Equity multiples growing at fastest rate since dot-com bubble

Today’s commentary

Summary: The gain in equity prices is now outpacing profits at a rate not see since the heady dot-com days. In fact, on a GAAP accounting basis, profits have been falling. I believe this creates a dangerous situation in view of rising interest rates and market turmoil.

I have talked about multiple expansiona lot in the past few weeks because the US market’s advance is predicated on multiple expansion.The statistic on the gain in share prices outpacing earnings comes from a Bloomberg article yesterday. Here are some illuminating details:

Price gains of stocks in the Standard & Poor’s 500 Index (SPX) are outpacing profits by the fastest rate in 14 years as the bull market extends beyond the average length of rallies since Harry S. Truman was president.

The benchmark gauge for U.S. equities has risen 14 percent relative to income over the past 12 months to 16 times earnings, according to data compiled by Bloomberg. Valuations last climbed this fast in the final year of the 1990s technology bubble, just before the index began a 49 percent tumble. The rally that started in March 2009 has now outlasted the average gain since 1946, the data show.

Bears say the failure of earnings to keep up with prices signals the bull market is in its last stages, as companies from Caterpillar (CAT) Inc. and Danaher Corp. (DHR) forecast slower profit growth and the Federal Reserve prepares to reduce stimulus. Optimists point to expanding multiples as proof individual investors are growing confident enough in the economy to return to stocks. History shows the final phases of rallies have provided some of the biggest gains.

I assume this article is pointing to operating earnings as opposed to GAAP earnings because the article suggests earnings have been rising. But if you do a Google search on GAAP earnings you will see a lot of non-GAAP reporting and misses on a GAAP basis as writedowns mount. We saw this at the end of the tech boom 14 years ago and this divergence between the change in GAAP and operating earnings is indicative of a bull market that is in its last legs.

The last time I wrote on multiples, I delineated three different time frames, short, medium and long-term. In the short-term – say the next six months – I am concerned about rising interest rates and incipient market volatility via emerging market risk assets and the potential of a large correction. I am predicting a 15% correction this year in fact. Over the medium-term, through 2014, if the economy holds on its present course, the cyclical bull could resume. I find it hard to believe stock prices would break down significantly for a lasting period without a concomitant breakdown in the real economy. A significant and lasting decline in earnings and valuation is a hallmark of recession.

Over the longer-term, I believe the policy mix in the US supporting multiple expansion is unsustainable. From a flow perspective, government deficits are the biggest driver of elevated corporate margins. And so the decrease in government deficits is likely to have a materially negative impact on earnings. Moreover, household debt levels are still high such that a recession with policy rates already at zero percent would be a period of significant retrenchment and falling retail sales. That suggests a savage market downturn when that recession comes.

So, I am cautious about the near-term and sanguine about the medium-term. Laszlo Birinyi notes that the final phases of a bull market have returned 39% on average. But I do not believe the problems in the U.S. are over. Policy makers have attempted to paper over the problem but still stagnant wages and high household debt tell me we still a lot of deleveraging left and most of this will occur around the economic troughs of recession.

If I can get some figures on GAAP and operating earnings divergence, I will post them.

Update: The US Bureau of Economic Analysis publishes corporate profits after tax. It makes two adjustments to inventories and to depreciation by including inventory withdrawals and economic depreciation at current costs. The data are available only through Q2 2012 and they show the following progression according to the Flow of Funds that the Federal Reserve releases: 

You can see profits had decreased in 2012. It is unclear how this data series has progressed since then.