Stock Market Bubble?Submitted by Ashland Heights Investments on March 5th, 2017
Chart: Historical S&P 500 (U.S. stocks) PE Ratios--Source: www.multpl.com
P/E Ratios highest since Tech Bubble and 1929 Black Tuesday
The primary valuation metric for stock prices, the Price/Earnings ratio (PE ratio or multiple), can be an effective tool in making sense of market conditions. The overall value of stocks is nothing more than the economic earnings earned by businesses multiplied by a factor, which represents the net present value (NPV) for the enterprise. The PE multiple is affected by interest rates. A lower rate leads to a lower discount rate, thus higher NPV. The opposite is true for higher interest rates, which can be clearly seen in the above graph. During the periods of high interest rates in the early ‘80s, the multiple took a large hit, and has since recovered to new highs. In short, business earnings tend to be relatively stable and increasing over time, while PE multiples can vary greatly, depending on the mood of the market.
During upward-trending markets, PE multiples have increased greatly in short periods of time. During the late ‘90s stock bubble, the multiple increased from 15 to 45, despite the absence of low interest rates and amidst a tech market boom in which most new enterprises generated no profit. The stock market became a game of guessing on future outcomes of fledgling technologies, and this detachment with fundamentals overflowed into the large company “blue-chip” space as many mature businesses became valued at more than 50 times earnings.
The 1929 stock bubble, which led to the Great Depression and a two-decade long market decline, was characterized by a large ramp-up in the multiple. This expansion was compounded by the lack of a unified government agency in regulating securities markets, which persisted until the founding of the SEC by the Securities Exchange Act of 1934.
Today's multiple stands at around 30--nearly twice the historical average.
These three eras share several common features:
- Sharp increase in extended credit
- Sharp increase in PE multiples
- High valuations for emerging enterprises lacking profitability
The total credit market in the U.S. is $65 trillion, which is up from $47 trillion in 2007 (1). U.S. government debt has nearly doubled from $11 trillion in 2008. During the late 1990’s, government programs aimed at making middle-class housing more affordable gave way to a sharp increase in the amount of subprime rated mortgages underwritten. In the late 1920’s, credit and stocks purchased on margin increased exponentially.
The PE multiple, based on trailing 10-yr inflation-adjusted average earnings, has increased from 15 during the financial crisis to nearly 30 today. Similar increases in multiples occurred in the late 1990’s and leading up to the Great Depression, as markets became swept away in speculation.
Enterprises in emerging industries with little or no profitability, such as social media and mobile technologies, are being valued at large capitalizations relative to revenue and hard assets. Technology companies are among the most difficult to value given the dynamic nature of competition. Social media is among the most competitive markets today with many enterprises finding it difficult to maintain a leading position. Many internet companies valued at tens of billions in the late 1990’s ceased to exist within a few years. A similar circumstance occurred during the railroad boom of the 1920’s, which saw a vast expansion of rail lines connecting the homeland. Growth, credit, and valuation become overblown, which, in large part, led to the bubble in stocks prior to 1929.
Factors Leading to Inflated PE Ratio
The primary factors leading to historically high valuations on stocks are:
- Low interest rates
- U.S. Federal Reserve Bank economic stimulus programs
- Low inflation due to global trade increase
With the Federal Reserve Bank’s prime interest rate at or near zero for the last decade, stocks have enjoyed a strong tailwind. Low interest rates boost stock returns on two fronts. Firstly, it lowers the cost of borrowing for business which increases operating income available to shareholders. Second, it lowers the returns on bonds, which is a competing asset class to stocks, making the equity class appear more attractive by comparison. However, the era of ultra-low rates appears to be concluding, with the prime rate increase in December 2016 and wide expectations of another hike from the Federal Reserve in March.
The Federal Reserve has instituted economic stimulus policies since the Financial Crisis, consisting, in part, of bond buybacks, which is essentially pumping temporary money into the economy. The Federal Reserve has a balance sheet which currently stands at around $4.5 trillion. To put the magnitude of the government’s intervention in perspective, until the recession, the Federal Reserve held less than $1 trillion in public assets. An unwinding of this portfolio is inevitable, as the Federal Reserve moves to normalize financial policy to pre-crisis conditions.
The Federal Reserve has alluded to concerns of rising inflation and the need to move quickly in raising interest rates and restricting monetary policy, as economic conditions demonstrate less dependence on government intervention.
Low levels of inflation go hand-in-hand with low interest rates. The Federal Reserve reduced interest rates to stimulate the economy following the banking crisis. Now, with economic conditions normalizing, the Federal Reserve must raise prime interest rates to impede the negative effects of inflation. In the U.S., inflation has been kept low primarily by unrestricted global trade. The U.S. imports more than $2 trillion of goods from other countries annually (2). Most of these goods are supplied at substantially lower cost than could be realized domestically. Lower costs have boosted corporate profits and shareholder wealth. As governmental policies shift toward protectionist trade, an economy built on low-cost imports may be in jeopardy. This will have the effect of raising costs for businesses, which in effect raises costs for consumers and the broad economy. It is not yet known how the financial markets will react to this swift change in policy.
Expectations for Future Returns
While no guarantees can be made, past and present factors may help to formulate a general expectation of future returns.
At times of similar valuations as seen today, an investment made in 1929 and 1999 required 20 years and 10 years, respectively, to simply break-even. The 10-yr U.S. Treasury is yielding only around 2.5% annually, a level that will, at best, keep pace with inflation. The financial markets will soon start to lose the tailwinds of government intervention and unrestricted global trade.
Considering these dim projections, it is difficult to forecast a scenario in which long-term future returns resemble recent returns, specifically, an average annual return of at least six to eight percent. Our projections are that real returns could be somewhat flat for some time, as the new reality of less government intervention, higher inflation, and more restrictions on global trade take shape. Compounding the inflation problem is the reality that the Federal Reserve cannot raise interest rates swiftly and substantially without causing a significant disruption in the economy, which has been built on a foundation of cheap debt.
For investors looking to ride out a market downturn, inflation-protected investments may be a suitable strategy.
There are several high-income asset classes which reflect the safety feature of bonds while protecting against inflation, interest rate hikes, and global trade slow-down. Core components include: healthcare real estate (REITs), midstream oil & gas transportation, and short-term corporate bonds. These classes produce steady income and may also experience an increase in core value over time, keeping pace with, or even outpacing, the value of inflation caused by the next era of rising rates, falling PE multiples, and changing trade policies.
Article authored by Eric M. Robken
Robken holds an MBA-Finance and is a Series 65 registered advisor.
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