I have been investing for more than three decades and have experienced several market bubbles. The stock market today contains all the characteristics of past bubbles. But do not just take my word on the subject, take a close look at the evidence presented before coming to any firm conclusions.
This is the highest this ratio has ever been, at least back to 1963. It did not reach 2 times in either 2000 or 2007. From that aspect it would appear that this market is more overvalued than at any time in history.
Chart Source: http://www.multpl.com/s-p-500-price-to-sales
Naysayers will point to low inflation and low interest rates as the reason that this and other ratios are so high. There is some validity to that argument and I will not try to deny it. However, it becomes more and more difficult to sustain this multiple as interest rates rise. Inflationary pressures may be rising as well as wages start to experience some upward pressure in certain skilled areas of the workforce. But this is not the only evidence that leads me to think this market is in bubble territory.
S&P 500 PE (Price/Earnings) Ratio
That was when we had huge market capitalization given to a multitude of technology companies that had little or no revenue and were losing money. Today the picture is much different. The S&P 500 Index is made up primarily of companies that have both revenues and earnings. The chart below does not look particularly as alarming as the previous one. But we need to take a closer look.
Chart Source: macrotrends.com
If we were to remove the craziness of the periods that led up to the bubble peak in 2000 and the earnings trough in 2008 the pattern becomes much clearer. So just ignore those two spikes and look closely at the rest of the chart. What I want you to notice is that faint dotted line that indicates a PE of 20. Now, notice how rarely the market goes above that line, how short the time usually is that it remains above that line and what often happens shortly after breaching that level.
Another thing to consider is that after the bubbles in 2000 and 2007, the market was supported artificially (especially after 2007) by Federal Reserve policies and federal government stimulus. Since the Fed (and its central bank counterparts globally) has little ammunition left (relative to what it had in 2008) and governments here and abroad have spent themselves deeply into debt there may not be much available in the way of support coming the next time around. Interest rates are already historically low (to an extreme) and the Fed balance sheet (as well as that of the Bank of Japan and European Central Bank) have been expanded to historically record proportions.
The PE ratio for the S&P 500 did not fall nearly as much or to as low a level as has commonly happened in the past. I suspect that, without the support of central banks and governments, it could act more as it has previously and over correct to the down side. This, of course, would create a buying opportunity of a lifetime for those who are prepared. But this is only the tip of the proverbial iceberg in terms of the evidence I want to produce in this short series. The next chart brings a whole new perspective to considering the validity of the previous two.
S&P 500 GAAP earnings
This is where the “rubber meets the road” in that we, as investors, are supposed to be paying for “future” earnings. The chart below, at first glance, looks pretty good; that is until we look more closely at the most recent few years. Be aware that this is a long-term chart that stretches all the way back to 1870. The overall, long-term trend, therefore, looks good. Again, the devil is in the details, as it were.
Chart Source: multi.com (year by year EPS table also available at this link)
If you look closely you will see that EPS (earnings per share) for the S&P 500 Index components taken in aggregate is still lower than it was in 2011. For that matter it is lower for 2016 than it was in 2007. This is a chart of GAAP earnings and I know all too well that the “accepted norm” today is to look at the adjusted earnings or the operating earnings. The reasoning is that adjusted earnings is a better representation of how a company is performing in the present. But the truth is that adjusted earnings removes such things as stock compensation, asset write-downs, and other expenses for which management does not want to be held accountable. If management overpays for an acquisition and must later write down the value of assets such as plant, equipment, brand value or goodwill it seems to me that such overpayments were mistakes made by management. I can see how management wants investors to forget and forgive, but the difference between GAAP EPS and reported EPS has increased significantly.
Let me try to explain this in another way. Since 2011, when EPS for the S&P 500 were $93.56, the index value has risen from 1257.60 to the current value of 2,372.60, or 88.7 percent. The S&P 500 EPS for 2016 were $89.61, representing a decline of 4.2 percent. To make matters worse companies have been buying back shares at a record pace in recent years. The total value of share buyback by S&P 500 companies during the last five years (2012-2016) is over $2.5 trillion according to Goldman Sachs. That represents more than ten percent of the current total market capitalization (share price x number of shares outstanding) for the entire index of$21.35 trillion. So, if those shares had not been repurchased to support share prices would the market still be at this level? That was a hypothetical question; just something to think about. And the ten percent figure is really closer to 12 percent but many shares were purchased in previous years when the total market cap of the index was much less (under $12 trillion at the end of 2011) so the real impact was far greater.
The point of this exercise is to understand that the market index value rose more than 88.7 percent and EPS fell 4.2 percent. The value of the index rose not because the underlying fundamental value of those shares increased due to rising earnings but rather due entirely to the expanding PE multiple. How does Wall Street justify this mismatch of price to fundamental value?
First, there is the argument mentioned above that says low interest rates lower the cost of money and increase the value of a diminishing asset (outstanding shares). That is another way of saying that there is a lot more money sloshing around in the economy chasing fewer stock assets (remember those share buybacks?). Again, that only holds water when interest rates are either low and falling or low and static, not when rates are rising.
The second argument, also presented above, is that EPS share really are rising if we just look only at adjusted EPS instead of GAAP. This is convenient for those managements that have something to hide but it does not paint an entirely true picture of how well those same executives have allocated capital for shareholders. To see the truth about the efficiency of capital allocation over time one needs to look at GAAP. The difference between GAAP EPS and adjusted EPS has been rising since 2010 when the gap between the two was about ten percent. The difference now stands closer to 30 percent. So, now we know where a good chunk of the market cap rise has come from: 12+ percent (buybacks, which probably really equal more than 20 percent given the timing of the purchases) plus 20 percent increase in the EPS reporting gap (smoke and mirrors). It is like magic!
So, I must admit that I am more than just a little confused. The future earnings did not materialize yet. What have we been paying for since 2011? The next installment will take a look at the possibility of a stock market bubble from a completely different angle. I hope you will join me for the next round and don’t forget to leave a comment whether you agree or disagree with my line of reasoning. A good healthy discussion is always a good way to exchange perspectives and give us all more to think about.
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