SPX Topping Valuations 4
The prevailing valuations in the lofty US stock markets are increasingly becoming a bone of contention. Wall Street calmly asserts stocks are fairly valued or even cheap, since it has a huge vested interest in keeping people fully-invested. But a growing chorus of dissenters is disputing that idyllic notion, warning that stock valuations are very high and portend great downside risk. Indeed, topping valuations abound.
Since investing is all about buying low and selling high, the price paid for any investment is everything. Buy good companies at cheap prices, and you’ll multiply your wealth over time. But buying those very same good companies at expensive prices radically stunts future gains. While cheap investments have great potential to soar as traders recognize their inherent value, expensive ones have already exhausted their upside.
And it’s valuations, not absolute stock prices that define cheap and expensive. Valuations are where stock prices are trading relative to their underlying corporate earnings streams. The less investors pay in terms of stock price for each dollar of profits, the greater their ultimate returns. Valuations are most often expressed in price-to-earnings-ratio terms, with stock prices divided by underlying corporate earnings per share.
This concept is so easy to understand, yet the vast majority of investors ignore it. Imagine purchasing a house for a rental property that has expected annual rental income of $30k. How much would you be willing to pay for it? If you can get it for $210k, 7x earnings, it will pay for itself in just 7 years. That’s a great deal. But if that same house is priced at $630k, 21x, it will take far too long just to recoup the initial cost.
The stock markets work the same way, with each dollar of profits completely fungible. And the US stock markets have a century-and-a-quarter average P/E ratio of 14x earnings. That’s fair value for the stock markets as a whole, paying $14 in stock price for each $1 of underlying corporate earnings. This makes a lot of sense, as stock markets exist to “lend” capital from those with surpluses of it to others running deficits.
The reciprocal of 14x earnings is 7.1%. That’s a fair rate of return for those with excess savings they want to invest, and a fair price to pay for those who want access to that scarce capital. 14x facilitates mutually-beneficial transactions for each side of the capital trade, so it’s right where stock valuations have naturally gravitated towards over the very long term. Cheap and expensive are defined from that baseline.
Half fair value, or 7x earnings, is very cheap historically. Buying good companies’ stocks trading at 7x earnings is a virtual guarantee of massive wealth-multiplying future gains. Conversely double fair value, 28x, is exceedingly-dangerous bubble territory. Buying the same good companies’ stocks at 28x dooms invested capital to many years of lackluster gains at best, and catastrophic losses exceeding 50% at worst.
There’s nothing more important for investors to understand than general-stock-market valuations. They move in great third-of-a-century cycles I call Long Valuation Waves. These are divided into secular bulls and secular bears that each last about 17 years. Valuations start out cheap near 7x, gradually expand to or through 28x in the first-half secular bulls, and then consolidate back to 7x in the second-half secular bears.
Unfortunately the US stock markets remain mired deep in the valuation-contracting secular-bear phase of their LVW today despite their epic cyclical bull of recent years. How can that be true when the US stock markets have more than tripled since early 2009? The flagship S&P 500, despite its massive gains, still remains below its real inflation-adjusted peak from the end of the last secular bull way back in March 2000!
The last cyclical bull peaked in October 2007, and ominously the US stock markets are trading at much-higher valuations today than they were back then. This first chart looks at general-stock valuations as seen through the lens of the benchmark S&P 500, SPX. Our methodology is simple and conservative, and very easy to replicate. At each month-end, we record some key data from all 500 SPX component companies.
Each individual stock price is divided by that company’s latest four quarters of accounting profits per share as reported to the SEC, yielding individual P/E ratios for all 500 SPX components. This is classic trailing-twelve-month methodology, involving hard historical data and no guesswork on future profits. Then all 500 of these P/Es are averaged, both simply and also weighted by individual companies’ market capitalizations.
Here’s the results since the topping of the last cyclical bull, with the popular SPDR S&P 500 ETF (SPY) superimposed on top for price reference. Contrary to Wall Street’s endless claims that the stock markets aren’t expensive today, prevailing valuations are actually way up at dangerous bull-slaying levels. The SPX and therefore US stock markets are trading at topping valuations today, which is a super-bearish omen.
As November waned, the 500 elite component companies that comprise the S&P 500 benchmark index for US stock markets were trading at a simple-average trailing price-to-earnings ratio of 24.9x! In other words, investors buying SPY shares today would have to wait a soul-crushing 25 years merely for underlying corporate profits at current levels to recoup the price they are paying. That’s before real gains start accruing.
And even if the 500 individual trailing-twelve-month P/Es are weighted by their respective companies’ market capitalizations, the valuations don’t look much better at 22.7x. Remember for the last 125 years or so, the US stock markets averaged 14x earnings. 21x was the warning level that signaled expensive markets likely to drift or slide, while 28x screamed of dangerous bubbles. We’re right up near that realm today.
The last cyclical bull cresting in October 2007 died at SPX simple and MCWA P/Es of just 23.1x and 21.3x, about 8% and 7% lower than the current lofty valuations. Stock-market valuations can only be bid so high before buyers are exhausted, paving the way for subsequent cyclical bear markets that cut stock prices in half to restore value. Prevailing valuations are dragged back down below historical fair value.
Indeed by early 2009 when that last bear bottomed, valuations were again on the cheap side near 12x earnings. So value-oriented institutional buyers returned, snatching up the widespread fundamental bargains. And with corporate earnings still beaten down by the economic and psychological aftermath from 2008’s once-in-a-century stock panic, valuations rocketed as stocks soared while profits couldn’t keep pace.
But by late 2009, earnings were stabilizing and growing again so the price-to-earnings-ratio multiple expansion stalled. Between mid-2009 and late 2012, the valuations of the SPX components weighted by their market caps were stable around 19x trailing earnings. The rising stock prices in that cyclical bull were nicely mirrored by climbing underlying corporate profits, so the bull-market gains in that span were righteous.
But heading into late 2012, the US stock markets were looking toppy on a variety of key fundamental, technical, and sentimental fronts. So the Fed decided to goose the flagging stock markets right before those key 2012 elections. It launched a wildly-unprecedented open-ended quantitative-easing campaign, conjuring up vast amounts of new money out of thin air to use to monetize debt including US Treasuries.
QE3’s deluge of money printing along with the associated Fed jawboning radically distorted the global financial markets. American stock traders came to believe the Fed was effectively backstopping the US stock markets, that it would quickly ramp up QE monetary inflation to arrest any significant stock-market slide. So with all material downside risk apparently mitigated, investors flooded into the stock markets in droves.
So they soared. But as this chart damningly reveals, nearly the entire SPX surge driven by QE3 over the past couple years was due to multiple expansion! Stock prices surged higher, but the underlying corporate earnings couldn’t keep pace. With the Ps of P/E ratios climbing much faster than the Es, general-stock valuations gradually rose to today’s dangerously-high levels. Earnings didn’t justify that SPX surge.
Without any fundamental foundation, everything between roughly 1500 to 2100 on the S&P 500 is merely hot air injected by the Fed. That means the overextended and expensive US stock markets face massive downside risk today. This is even more apparent when considering where SPY would be priced if P/Es based on current trailing-twelve-month earnings merely mean reverted to 14x fair value.
The white line above shows where SPY would be trading at fair value, and it was way down near $116 when November ended. That was a whopping 44% below where SPY was actually trading! And even that was high in historical context. Note above that the long sideways trend in fair-value SPY levels is between about $90 to just over $100. SPY wasn’t able to break out of that until just in recent months.
With years of SPY (and therefore SPX) precedent within that consolidation fair-value trend, odds are the recent breakout not supported by earnings growth won’t last. At some point very soon, the prevailing lofty stock-market valuations are going to mean revert dramatically lower. And given our current position in those great third-of-a-century Long Valuation Wave cycles, that overdue multiple contraction should be massive.
This next chart zooms back out to show the entire secular bear in SPX terms since 2000. Secular bears arise because stocks get wildly-overvalued by the ends of preceding secular bulls. The mission of these 17-year bears is to gradually whittle stock valuations back down, from super-overvalued levels above the 28x bubble threshold to ultimately deeply-undervalued 7x levels near the ends of those secular bears.
This is accomplished not through a sharp stock-price decline, but a grueling 17-year sideways grind. That gives underlying corporate earnings time to gradually grow into the lofty stock prices seen at the ends of secular bulls. And that’s exactly what’s happened in the US stock markets since early 2000. All the record highs in the SPX are a Fed-conjured illusion, as no new records have been seen in real terms!
In today’s dollars, the last S&P 500 secular bull crested well above 2125 in March 2000. The best level we’ve seen in the Fed’s QE3 levitation is 2075, still well under that peak a whopping 14.7 years later. So the secular-bear sideways grind is very real. And while 14.7 years is a long time, it is considerably less than the full secular-bear duration of 17 years completing Long Valuation Waves. The secular bear still lives!
And that means general-stock valuations are still headed back down near 7x earnings. This long trend of multiple contraction is readily evident in this chart, as evidenced by the big dashed line. At today’s stage in secular bears, prevailing stock-market valuations should be back down around 10x or 11x the underlying corporate profits! And that will gradually trend down towards 7x before the 17 years are completed.
The SPX components’ trailing-twelve-month P/E ratios were right on secular-bear trend in late 2012 before the Fed decided to goose the stock markets with QE3’s vast debt monetizations. And ever since then they have catapulted farther and farther away. This has created enormous risk because nothing, not even powerful central banks, has ever been able to prematurely kill secular bears before their work is done.
So the next cyclical bear market, which is way overdue given today’s extreme overvaluations and far-overextended cyclical bull, is set to be particularly nasty since prevailing valuations were manipulated so far over where they should be at this point in the long-term stock-market cycles. Normal secular-bear activity sees internal cyclical bulls double stocks after cyclical bears cut them in half. This latest bull tripled them!
And there will be a steep price to pay, stock markets always see reckonings after any exceptional extreme. They mean revert dramatically to not only unwind the unnatural extreme, but almost always to overshoot in the opposite direction before they stabilize. Investors today need to be aware of the vast downside risks in these super-overvalued stock-market levels spawned by Fed manipulations, not profits growth.
Wall Street loathes this prudent contrarian perspective, as it is bad for business. Professional money managers are always bullish because they get paid a percentage of assets under management. So their financial incentives to keep people fully-invested no matter what, no matter how expensive and risky the stock markets happen to be, are vast beyond belief. So they ignore overvaluations or rationalize them away.
The method of choice for lulling naive investors into complacency is to substitute forward P/E ratios for the classic trailing ones. Rather than using the past four quarters’ hard actual earnings data, analysts estimate the next four quarters’ future earnings. Of course this task is impossible given all the uncertainty, and analysts are not only always wrong on future earnings they are endlessly far too optimistic on them.
So when you hear some prominent money manager or analyst or economist declare that today’s stock markets are fairly valued, realize they aren’t talking about classic trailing-twelve-month P/E ratios. What they are really saying is if corporate earnings surge dramatically in the coming year, today’s stock prices justify those future earnings. Forward earnings are a farce, a confidence man’s tool used to fleece sheep.
The Fed’s QE3 money printing catapulted stock prices into this perverse fantasyland with no earnings foundation, but QE3 is now over. The Fed recently killed QE3’s new bond buying, and thanks to the sweeping Republican Congressional victory last month the Fed’s hands are tied in launching any QE4. For very good reasons, Republican lawmakers have long hated this Fed’s easy-money inflationary schemes.
They’re going to pressure the Fed politically to not only unwind its massive QE-inflated balance sheet, but to end its ludicrously unfair zero-interest-rate policy that has robbed from savers to subsidize debtors continuously since late 2008. And rising rates have hugely bearish implications for prevailing stock-market valuations and absolute price levels. Overvalued stocks and rate hikes are truly a recipe for disaster.
One of the reasons QE3 pushed stock prices to such lofty extremes was the Fed squeezing the rates of return in the bond markets so hard. As bond yields were forced down to next to nothing, well below money-supply inflation rates, investors fled to stocks catapulting them higher. As interest rates inevitably start to normalize, some of the bond investors who didn’t want to park capital in risky stocks are going to sell.
In addition, one of the biggest sources of stock-share demand in the past couple years of the Fed’s QE3 levitation was the gargantuan corporate buybacks. In order to keep their earnings per share growing in Obama’s stagnant economic environment, companies spent hundreds of billions repurchasing their own shares to reduce their float which increases EPS. They paid for these not through profits, but borrowing.
So as the Fed’s zero-interest-rate policy ends, the ability of companies to borrow money at artificially-cheap next-to-nothing rates will vanish. So will the stock buybacks, which incidentally are also a major topping sign. This will not only greatly reduce overall stock-share demand, but slash the fancifully-high earnings-per-share growth analysts are hoping for in the coming years. So valuations will look even higher!
In light of all this and even more very bearish developments on the fundamental, technical, and sentimental fronts, today’s stock-market topping valuations are extraordinarily risky and dangerous for investors. Bulls are always followed by bears, and this latest bull specimen was abnormally long and large thanks to the Fed’s manipulations. So when the stock markets inevitably swing the other way, it’s going to get ugly.
Investors have rarely needed a prudent contrarian source of market intelligence as much as they do today. Massive stock-market changes are coming as stock prices and valuations mean revert far lower, and the investors trapped unaware in this are going to lose fortunes. Merely-average cyclical bears cut stock prices in half, and after the epic excesses of recent years the next cyclical bear will likely be exceptional.
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The bottom line is the US stock markets are dangerously overvalued today, with trailing P/E ratios well above bull-slaying levels. After the last time this happened, stock prices were more than cut in half. And once again another cyclical bear is overdue, and it’s likely to be a doozy after such an incredible and artificial stock-market surge fomented by Fed manipulations. Buying stocks high has rarely been riskier.
And the same Fed that created the conditions to spark such rampant overvaluations has been sidelined politically. So once the next serious stock-market selloff inevitably gets underway, there will be no Fed backstop to entice euphoric investors to rush back in to buy expensive stocks. Merely to return to fair value based on today’s corporate earnings, not even overshoot, stock-market levels will have to fall dramatically.
Adam Hamilton, CPA
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Adam Hamilton, CPA, is a principal of Zeal LLC, which he co-founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Hamilton is a lifelong contrarian student of the markets who lives for studying and trading them.