The tulips are in bloom in Toronto and the entire front yard of a house on my street is devoted to them. The flowers were originally planted by the owner’s parents who passed away some time ago. But their memory lingers in the glorious blanket of red and yellow that appears each spring.
As it happens, tulips and stocks have a sordid history that dates back to the 1600s, when the Dutch were afflicted by tulip mania. Charles Mackay tells the tale in his book Extraordinary Popular Delusions and the Madness of Crowds, which is itself so old that it’s in the public domain. You can think of tulips as being the internet stocks of their day. They followed a similar pattern, with bulb prices running up and then crashing spectacularly. Ever since then, the flowers have been associated with speculative bubbles.
It’s impossible to tell for sure whether stocks are now approaching a tulipy top, but there is reason to worry.
One of my favourite market measures is Prof. Robert Shiller’s cyclically-adjusted price-to-earning ratio for the S&P 500. It’s based on the index’s current price divided by its average inflation-adjusted earnings over the last 10 years. These days the ratio hovers near 25, which is well in excess of its long-term average of 16.5.
If you invert the ratio, it turns into an earnings yield of about 5 per cent, which is a more intuitive way of thinking about it. Buying stocks with such low yields is likely to lead to low returns, which doesn’t leave much room for error.
Even worse, the outlook for value stocks isn’t great according to money manager Tobias Carlisle. He recently examined both value and glamour stocks in the S&P 500. But instead of using earnings yield, he used EBITDA yield as his measure. You can calculate it by dividing EBITDA by enterprise value.
You’ll remember that EBITDA stands for earnings before interest, taxes, depreciation and amortization. It’s a rough measure of a firm’s operational profitability that is independent of its capital structure. Enterprise value represents the market value of a business, including both equity and debt, while adjusting for cash. It’s an estimate of what a private buyer might have to pay for a firm while also settling its debts.
Mr. Carlisle tracked three equally weighted portfolios based on stocks in the S&P 500 with annual rebalancing. The first portfolio followed 50 stocks with the highest EBITDA yields, the second tracked 50 stocks with the lowest EBITDA yields, and the third contained all 500 stocks in the index.
As one might expect, the high-yield group fared the best with average annual gains of 10.7 per cent since the summer of 1999. In comparison, the market climbed 8.2 per cent annually over the same period and the low-yield group provided gains of only 2.1 per cent per year.
The return pattern represents a win for value investing, but it also comes with a worrisome observation. Currently, the EBITDA yield for the S&P 500 is at a low of 8.2 per cent. The value group’s EBITDA yield is more generous at 16.2 per cent, but that’s just a touch higher than its lowest point. As a result, both the market and value stocks are expensive, according to this measure.
Mr. Carlisle’s work was inspired by a much longer-term graph from money manager Patrick O’Shaughnessy, which provides little solace. He looked at EBITDA yields for U.S. stocks from 1971 through 2013. The yields for both value stocks and the market overall are near their long-term lows.
While it’s impossible to say how stocks will fare in the short term, the tulips are growing and it doesn’t seem that the gardens of value investors are immune to their charms.