Diamond News

This post is based on excerpts from recent reports published at TFR Premium[1].

A couple of weeks ago[2], I wrote about how extreme valuations can be explained by extreme sentiment or euphoria. This week, I’d like to discuss the sort of euphoria we are witnessing in regards to owning equities today because it’s certainly very different than the sort of euphoria we saw at the peak of the dotcom mania, the last time valuations were as high as they are today. Back then, investors were making heroic assumptions about the prospects for growth in corporate sales and earnings. Today, they are making heroic assumptions about the sustainability of corporate profit margins and valuations, even if they’re not conscious of doing so.

As noted in my last post, the Buffett Yardstick is near all-time highs. However, while earnings based measures still show the stock market to be expensive they suggest the over-valuation is less extreme. The difference is the former is not affected by profit margins and the later is entirely dependent upon them. Thus investors leaning on earnings-based measures like the price-to-earnings ratio are making the assumption that margins will at least maintain at their current record highs indefinitely, as euphoric a premise as I’ve ever seen.

This issue of profit margins is so critical because if earnings-based valuations were to simply return to their historical averages it would mean a substantial decline in prices. But if profit margins were to revert at the same time, it would mean a far more substantial decline. It works like this: trailing earnings for the S&P 500 are currently $130. Put a 15x multiple on that, the long-term historical average, and you get a price of 1,950 for the index, or 30%...

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