23rd November 2020 JANUS ANALYSIS

Plateau, Break, Rebound, then Purgatory

• S&P has increased >50% over the past 18 months

• Equity price ratios now exceed Dot-com levels
• US Corporate profitability has plateaued for over a decade
• 50% mean-reversion just to reach LT average valuation
• Minimal market volatility, indicative of continual internal strength

If advice had been followed 18 months ago, when we suggested that the market was vastly
over-valued and a mean reversion event was likely to occur before the end of 2020 (see
Figure 3), you would have missed a 50% market appreciation of the S&P 500. Which, if
anything, is evidence that it is hubris to predict anything based around notional
fundamentals at various stages of the market cycle.
We continue to contend, nevertheless, that the markets are at extreme levels only seen
thrice over the past 300 years, and that a mean-reversion event is inevitable. Note that a
50% decline would only depress stocks to long-term valuations based on profitability
measures. However, given that markets at times over and under shoot fair value, we
forecast the eventual market nadir will be substantially lower still. Rather than being
despondent, we perceive the current situation to be a once in a life-time opportunity where
fortunes will be made/lost.

We examine why significant market bubbles occur, whether they are inevitable or even
desirable in a capitalist system, and why the largest market bubbles in history are associated
with financial innovation. We explore the role of new technologies and their preferential
adoption over existing businesses and profitability. Critically, we look for specific tell-tale
signs and timing for when this market will mean-revert.

Figure 1: US corporate profits (US$Bn) on a semi-annual basis (March/Sept.) (left); versus S&P
Market (US$Tn) (right).

Gaius L.L. King

Source: Trading Economics (2021), YCharts (2021), Bloomberg (2020), BEA (2020), Piper Sandler (2020), Steve Blumenthal (2020),
Janus Analysis
 Macroeconomic Strategy

“Blue skies... From now on?”

In the late 1920s, “Blue Skies”, released in 1926 by Irving Berlin became the
unofficial anthem, capturing the Zeitgeist of the age.

Never saw the sun shining so bright

Never saw things going so right
Noticing the days hurrying by
When you're in love, my how they fly

We are permanently fascinated by market bubbles, the repeated history of such

have led some market commentators, such as James Dines, to conclude that
bubbles are somehow invisible to the masses, and in particular, “are invisible to
those inside” and the axiom “it is different this time” always applies. Arguably the
current era is akin to that in the 1920’s, in particular, the quantum of financial
innovation and the adoption of new technologies covering all facets of life.
Examples include the widespread adoption of cars, airplanes, washing machines,
radio, the assembly line, fridges, vacuum cleaners etc. The period was also
important for the development of banking, resulting in new lending practices that
strongly favoured credit expansion, in particular measuring credit risk based on
statistical analysis, thus replacing previous rules of thumb for consumer credit tied
to purchases of durable goods like vehicles. It was this new source of credit that
fuelled a real estate boom in 1925, and the Wall Street bubble in 1928/29.

They say history doesn’t repeat itself, but it certainly rhymes. Not unlike the 1920’s
we too reside in an era of technological disruption, work from home, machine
learning, the internet of things, automation and robotics, artificial intelligence,
connectivity and 3D printing among a host of other advancements. Likewise, the
explosion of credit, the ability to buy fractional shares using margin borrowing (see
Figure 2) and Apps has introduced an entirely new generation to the appearance
of ‘free money”.

Figure 2: Investor credit versus the S&P 500.

Source: Advisor Perspectives (2021)

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 Macroeconomic Strategy

As evidence of the irrationality of these market events, what we find particularly

intriguing, is not how many people participated in these massive stock runs, but
how very few actually made anywhere near the theoretical multiples that were
implied by share appreciation. If there were anything logical, predictive or insightful
about why markets (which, at times) reach extreme valuations, would have the
presence of a select cadre of investors able to trade on some level of arcane
knowledge. Alas, these people do not exist. As a personal observation, investors
can be generally divided into two distinct groups: the first group are conservative,
sell after making several multiples of their initial investment, arguably suffering a
lack of imagination of what could be. The second group, typically, hold their shares
all the way to the top, then all the way back down again once the correction takes
hold, as he/she becomes a true believer to the new Zeitgeist paradigm of the age.

We have yet to meet an individual who was able to get in early, retain their faculties
of reason to recognise financial bubble-like behaviour, and more importantly, had
the fortitude to hold and sell anywhere near the top. The reason why this is
uncommon resides in the fact that if one’s market orientation is based on market
fundamentals, you will exit those positions far too early, and criticise from the side-
lines as subsequent “asset” appreciation proves you wrong. Conversely, if the
investor accepts that this is a new paradigm, he/she then becomes a true believer,
refusing to exit even after the peak; many reasoning that they have incurred a
theoretical loss, promising themselves they will sell on the next rebound.

Figure 3: US corporate profits (US$Bn) on a semi-annual basis (March/Sept.) (left); versus S&P
Market (US$Tn) (right) up to July 2020. Corporate profits peaked ~2015, long before the recent
pandemic, and had largely plateaued for a decade. When we released the note, at the time we felt
that on a fundamental basis, the market was over-valued and forecasted a mean-reversion event by
the end of year. Instead the S&P 500 has climbed another 50% since (see Figure 1 for comparison).

Source: Bloomberg (2020), BEA (2020), Piper Sandler (2020), Steve Blumenthal (2020), Janus Analysis

We are not immune to hubristic market predictions. More than a year ago, Steve
Blumenthal1, using a variation of Figure 3, asked whether (i) US company profits
are about to double? alternatively: (ii) the S&P mkt capitalisation was about to
halve? or (iii) a combination of both? Unsurprisingly, the answer is - none of the

1
https://www.linkedin.com/in/stephen-blumenthal-36648664/
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 Macroeconomic Strategy

above (given the market never does what it’s supposed to)! However, we were in
full agreement with Blumenthal’s prognosis, while admitting that we didn’t know
how this future crisis would be triggered, concluded “it cannot be far away…” The
joke is on us, as the updated Figure 1 suggests, the “Bubble of Everything” is still
very much intact, with internal liquidity measurements suggesting that this market
has considerable strength yet. Profits be damned! As Yogi Berra observed, “it's
tough to make predictions, especially about the future”.

"It's only hubris if I fail" – Gaius Julius Caesar

There is an increasing body of academic research looking at why the largest of

market bubbles are exclusively associated with financial innovation, past examples
including the South Sea Bubble, the 1929 market crash, the 2000 Tech Boom;
periods where the investor had to grapple with growth implications associated with
new technologies. Blockchain is the perfect example, crypto-trading aside, it has
been around for over a decade, with purported uses such as smart contracts,
tracking raw materials, IP sales (e.g. music), property titles, international money
transfers, even parliamentary voting – but for a plethora of reasons, it is rarely (if
ever) used for any of these applications. For example, BTC ownership is still
largely held by its founders, the remainder primarily used for speculative trading.
Although US centric, a recent study by data analytics firm Engine Insights,
indicated that 59% of Gen Z investors think crypto will make them millionaires.

Figures 4 & 5: Bitcoin price profile over the past 12-months in USD (Left); and Ethereum price profile over the past 12-months in USD
(Right); both diagrams GMT 10am 23/11/21.

Source: MarketsInsider (2021)

From a macro-economic perspective, the great difficulty analysing this particular

market, is the emergence of a whole host of new disruptive technologies affecting
existing participants in a variety of segments, whether that be in electric cars,
batteries, 5G, payment providers, e-commerce, or even the $3Tn cryptocurrency
market. The reason why we think this period is more akin to the 1920’s than the
late 1990s, is the scale and breadth of this technological transition. Changing the
way we do business, education, job opportunities, where we work, even how we
meet life partners.

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 Macroeconomic Strategy

This underlies the real problem when dealing with new technologies, which in many
instances, future uses may not yet exist or even be conceptualised. An example
of this quandary is graphene2, an incredibly efficient electrical conductor at room
temperature, it can sustain densities six orders of magnitude higher than that of
copper; its charge carriers have the highest intrinsic mobility, and has the best
thermal conductivity of any composite. Lithium sulphur (Li-S) batteries have low
toxicity, are low cost, and have an energy density of 2,567 Wh/kg-1, five times
higher than that of existing Li-ion batteries (see Figure 7). Samsung’s experience
is a salient lesson, however, in subdued expectations, primarily centred around
production costs and quality control. Despite purportedly spending billions in R&D,
its ability to commercialise any of the purposed applications has proven to be far
more difficult; with all its glitzy graphene PR releases in past years, having now
been quietly shelved.

Figures 6 & 7: Patents for graphene related applications (2005 to 2020E) over time have fallen out of favour due to the long development
times and costs, and, we assume, technical difficulties (left); and comparing various battery types, in particular Li-ion with the new
generation of graphene batteries (right).
400
300

350
250

300

200
250
Wh/kg

150 200

100 150

100
50

50
0
0
05

06

07

08

09

10

11

12

13

14

15

16

17

18

19

E
20
20

20

20

20

20

20

20

20

20

20

20

20

20

20

20

Lead Acid NiCd NiMH Li-ion Graph. Li-ion Graph. Li-S

20

Source: European patent office (2020). Bloomberg (2018), NanoGraphene (2019), Janus Analysis

There is, however, an unconfirmed rumour (from several sources) that Tesla is
working on a graphene battery3. The advantages of graphene batteries include
durability (i.e. greater number of recharges), lightweight (20% of its equivalent
lithium-ion), cost (20% of current material inputs), with dramatically shorter
recharge times (~80% in 8 minutes)4. Elon Musk is the Edison of our times,
incredibly well financed, not terribly motivated by short-term profit, and if
successful, has the potential to transform personal transport, and quite possibly
propel Telsa into being the most valuable company globally.

Which raises an interesting conundrum, that possibly, the long-term success of

capitalism relies on funds flowing into speculative ventures, and at regular intervals
these extravagant technological missives eventually morph into speculative

2
First discovered in 2004, Russian Physicists, Professors Andre Geim and Konstantin
Novoselov were awarded the Nobel prize in physics in 2010.
3
We assume from what we have read that Tesla are trying to develop a pure graphene
based battery, not just a graphene composite. https://cleantechnica.com/2014/08/25/500-
mile-tesla-graphene-battery/
4
https://www.graphene-info.com/gac-group-announces-its-aion-v-sporting-graphene-
battery-will-start-production
5
 Macroeconomic Strategy

bubbles, until at some point, valuations matter, and the market then mean-reverts.
In this framework, it could be argued that bubbles are a capitalist necessity (minus
the financial excess), in which enormous sums are invested into infrastructure,
research, establishing new business models, creating efficiencies and
opportunities which are commonplace, even standard today, but inconceivable five
years ago.

How will it End? Plateau, Break, Rebound, then Purgatory!

It is the ultimate cliché that market bubbles continue for far longer, and reach levels
much higher than was ever anticipated; and so it has for this current bubble. In an
already over-valued market, our nascent prediction that a correction would occur
before years end (in 2020), in hindsight, was extremely naive. Any investor who
listened to us would have missed out on 50% gains over that relatively short period
of time.

Figure 8: S&P Market (US$Tn) on 12/11/21 (left) divided by US Corporate profits (US$Bn) (right).
The current ratio (16) exceeds the peak of 2000 Dot-Com boom.

18

15.7 16.0
16
S&P Mkt. Cap./Corporate Earnings

14

12

10

8
5.2
6

4
2.5
2

0
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Source: Trading Economics (2021), YCharts (2021), Bloomberg (2020), BEA (2020), Piper Sandler (2020), Janus Analysis

Part of the problem with providing any accurate market forecasts currently, is that
we are not dealing with free markets, hence how can one forecast accurately
without an historical market analogue? The breadth of monetary stimulus has, as
a by-product, introduced a significant degree of moral hazard, as investor
expectations are now viewed through the lens of continued government largesse,
which in turn, has fuelled continued market speculation (see Appendix A). A recent
survey in Australia found that almost 50% of consumers aged 18 to 24 are now
interested in trading and/or investing in financial markets, with aspirational wealth
creation becoming a mainstream fixture for Gen Z pop culture. For the rest of us,
who have seen a market cycle or two, the replacement of unbridled optimism with
pervasive pessimism does occur, just not recently.
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 Macroeconomic Strategy

Using a Game Theory decision matrix, it could be argued that current investor
actions are, in fact, logical, whatever future economic angst arises, it is extremely
probable that additional, if not massive, Governmental/Central Bank monetary
accommodation would ensue. Alternatively, if you don’t participate, you lose in
absolute terms against your peers unless you can accurately anticipate any
impeding correction (which all evidence suggesting its more luck than skill).
Moreover, from a fund-managers perspective, performance is measured on a
relative, not an absolute basis, if and when a market correction occurs, no matter
the severity, all participants suffer with equal equanimity.

Figures 9 & 10: Dow Jones average 1929 (Left); and South Sea Bubble from December 1718 to the end of 1721 (Right). In both
instances, there was a short-term recovery that lasted several months before the inevitable crash.

Source: SBNCHF (2017), FactMyth (2021)

Looking at the largest market bubbles in history, there is an uncanny consistency

in how these markets break-down. It’s this transformation from optimism to
pessimism and the commonality at numerous bubble tops that we find so
fascinating. When investors speculate, they largely do indiscriminately, so that
gauging where we reside within the general market cycle is strongly tied to the
uniformity in direction among sectors, industries, commodities and stocks. We try
to articulate not only why these manias occur, but also the forces that trigger their
demise. We don’t agree with the premise that markets suddenly change on a dime,
buying one day, selling the next, seeing no historical analogue5. After looking at a
number of major bubbles, we have collated a number of (what we consider) salient
observations:

i. From a historical perspective, and in context with the general theme of

the note, is that although great market missives may take many years to
reach fruition, the final explosion thrust to the top rarely lasts several
years. By this measure, the current market is already very long in the
tooth, which is the reason why we are actively looking for a brief plateau
and increasing volatility (as described below).

5
Possible exception of 1987, but clearly a correction rather than a sustained market
bubble with all losses recouped by 1990; precipitated by computer program-driven
trading models inducing investor panic.
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 Macroeconomic Strategy

ii. Although it is almost impossible to accurately delineate what specifically

triggers a collapse in a particular market bubble, what is evident is that a
market deflation event is more of a process than any specific spark.

iii. Our belief that within a market bubble, the majority of investors comprise
of two main groups: the first makes several times their money then
typically exits; the second faction typically hold their shares all the way to
the top (at times trading in and out), many of which, become true
believers, that things really are different this time, and never Sell (or at
least, never in time).

iv. Plateau: At the advent of the market top, there are an increasing number
of long-term investors who question the prevailing Zeitgeist, with sellers
slowly out numbering buyers. A key characteristic of a top (as buyers
and sellers battle for dominance) is a brief plateau, typically covering
several months; in addition, with increasing volatility. In all instances,
large intraday variations, typically >10% precede the initial “break”.

v. Break: Initial correction typically ranges from 41% (Dot.com) to 47%

(1929).

vi. Rebound: Resultant dead-cat (Bull Trap – see Figure 12) bounce typically
occurs over twice the period that over which the initial correction occurs
(e.g., correction five weeks, rebound is ~10 weeks).

vii. Purgatory: Eventually, all vestiges of optimism evaporate, and calamity

ensues with the bottom of the market not seen for at least several
additional years of declines.

Figures 11 & 12: Nasdaq 1994 to 2003 (Left); and generic bubble profile (Right). Note the rebound period for several months after peak.
That is the critical time to recognise and exit all positions.

Source: HDent (2019), SCMP (2020)

Looking at today’s markets, we have not yet observed any discernible plateau, nor
any significant intraday market volatility. Some technical analysis using the DJIA,
suggests that we have (at least) another 8 to 10% left in upside. On profitability
measures (see Figure 1), the coming correction would need at least a 50% decline
just to reach a long-term average. Given that markets typically over and under-

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 Macroeconomic Strategy

shoot the average, it is reasonable, therefore, to expect this coming deflation event
to be far more severe6.

The whole point about writing this note, is that we perceive this coming market
crash to be a once in a life-time opportunity. A number of possible strategies to be
employed are outside the remit of this note, but may be covered at a later date.
Other than to say – those who panic first, panic best...

Case Study Update - S&P Global Inc (SPGI)

We have previously written about the benefit of buy-backs over time on EPS, using
S&P Global Inc. (formerly McGraw Hill Financial Inc.), a provider of ratings,
benchmarks, analytics and data for capital and commodity markets globally. With
a market capitalisation of US$109Bn, SPGIs net yield is a pre-tax ~2.5%, in the
midst of favourable “bubble-like” market conditions. On that basis, using the 72
Rule, it would take ~28.8 years to make back your original investment in pre-tax
income; a level not dissimilar to the S&P 500 PE ratio, currently trading at ~29.57.

Figures 13 & 14: Net increase/decrease of SPGI shares (semi-annually, March/Sept.)* (left); and the net impact (-36%) in the number of
shares on issue over time largely the result of company buy-backs (right).
4.0%

2.3%
2.0%
1.1%
0.3% 0.4%
0.0%
0.0%
-0.4%
-2.0%

-2.6% -2.4%
-4.0%
-4.2% -4.4%
-6.0%
-6.4%
-8.0% -7.2%
2006 2008 2009 2011 2012 2014 2015 2017 2018 2020 2021

Source: Macrotrends (2021), Janus Analysis. * Assuming conversion of all convertible debt, securities, warrants and options (excluding treasury shares).

The effect of buybacks should, theoretically, have negligible corporate benefit,

because in effect, a company is merely buying an instrument that mimics existing
return over the cost of equity with no net upside. But that misses the point, as we
now reside in a world that offers few opportunities for established companies to
invest with returns above what they already receive. The vast majority of
established companies are “running to stay still”, with executive teams unable to
offer any additional insight or strategic direction than what upper company
management have already implemented. This inability to control or manipulate

6
A deflation event implies that in the medium to long-term, the cost of capital will fall
further, despite recent nascent inflationary expectations. Anatole Kaletsky (aka Gavekal)
makes the point that in the midst of mean-reversion events, they often destroy good
companies together with the bad. Despite inherent competitive advantages, Lucent,
Nortel and Sun Microsystems all failed during the Dot-com crash. Even modern tech
giants, such as Apple and Amazon, barely survived financially. Which makes both
picking the bottom of the next decline and the companies likely to survive, perilous.
7
https://www.multpl.com/s-p-500-pe-ratio
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 Macroeconomic Strategy

external business conditions has executives advocating buybacks as a method to

inflate EPS, justifying salaries and bonuses.

Figures 15 & 16: Net income 12-month trailing (US$Bn) for SPGI (left), implying a 234% growth in earnings over the 16-year period (left);
however, once you factor in a 36% decline in issued equity results, it boosts apparent EPS by 56%.
3.000

2.500

2.000

1.500

1.000

0.500

(0.500)
2006 2008 2010 2012 2014 2016 2018 2020

Source: Macrotrends (2021), Janus Analysis

The compounding power of buybacks can be readily seen in Figures 17 and 18,
which are directly comparable; SPGI EPS assuming no buybacks from 2006
onwards at 7.4, versus 11.6 currently. As the WSJ wryly notes, “in the current in
a deal desert, even Warren Buffett’s Berkshire Hathaway keeps buying itself”.

Figures 17 & 18: SPGI EPS (semi-annually, March/Sept.) assuming a flat 377m shares on issue (at H106 levels) (left); and historical EPS
taking into account cumulative reduction in issued capital overtime resulting from buybacks (right).
13 13
11.6
11 11
EPS assuming 2006 equity issuance

9 9
7.4
7 7
EPS

5 5

3 3

1 1

(1) (1)
2006 2008 2010 2012 2014 2016 2018 2020 2006 2008 2010 2012 2014 2016 2018 2020

Source: Macrotrends (2021), Janus Analysis

In our last note on this topic eighteen months ago, we concluded that over the past
decade, buybacks were one of the major causes of share price market
appreciation. However, over the past 24 months (see Appendix a), this is clearly
no longer the case, as evidenced by SPGI, which has not undertaken material
buybacks for at least six quarters. Looking at current (Q321) cumulative purchases
(see Figure 19), collectively they are still considerably lower than the Q418 peak,
and yet the market has appreciated >90% in the interim. It is increasingly
obvious that over the past 24 months, share buybacks have had little impact
on current market appreciation.

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 Macroeconomic Strategy

Appendix A – Share buybacks & S&P 500 appreciation

The continual decline in yield from >6% in 1999 to around 2.5% presently, runs
contrary to the argument that buybacks are a valid method of redressing
valuation failure. If a company’s Board believe its shares are undervalued (when
has a corporation ever thought its shares over-valued?), purchases on-market is
a tool to rectify this inequity. But no amount of share buybacks can explain the
recent bout of S&P 500 appreciation.

Figures 19 & 20: Cumulative S&P 500 dividends and buybacks (top); and S&P buybacks versus
forward earnings yield (bottom). In the decade between 2009 and 2018, 465 companies on the S&P
500 spent a collective US$4.3Tn in buybacks, equal to 52% of all net income generated over that
period; hence the approximate morphology between the cumulative rise in buybacks and dividends
versus that of the S&P. The almost exponential rise in the S&P over the past several years is clearly
not related to company profitability nor buybacks.

Source: Yardeni (2021)

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 Macroeconomic Strategy

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