fear and greed).  As can be seen in the chart below, the spread is beginning to scream “bubble.”

From FOMO to FOMU …

Much of the market performance in 2017 was attributed to strong earnings, the prospect of lower regulation and tax reform.  With this as a backdrop, the market moved strongly higher, in spite of the fact that many valuation measures, including the Cyclically-Adjusted P/E, or CAPE ratio, reached past bubble heights.  This was essentially a Fear-of-Missing-Out (FOMO) rally, quite similar, in our view, to the frenzy behind bitcoin and other crypto-currencies.

As we approached year end, many market pundits began speculating on a potential market “melt up,” supported by a paper written by superstar investor, Jeremy Grantham of Grantham, Mayo van Otterloo (GMO).  In his paper, the well-known and highly respected (and highly successful) sage mentioned the possibility of another 30%-60% market rise.  This theme helped push the S&P 500 to new highs in January, and helped fuel the rapid post-correction snap-back in mid-February.

With this new “pre-bubble” talk, we have essentially transitioned from a Fear-of-Missing-Out (FOMO) rally to a Fear-of-Melting-Up (FOMU) rally.  After all, who would want to be in cash if the market was about to rise another 30%-60%?  Certainly not the individual investors we chronicled above.  And not a prominent (and also very successful) hedge fund manager who was recently quoted saying, “If you’re holding cash, you’re going to feel pretty stupid.”

… But Have We Already Melted Up?

The prospect of a near-term melt-up continues to entice many investors, but in light of 1) the market’s performance over the past 18 months, and 2) individual investors’ equity and cash allocations, we feel compelled to ask, “Have we already melted up? and if so, “when will it end?”

Grantham cited the paper, Bubbles for Fama, by Robin Greenwood, Andrei Shleifer, and Yang You of Harvard University.  It’s a fun read.  In this paper, the authors looked at industry bubbles over the past 100 years, and studied the subsequent industry and overall market performance.  The authors classified a bubble, as an industry that had:

  1. An absolute performance of +100% over the past two years,
  2. An outperformance relative to the market of at least +100% over the past two years, and
  3. An absolute performance of +50% over the past five years (to avoid categorizing a collapse and return as a “bubble”)

A total of 40 instances of industry bubbles met their definition over the past century.  In half of these instances, the industry suffered a subsequent “crash,” defined by the authors as a 40% decline within two years.  While this means that half of the industries didn’t reach the definition of a crash, the risk of crash following a bubble is much higher than the normal probability, which is about 11%.

Perhaps unsurprisingly, many of the bubbles were concentrated around market peaks: notably 1929, 1967/8 and 1999.  Oddly, only one industry (coal, of all things) hit bubble-level in 2008.  Interestingly, the authors found that, while some industries crashed and others didn’t, the average overall market forward 2-year performance once an industry hit bubble-level was quite poor.  Thus it seems that the presence of an industry bubble in the market is an indication of overall market euphoria – which is generally an indicator of poor future returns.

For fun, we looked for industries close to the paper’s definition today, and we found some that were very close.  Semiconductors, for example, easily matched the first and third criteria, with 2-year investment returns reaching +145% in mid-January.  But performance relative to the S&P500 was “only” +96%!!

While semiconductors just missed the author’s definition of a bubble, to our view the industry’s performance is close enough to warrant meaningful caution – not just for that industry but for the market overall.  In his “melt-up” thesis, Grantham speculated that markets could rise 30%-60% before, most likely, crashing.  We would note, however, that since January 1, 2017 – a time when most would have said that the market was already fairly fully valued – the S&P has already risen 30% and NASDAQ is up 40%.  So are we already looking at the melt-up, or at least much of it, in the rear-view mirror?  Market valuations, discussed below, would suggest “yes.”

Just How Expensive is the Market, Anyway?

The most oft-cited measure used by the bears to warn against market valuation levels is the CAPE ratio.  A chart of the CAPE ratio since 1881 is shown below.  While we’re not at 2000 levels, the fact that we are now above 1929 peak should be cause for at least a little concern.

While the CAPE ratio seems to have predictive ability over a 10-year time frame, few investors actually invest with this level of patience and foresight.  The CAPE ratio also has meaningful limitations, as profit recessions (such as those that occurred in 2000/1 and 2009/10) can depress earnings, and thereby inflate the ratio for a decade to come.  Some detractors cite the fact that the bull market of 2003-2007 occurred in spite of the high CAPE ratios at the time (driven, in part, by a low “E” which included the 2001-02 recession), and they claim a similar situation today as the “E” in the current CAPE includes the losses of the Great Recession.  Thus CAPE will naturally fall in coming years merely because we start dropping off the poor earnings years 2008/09.  So why should we be worried?

As noted above, analysis of the CAPE ratio can get quite complex, and has many limitations.  In contrast, we find that quite a bit of information can be derived from looking at relatively simple ratios.  For example, the ratio of enterprise value (equal to equity market value plus net debt) to sales (EV/Sales) can provide insight into the richness or cheapness of the market, and has advantages over traditional P/Es, since sales tend to be much more stable over time than earnings.  This ratio can, however, vary dramatically by sector due to differences in underlying profitability.  Financials in particular can significantly distort the ratio, and we also prefer to exclude Energy, as swings in oil prices can cause significant distortions in the data.  We show EV/Sales for the total stock market, excluding Financials and Energy, below:

While more simplistic, EV/Sales makes a more compelling case that valuations are exceptionally inflated.  Additionally, in contrast to CAPE, it is tough to make the argument that the current ratio is high because the denominator (sales) is artificially low.  The ratio also hasn’t changed because of large shifts in the sector composition of the market –  each sector’s percentage of total sales has remained more constant than one might guess.

One might ask if the EV/Sales ratio has risen because sales have become more profitable.  A company with a 10% net margin (income to sales) is clearly worth a higher multiple of sales than a company with only a 2% net margin, and if net margins have risen market-wide, the market should pay more for EV/Sales.  Surprisingly, however, operating margins, aside from recessionary periods, have remained relatively constant over the past three decades, as shown below – again excluding Financials and Energy.  Note that the dip in 2008 isn’t nearly as deep as might be expected due to the exclusion of Financials, which endured most of the pain. Additionally, the exclusion of Energy eliminates a more recent decline in response to the drop in oil prices.

While we’ve  enjoyed a period of stable, and relatively high, operating margins over the past several years, we find it difficult to justify a market with 12% operating margins trading at 2.9 times sales when 11% margins were worth 1.3 times sales in the late 1980’s and 1.7 times sales in the mid 1990s.  The bullish skeptic could argue that interest rates are much lower today than in the past (although just how long this remains is open to debate) and that tax reform means that a greater percentage of operating earnings will drop to the bottom line (making them more valuable).  We worry, however, that lower tax rates will be competed away over time in the same way that lower raw material costs usually result in cheaper products, not higher profits.  If nothing else, this chart should emphasize the market’s vulnerability to higher rates, earnings disappointments, or the eventual outright recession.

While EV/Sales is helpful, we believe an even better measure of valuation is EV to Invested Capital, which is best viewed in the context of the Return on Invested Capital (ROIC).  There are many different ways to measure these ratios, but a pair of our favorites – again due to their simplicity – are EV to Total Assets (EV/A) and Return on Assets (ROA).  We again exclude Financials and Energy due to the former’s high asset levels relative to other industries and the latter’s volatility.  We also exclude cash from the total asset figure, preferring instead to subtract it from enterprise value (i.e., EV = equity market value plus net debt).  Here’s the chart:

Once again, current valuations – as measured by EV/A – for the total market ex Financials and Energy, are higher than at any time excluding the Tech Bubble, and multiples are nearly twice the level seen in the late 1980’s.  So what could justify these higher multiples?  Just like more profitable sales are worth more, higher multiples of EV/A could be rational if the return on those assets was also commensurately higher.  Unfortunately, this is not the case.  Shown below is the return on assets (ROA), measured here as operating profit to total assets excluding cash.

During non-recessionary times, ROA (as measured by operating profit to total assets excluding cash) has been remarkably constant. It was 10% in the late 1980s, 10% in the mid-90’s, 10% again in the mid-00’s, and 10%today. (Note: the ‘bump’ post the Great Recession was due to significant asset write-downs, not improved profits.) This is capitalism at work – with competition keeping return on assets capped across time. Once again, it remains to be seen whether lower taxes will result in improved ROA, or whether the benefit will be competed away.

Of course, from a valuation standpoint the other major differences between these time periods was the prevailing interest rate, with today’s lower rates providing for higher valuations. But this also points out the market’s potential vulnerability to rising rates today – should we return to the rates and valuations of the mid-00’s, the market has a long way to fall from here. Investors also shouldn’t forget that leverage means that market value declines will be much greater than EV declines. For example, the one-third decline in the EV/A ratio in 2008 translated into a nearly 60% decline in the stock market.

So, Where’s the Bubble?

Yogi Berra once said that history doesn’t repeat itself, but it often rhymes. Many investors have taken comfort that there isn’t any obvious “bubble” on which to hang their hat of worry. The 1990’s had the Tech Bubble, the 00’s had Real Estate – but where is the bubble of today? Some say it’s bitcoin and the rest of the cryptocurrencies, which implies that it’s not in the stock market. We disagree.

The surprising answer is that today’s high equity valuation isn’t just in one place – it’s everywhere. Previous bubbles had a few sectors that went completely out of whack, whereas others were more reasonable. The odd thing about today’s market is that euphoria isn’t contained in a single industry or sector. Tech, for example, seems expensive, but much less so than in 2000. But in 2000 and 2008, there were other sectors that were valued relatively reasonably relative to history, whereas today almost everything is expensive in a historical context. This has given rise to the NOA market (as in “No Other Alternative”), which we suspect is mainly driven by the persistently low level of interest rates.

This is not a prediction that markets are about to collapse – high valuations can often persist for considerable periods of time. As Keynes said, “markets can often stay irrational longer than you can stay solvent.” But euphoria seems to be in the air, and current market valuations, on a number of measures, are near peak levels relative to almost every past episode save the Tech Bubble, plus interest rates finally appear to be moving upwards. There’s a chance that higher rates will come more slowly than expected, but the current market conundrum is that embedded earnings estimates and growth expectations almost require a return to “normal” market conditions, whereas the rates implied in such a return are likely to cause significant stock market indigestion – a situation not unlike the mid 1960’s. But even without a market calamity, the gap between prices and valuations is poised to narrow and that bodes well for strategies that attend to
valuations, like ours.

This material is for discussion purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy or sell, any securities. Past performance does not guarantee future results.

Mutual Fund investing involves risk, principal loss is possible. An investor should consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. To obtain a summary prospectus and/or prospectus, which each contain this and other important information, go to or call (888) 890-8988. Please read the summary prospectus and/or prospectus carefully before investing. The Fund may not be suitable for all investors.

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In the above discussion, we use certain terms, which have the meanings described below. Each of the indices defined below are not investible products. You cannot invest directly in an index.

Dow refers to the Dow Jones Industrial Average, a stock market index that tracks the daily price of shares of stock of 30 large publicly-owned companies sold on the US stock exchanges.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Source:

The Russell 2000 Index is an index measuring the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States. Source:

The Russell 2000 Growth Index is a subset of the securities found in the Russell 2000 Index. It measures the performance of Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. It refers to a composite of small cap companies located in the United States that also exhibit a growth probability.…/russell-2000-growth-index/.

The Russell 2000 Value Index is also a subset of the securities in the Russell 2000 Index. The stocks in the value index are selected based on a “probability” of value, measured by their relative book-to-price (B/P) ratio. Source:

The S&P 500 is The Standard & Poor’s 500, sometimes abbreviated as the S&P 500, or S&P. The S&P is an American stock market index that is based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices. Source:

NASDAQ is an acronym for the “National Association of Securities Dealers Automated Quotations,” which was founded in 1971 by the National Association of Securities Dealers (NASD). It is a US electronic securities market that quotes prices through a computer network, and allows brokers to conduct trades online or via telephone. Since there is no physical ‘exchange’ involved, it is referred to as an “over the counter” or OTC market. Source:

Price to Earnings Ratio or P/E Ratio is a commonly used measure of how expensive a stock is. The P/E ratio is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing 12 month period. A P/E Ratio for a stock is the same whether it’s done for the entire company or on an individual share basis. Source:

A company’s operating margin is a measure of a company’s profitability, calculated by dividing operating income by revenue. Source:


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