Commentary

Market valuation and corporate earnings

By Edward Harrison

Today’s commentary

Markets have failed to correct 15 or even 10% for a record period of time during this cyclical bull market. Given the stretched valuations, this makes the market vulnerable to a pullback. What are the types of events which could precipitate such a pullback? Would this pullback presage a new bear market and recession? Thoughts below

I am going to keep this piece short given the last piece by Niels Jensen on valuation. I think Niels makes a very good case for seeing the US market as overvalued relative to other markets and for seeing the market as rich but not in a bubble.

That said, I am surprised at how long this market has been able to rally without a correction of 10 or 15%. The S&P 500 hasn’t suffered a decline of 10% or more since December of 2011. That is fully two years ago. Given this backdrop, I had predicted a major correction, i.e. a pullback of at least 15% on the back of a decline in earnings growth this year. It hasn’t happened.

What has happened is that companies flush with cash have bought back stocks in massive quantities, further fuelling EPS growth via debt-based capital that has taken advantage of record-low interest rates. Indeed the companies that have bought back the most shares are outpacing the market which itself has gained at an impressive pace. Those buyback companies are up 40% this year including reinvested dividends versus only 27% for the market, according to Bloomberg.

If you look at a traditional yardstick like the P/E ratio, stocks don’t look that expensive. For example, as of yesterday, the S&P500 was trading at 17x earnings versus a 15-year average of 19x earnings. Yes, this includes an extreme bull market/bubble period but one can still make the case that stocks are not that expensive using these metrics.

It is when you start looking at cyclically adjusted metrics that stocks start to look expensive. GMO, as a value investor, has a model under which  stocks sell at replacement cost and the return on capital and cost of capital are in equilibrium in the long run. The point is to price stocks on this basis and compare them to current valuation to find over- or under-valuation. What they have found is that “fair value for the S&P 500 is about 1100 and the expected return is -1.3% per year for the next seven years after inflation.” That’s wildly overvalued since the S&P 500 is now at 1780.

If one looks at the market from a Shiller P/E perspective the market is now trading above 24x earnings. Russell Napier of CLSA says that “at 24.4x CAPE, US equities have just exceeded the highs of April Only time the backward-looking CAPE was higher was November 1928-October 1929 and November 1995-June 2002. and January 1966,” which are the cyclical highs for two of the three previous secular bull markets last century, the other was October 1929. Napier also notes that the only time the backward-looking CAPE was higher was November 1928-October 1929 and November 1995-June 2002.

I made some comments on this via Twitter last Friday:

Niels shows in various other ways how markets are frothy at the present. But, he argues that we are not in a bubble period yet. And I think one really needs to think about what was happening in 1999 to see what a bubble in shares is like. Joe Fahmy has a great article which recalls exactly this. The bottom line here is that most value-oriented investors are seeing few bargains but the psychology has not reached true bubble proportions.

So what is the catalyst from here for a correction. I have argued it is a slowing of earnings. But what we have seen this year is buybacks buoying earnings and multiple expansion adding to the upside.  Albert Edwards sees negative earnings as a harbinger of trouble.

And I think his concerns are valid. Josh Brown has noted the same dynamic where Q4 guidance is poor. And we can see that companies have over-estimated demand via the inventory building now ongoing. For example, in the auto industry, we have the most cars on auto lots since 2005, which was a big year. That’s telling you that production is outstripping demand in a way that could catch these companies out.

I believe that if we see a weak holiday season and inventories are still high in December, earnings for Q4 will be weak and guidance will be weaker as companies work to pare inventories. This could be a catalyst for a correction and bears watching. None of this speaks to recession or a secular bear market re-asserting itself yet. For that, we will need to see jobless claims data trend 50,000 higher consistently for a month. Right now, things seem to be going the opposite direction, with higher anticipated GDP growth.

To be continued.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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