The tally of the forward price-to-earnings ratio of S&P 500 companies (SPY) is 17.1 times. That’s forward earnings, and on the largest and most mature companies in the US.
Valuations are off the charts, and the illiquid private markets are even worse.
Both the 5-year and 10-year forward earnings multiples on S&P 500 companies hover around 14 times, and their measurement period arguably includes a time of elevated PE multiples on depressed earnings, especially coming out of the dot-com bust and housing crisis.
Today, the markets reveal elevated multiples on elevated (near-peak cycle) earnings – the classic sign of an inflating bubble, if not an inflated one.
We need to put all of this into perspective. Three earnings-multiple turns lower to a “fairly-valued” broad market valuation of 14 times forward earnings means as much as a 360 point fall in the S&P 500 to ~1740, or a ~20% drop. That move wouldn’t be shocking.
But markets overshoot and undershoot intrinsic value all of the time. We wouldn’t be “up here” if they didn’t. If the equity markets do start falling aggressively, how far could they undershoot? And what if earnings fall flat in 2016, or even decline?
The ~20% drop only reflects a reset of the valuation to normalized levels – not valuations that may prevail under weaker economic conditions.
This is probably the last thing investors want to think about heading into their retirement years, but we can’t ignore the possibilities of an impending stock-market crash. We don’t pretend to know with certainty that a crash will occur, nor do we pretend to know when it will.
We just know the market environment is setting up for something big…and it doesn’t look good.
Frankly, we’re puzzled by the activity of the Fed, which again spooked the markets Tuesday about a rate hike. We simply don’t see the hurry in raising rates. Crude oil prices have been cut in half, and iron ore markets are still working through a supply glut. Where’s the inflation? Food costs are actually falling — $1.49 for 10 chicken nuggets at Burger King (QSR); $5 for a pizza that feeds a family of four at Little Caesars.
Housing prices across most of the country haven’t yet returned to pre-crisis levels, and subdivisions across the nation remain unfinished. According to S&P/Case-Shiller Home Price Indices, average home prices for the metropolitan statistical areas within the 10-city and 20-city composites are back to their autumn 2004 levels. That’s not a typo. We’re only back to 2004 levels. We need inflation for the country to grow out of its debt binge. Real wealth is created when debt is inflated away – most Americans are in debt.
Despite what the Fed says, the only tangible inflation out there is wage inflation. Walmart (WMT) recently hiked its minimum wage for employees, and TJX Companies (TJX) followed suit. Barack Obama keeps calling for an increase in the federal minimum wage, and cities such as Seattle mandate a $15 minimum hourly pay. But yet, the only mention of deflation in the latest Fed minutes was in reference to wages. That’s the only reference. It’s ludicrous.
We know the Fed has access to all the best data, but does it really have a pulse on the economy? The unemployment rate is at 5.5%, and while underemployment is a concern, is there any worker out there that thinks they aren’t underemployed or that they shouldn’t make more money? Job postings are at 14-year highs.
Businesses can’t find good help, and workers are actually quitting their jobs (the number of people walking away from work jumped 17% during the past 12 months according to the Labor Department). Consumers are spending like mad. Apple’s (AAPL) market capitalization is $725 billion. That’s more than Microsoft’s (MSFT) and ExxonMobil’s (XOM) combined. Need we say more about the health of the consumer?
The US dollar is strengthening, and assets are flowing into the US. So why in the world is the Fed talking about raising rates to attract even more asset flows, which would further depress dollar-denominated commodities, thereby driving more input cost deflation. A deflationary death spiral is much worse than even moderately-elevated inflation. Input costs have already fallen considerably.
We can’t be completely certain, but it’s most likely that the Fed wants to start building “insurance” for the next downturn, which we know will inevitably come. Said differently, the Fed needs rates higher so that it can cut them again when things get bad. Interestingly, the very idea of raising rates may in fact create the environment where rate cuts would then be needed.
It’s a Catch-22 in all the worst ways, and the Fed knows it.
The biggest problem for the equity markets, however, is not necessarily that the Fed wants to raise rates. It’s understandable that the Fed wants to build a safety net in the case things get worse in coming years. The problem is the relationship between what’s driving the “frothy” characteristics of the equity markets and the means by which the Fed would have to build such a safety net, or the relationship between dividend yields and the 10-year Treasury.
The equity markets are not being led higher by risky, speculative, flash-in-the-pan companies. Not saying that they are, but firms such as Gilead (GILD) and Apple are barely trading above 10 times earnings, after excluding their respective cash positions. The “bubble” in stocks, instead, is in dividend growth equities. For example, the SPDR S&P 500 Dividend ETF (SDY), which tracks the performance of the S&P High Yield Dividend Aristocrats Index (1), is trading at more than 19 times ‘Year 1’ earnings according to the last measure.
That’s right. The closing price of the SDY divided by the sum of the forecasted fiscal year earnings per share is more than 19 times. These aren’t no-moat, negative cash flow companies that are losing money hand over fist. Quite the contrary, these are mature, fantastic businesses with shareholder-friendly policies, and their valuations are completely out of whack. Yield-hungry investors are paying nosebleed prices for companies with long dividend growth track records, and many of them don’t care.
This is how bubbles are created.
The Federal Reserve’s dual mandate essentially boils down to keeping inflation at ~2% and targeting unemployment in the range of 5.2%-5.5%. But to a large degree, these mandates are arbitrary. What it could set in motion should it start materially raising rates will almost certainly mark the end of this 6-year equity bull market from the depths of the March 2009 panic bottom.
We accept that.
But the “frothy” nature of dividend-paying stocks could simply spell disaster for the markets in the event that higher rates prompt investors to rapidly swap out of these equities into higher-yielding bonds or other asset classes. It’s not so much a valuation equation; most dividend-paying stocks are overpriced by almost every measure.
It’s an asset shift dilemma. The move from equities into fixed income, despite the risks of capital loss in bonds during a rising interest rate environment, or other asset classes could put into place the makings of a stock-market crash.
The Fed is playing with fire. Patience is no longer its modus operandi, and a rate hike in June is becoming increasingly more likely. The equity markets have a good reason to sell off. The bull market in equities is probably over, but it’s the potential crash in 2016 that we’re worrying most about.
Stay tuned! Knowing how to navigate such an environment is just as important as knowing that it is coming.
(1)
Source: SSgA, S&P
Image Source: Ethan Stock