A Bubble on a Bubble
Ceasefires that don't hold, debt that keeps compounding, and a valuation picture that gets stranger the closer you look. This week Steve, Tom and Jacob work through what the numbers are actually saying, and where the value still hides.
Calm headlines and real risk are two different things. A ceasefire interrupted by a bombing, rising debt, and military spending feeding into inflation are all reminders that the background noise this week was louder than the price action.
The CAPE sits at 41.0x, 2.9 standard deviations above trend. Adjust for the fact that earnings themselves are already 1.8 standard deviations above trend, and the honest number is closer to 67.6x, a level with no precedent in US market history.
Mainstream strategists are starting to say the quiet part out loud on AI. Our view is blunter still: this cycle ends worse than the dot com bust, not better.
Energy remains one of the few pockets of genuine value. Santos and Woodside stand out on cost and productivity, now tracking in line with ExxonMobil's own numbers.
Valuation is not optional information. Ben Graham and John Templeton both built their approach to asset allocation around it. Staying fully invested regardless of price is not discipline, it is a failure to look at the evidence.
We interrupt this ceasefire with a bombing. That is not a punchline, it is the pattern of the last few weeks, and it is worth sitting with before moving on to markets. Fragile diplomacy tends to get priced as if it were durable, right up until it isn't.
Debt demons are back in the conversation too. Governments carrying record debt loads into a period of higher military spending is not a neutral combination. Military spending has a habit of leaking into inflation, both directly through demand for materials and labour, and indirectly through the deficits that fund it.
Closer to home, Australia's mood has turned pessimistic rather suddenly, and auction clearance rates are one of the more honest gauges of that shift. They move fast, they reflect real decisions with real money attached, and right now they are telling a different story to the one being told a few months ago.
Some astute commentators are now voicing real concern about AI valuations and what happens next, and it is not just the usual permabears. Even mainstream strategy desks are flagging the same worry.
Our own read is more direct. We think this cycle ends worse than the 2000 dot com bust, which points to negative returns from current levels over the next decade for the parts of the market most exposed to this theme. That is not a prediction of when the turn happens. It is a statement about the odds on offer from here.
Professor Robert Shiller's cyclically adjusted price to earnings ratio gives us the cleanest long run read on US valuations, and the history is instructive. In 1929 the CAPE reached 32.6x, 1.8 standard deviations above trend. In 2000 it reached 44.2x, 3.3 standard deviations above trend, a clear bubble by any measure. In both cases, earnings themselves were unremarkable, sitting less than one standard deviation above trend.
Correct for the earnings bubble and the current CAPE would sit closer to 67.6x, or 4.6 standard deviations above trend. If valuations were normally distributed, which they are not, so this figure is illustrative rather than literal, an event of that size would be expected roughly once every 43,432 years. Whatever the exact number, the direction of the signal is not subtle.
And yet the mood among market commentary remains loose. Music's playing, keep dancing seems to be the operating principle for plenty of investors right now. Nobody wants to be the one who went to cash the day before the next big announcement. That is a understandable impulse. It is not the same thing as a sound process.
We have believed energy is a bright spot inside an otherwise overvalued market for some time now, and that view has not changed. Australian energy names in particular have spent long stretches trading below their own historical average multiple, even after the run higher over the past two years.
The sector's multiple has round tripped from below 10x back toward 21x and is now sitting back near 10x again, below its own multi year average of roughly 13x.
Fund manager Chris Leithner has made a similar case at the stock level, naming Santos and Woodside among his largest holdings. His argument is that both companies have become globally significant explorers and producers over the past decade, with costs falling and productivity rising to the point where they now track in line with ExxonMobil's own figures. We are not making that recommendation ourselves, but it is a well reasoned thesis worth reading in full, and it lines up with our own sector level view.
Investors today are coached to believe that whatever the valuation, you should stay fully invested. That is not a neutral piece of advice, and it is not what the two most influential value investors of the last century believed.
Ben Graham, the father of value investing, treated valuation as a central input into what an appropriate asset allocation should look like at any given time, not a detail to be ignored in favour of a fixed formula. John Templeton ran his own funds the same way.
When the market traded more than 60% above its normal level, Templeton's allocation to stocks fell toward zero. When it traded more than 30% below normal, allocation could theoretically rise toward 100%.
It can feel uncomfortable holding cash while everyone else, most of whom have never studied markets or valuation in any depth, leaves their savings fully exposed to whatever the market does next. History gives a reasonably clear account of how these episodes tend to resolve. Plenty of people would still rather believe this time carries no such risk.
Taken together, this week's session is less about any single headline and more about the gap between how calm things look and how stretched the underlying numbers actually are. A ceasefire that didn't hold, debt and military spending feeding inflation, and a valuation picture that gets more extreme the closer you examine it. Set against that, energy remains one of the few areas where price and value still look reasonably aligned.
As always, this is general information about markets and how we think about them, not personal advice tailored to any individual's circumstances.
Steve: A bubble on top of a bubble is still worth naming even when nobody wants to hear it. The CAPE at 41x undersells the problem once you account for where earnings themselves sit.
Tom: Energy is doing what unloved sectors are supposed to do. It sits there quietly offering better odds while everyone's attention is elsewhere.
Jacob: The clients asking about valuation right now are the ones who will handle the next leg down the best, whenever it comes. That conversation is worth having before you need it, not after.
This newsletter is for informational purposes only and does not constitute financial advice.
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