The daily press appears convinced the S&P 500 is overvalued and due for a crash. Yet the macro-economic and volatility filters that we use at Porter Capital and Research & Investment — to identify market risk so that we can move to cash when risks are elevated — show no signs of stress. So I have been delving into some of the aggregate index data, kindly provided by Standard and Poors, to see whether some of their arguments hold water.
The Price-Earnings ratio for the S&P 500 itself is not excessive when compared to the last decade.
The bears argue, however, that earnings are unsustainable. One reason advanced for this is that earnings growth has outstripped sales, with corporations focusing on the bottom line rather than business growth.
Faced with weak domestic demand, large US corporates have actively sought to manage their expenses so as to meet and exceed the market’s expectations. Combined with the unwinding of provisions taken in the GFC, cost management has allowed US corporates to achieve a 124% increase in 12-month trailing earnings off the back of a 25% increase in 12-month trailing sales since October 2009.
~ Elliott Clarke, Westpac
That may be so, but any profit increase would look massive if compared to earnings in 2009. When we plot earnings against sales (per share), it tells a different story. Earnings as a percentage of sales is in the same band (7% – 9%) as 2003 to 2006. A rise above 9% would suggest that earnings may not be sustainable, but not if they continue in their current range.
The second reason advanced is that business investment is falling. Westpac put up a chart that shows US equipment investment growth is close to zero. But we also need to consider that accelerated tax write-offs led to a surge in investment in 2009/2010. The accelerated write-offs expired, but the level of investment merely stopped growing and has not fallen as I had expected.
Private (non-residential) fixed investment as a whole is rising as a percentage of GDP, not falling.
Lastly, when we compare the S&P 500 to underlying net asset value per share, it shows how frothy the market was before the Dotcom crash, with the index trading at 5 times book value. That kind of premium is clearly unsustainable without double-digit GDP growth, which was never going to happen. But the current ratio of below 2.50 is modest compared to the past decade and quite sustainable.
I am not saying that everything is rosy — it never is — but if sales and earnings continue to grow apace, and with private fixed investment rising, the current price-earnings ratio does not look excessive.
Hi Colin,
what are you thinking about the stock market value according to q? If one reference to the two links given below one should come to the conclusion that the stock market indead overvalued.
http://www.smithers.co.uk/page.php?id=34
http://www.advisorperspectives.com/dshort/updates/Q-Ratio-and-Market-Valuation.php
Thank you for your work!
Klaus G. Singer
Good to hear from you Klaus,
The Q Ratio is based on replacement cost of companies. I would not place much store in this as estimates of replacement cost may vary widely, especially with technology stocks. What is the replacement cost of FaceBook, Google or Apple? Likewise with Pharma and Biotech stocks. Book value would also understate the value of assets, but at least it is applied consistently and is verifiable.
Regards,
Colin
A comparison period of the last 20 tears might be more appropriate for this discussion.
Unfortunately S&P data only starts in the first quarter of 2000.
when they want you out of the market, they say in the press ‘market is bad’
then the market is rising….then after it rises and is reaching a top…and they want you in the market, they say in the press ‘market is good’ and build the hype….then the market falls….and it repeats
THX 4 XCELENT DATA
Great factual presentation. Many thanks.
We see the graphs through different lenses.
The P/E S&P 500 chart seems to show that there was a steady decline
starting in late 2001 which was momentarily reversed by the 2007-2008
bubble. After the bubble, we seem to be bouncing along the previous
bottom. For markets to rise from here at this ratio, we need corresponding
growth in earnings which I find it hard to see in the other charts.
The Earnings/Sales looks like a recovery on first glance, but consider:
1) we are now turning down from the same 9% level that preceded the last
crash; and 2) the companies doing the earning have drastically increased
productivity/reduced their staff levels. This increased efficiency is largely a
one-shot deal. Those former employees are now un/under-employed;
where is the demand going to originate to keep the party going? A lot of upper income jobs have been lost and replaced with part time and service sector jobs. There are
already signs that the slight recent increase in consumer spending is coming
from re-leveraging, since real income is flat for most. The increases in
household net worth have a large housing price increase component, which
seems to be stalling in many markets. Using the house as an ATM seems likely
to crash even more abruptly this time. We also are seeing a net decrease in
hours worked. IBD just reported that the latest data shows a 30 hour work
week, down from 30.7. That prevents an increase coming from total earnings generated by the slight decrease in unemployment. Where is the money going to come from?
On the PNFI/GDP chart, the current slightly positive sideways squiggle
looks (to me) like the previous ones which required a trip through a grey
recession band before going significantly up again.
Finally, while the Price/Book ratio does appear to be breaking upwards
at a moderate rate, that book value is based on relatively free liquidity. Any debt that
is included in net asset calculations is being serviced at artificially low rates
that could increase very suddenly. A rate surge will make a lot of book
values plummet, blowing the ratio up beyond sustainability.
Maybe this time is truly different, but between geopolitical instability; repatriation of gold and odd fluctuations in its value; unprecedented (and unsustainable) levels of CB expansions of fiat currencies, large amounts of which are used to monetize government debt; and demographic pressures in the West, which eat growth with increased entitlement spending while simultaneously reducing the labor supply; this feels to me like a bomb about to go off. I find it difficult to take the omens presented as good, but I would truly be glad for someone to show me my errors in this evaluation.
Thank you for your observations. You are correct in your statement that “For markets to rise from here at this ratio, we need corresponding growth in earnings” but that is what the Earnings/Sales tells us — that margins are strong, but not excessive, and that sales are growing in line with earnings.
Consumption funded by debt would be cause for concern, but growth in household debt remains low and is growing at a slower rate than NGDP (nominal GDP) so there are no signs of this on an aggregate basis.
The latest BEA report highlights that offshore profits are rising and local manufacturing is also experiencing strong growth, especially the petroleum and coal industries:
The accounting concept of Book Value is unaffected by interest rates.
I find myself in the uncomfortable position of being more bullish than broad opinion where I am normally on the bear side. I believe the explanation for this lies with the severity of the banking crisis experienced in 2008/2009 which was far greater than a normal recession. It will take the average investor many years to recovers his/her confidence in stocks — more than after the Dotcom crash — which means they are likely to miss most of the recovery.