Tag: PE of Highest Trailing Earnings

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S&P 500 losing touch with reality

The S&P 500 climbed to a new high after breaking resistance at its January ’22 high of 4800. Rising Trend Index troughs warn of strong buying pressure. Pricing seems to be losing touch with reality.

S&P 500

The S&P 500 Price-Earnings ratio climbed to 24.2 on December 31st and is forecast to reach 24.9 at the end of the quarter (based on the current index price and forecast Q1 earnings). The chart below shows the pricing history of the index (and its predecessors) over the past 120 years. We use highest trailing earnings to eliminate distortion caused by sharp falls in earnings during past recessions. Prior to the Dotcom bubble, PE had never exceeded 20 times earnings — even during the heady booms preceding the Black Friday crash in 1929 and Black Monday in 1987. The long-term average PE of 16.5 (since 1973) suggests that the index is currently over-priced by close to 50%.

S&P 500 PE of Highest Trailing Earnings

The price-to-sales ratio of 2.57 shows a similar excess compared to the average of 1.70.

S&P 500 Price-sales Ratio

The operating margin of 11.0% in the December quarter has declined from its 2021 peak at 13.5% but is still above its 10-year average of 10.2%. We expect margins to revert to the mean over the next year or two.

S&P 500 Operating Margins

While margins are still reasonably healthy, annual sales growth plunged to 4.0% in the December quarter. Core PCE inflation of 2.9% in 2023 means that real growth in sales was a paltry 1.1% last year.

S&P 500 Annual Sales Growth

Conclusion

The S&P 500 is over-priced relative to earnings and sales growth, with long-term intrinsic value estimated at  3200 — roughly two-thirds of the current price. If the Fed continues to inject liquidity to support financial markets ahead of the November elections, we do not expect a major correction in 2024 — bar a major geopolitical event that impacts on energy prices.

The following year is likely to prove more difficult, however, with the Fed draining liquidity to ease underlying inflationary pressure and Treasury increasing issuance of notes and bonds, driving up long-term yields.

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Have stock prices lost touch with reality?

Robert Shiller’s cyclically-adjusted PE (or CAPE) is at a similar level to the 1929 peak before the greatest crash in US history. CAPE uses a 10-year average of inflation-adjusted earnings in order to smooth out fluctuations in earnings. The current reading of 29.2 is almost double the low during the 2008 global financial crisis (GFC).

S&P 500

We use a different approach. Rather than smoothing earnings with a moving average, we use highest trailing earnings as the best indication of future earnings potential. Earnings may fall during a recession but stock prices tend to fall by less, in expectation of a recovery. Our projected value for the end of Q4 is based on highest trailing 12 months earnings at Q1 of 2022. At 20.16, the PE is higher than 1929 and 1987 peaks, which preceded major crashes, but still much lower than the Dotcom bubble.

S&P 500

Forward price-earnings ratio is more reasonable at 17.91.

S&P 500

But S&P earnings forecasts seem optimistic, with no indication of a recession in 2023.

S&P 500 Historic Earnings & Forecast Earnings

Declining real sales growth, in the first half of 2022, suggests that profit margins will come under pressure, with both earnings and multiples declining in the next 12 months.

S&P 500 Real Sales Growth

Shifting from earnings to a wider perspective, price-to-sales for the S&P 500 avoids distortion caused by fluctuating profit margins. Projected to rise to 2.30 in Q4 (based on the current S&P price and Q3 sales), prices are similarly elevated compared to the long-term average of 1.68.

S&P 500/Sales

Price to book value, estimated at 4.01 for Q4, shows a similar rise compared to a long-term average of 3.07.

S&P 500/Book Value

Warren Buffett’s favorite indicator of market pricing compares stock market capitalization to GDP, eliminating distortions from fluctuating profit margins and stock buybacks. The Q3 value of 2.0 is way above the long-term average of 1.03, suggesting that stocks are way over-priced.

US Stock Market Capitalization/GDP

Australia

Data is a lot more difficult to obtain for the ASX, but the ratio of market cap to GDP (Buffett’s indicator) is a lot more modest, at 0.96, indicating prices are close to fair value.

ASX Stock Market Capitalization/GDP

Conclusion

The chart below shows how rising US liquidity (black) fueled rising stock prices as reflected by the ratio of market cap to GDP (blue). The steep rise in the money stock (M2 excluding time deposits) after the 2008 GFC, created a scarcity of investment-grade assets, driving down interest rates and driving up stock prices.

US Stock Market Capitalization & M2/GDP

Central banks are now shrinking liquidity, in an attempt to tame inflation, and stock prices are likely to fall.

We estimate that US stocks are likely to fall between 30% and 50% if there is a recession next year. Australian stock prices are a lot closer to fair value and only likely to fall 10% to 20% in the event of a recession.

In our view a recession is almost inevitable in 2023 as the Fed cannot inject liquidity to create a soft landing — as it has done repeatedly in recent times — because of the threat of inflation.

Acknowledgements

  • The graphs of Robert Shillers CAPE, S&P 500 real sales growth, and S&P 500 price-to-book value are from multpl.com
  • Sales and earnings for the S&P 500 are from spglobal.com
  • All other US data is from FRED at stlouisfed.org
  • Market cap for the ASX is from asx.com.au while GDP is from the RBA.
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Stock prices: Jay Powell is talking through his hat

Daily COVID-19 cases in the US continue to climb, reaching 236,211 on Thursday 17th.

USA: COVID19 Daily Cases

Unemployment claims jumped by 1.6 million in the week ending November 28, exceeding more than 1 in 8 of the total workforce (Feb 2020).

DOL: Total Unemployment Claims, 28Nov2020

Initial claims under state programs climbed to 935,138 (unadjusted) by week ending December 12, compared to 718,522 for w/e November 28, while initial claims under pandemic assistance programs run by the federal government jumped to 455,037 compared to 288,234 for w/e November 28.

Further escalation of both daily COVID-19 cases and unemployment claims is likely before vaccine distribution achieves a wide enough reach to make a difference. A major obstacle will be public reluctance to get the vaccine shot:

As states frantically prepare to begin months of vaccinations that could end the pandemic, a new poll finds only about half of Americans are ready to roll up their sleeves when their turn comes.

The survey from The Associated Press-NORC Center for Public Affairs Research shows about a quarter of U.S. adults aren’t sure if they want to get vaccinated against the coronavirus. Roughly another quarter say they won’t. (Associated Press, December 10, 2020)

Federal assistance

Further federal assistance may soften the impact of rising unemployment on the economy but Senate leaders are yet to conclude a deal. Both sides claim to want a deal but it seems unlikely that agreement will be reached before the Georgia run-off elections on January 5th. If the Democrats win both seats, and a Senate majority, they will not need to compromise. Unfortunately, large numbers of the least fortunate will suffer before then. Real leadership from the White House, needed to break the logjam, is sadly absent.

Jay Powell and stock prices

Jay Powell says he is relaxed about stock prices:

Stocks at record highs and bond yields not far from their historic lows are telling two different stories, but Federal Reserve Chairman Jerome Powell said he isn’t worried about the disparity.

In fact, the central bank chief said during a news conference Wednesday, the low rates are helping justify an equity surge that has gone on largely unabated since the March pandemic crisis lows.

“The broad financial stability picture is kind of mixed I would say,” Powell said in response to a CNBC question at the post-meeting media Q&A. “Asset prices are a little high in that metric in my view, but overall you have a mixed picture. You don’t have a lot of red flags on that.” (CNBC, December 16, 2020)

There is just one problem: bond yields are distorted by the Fed and do not reflect market forces.

S&P 500 PEmax

If we take the S&P 500 Price-Earnings ratio based on the highest trailing earnings (PEmax), this eliminates distortions from sharp falls in earnings during a recession. The current multiple of 26.69 is the second highest peak in the past 120 years, exceeded only by the Dotcom bubble. By comparison, peaks for the 1929 stock market crash (Black Friday) and 1987 (Black Monday) both had earnings multiples below 20.

S&P 500 PE of Maximum Trailing Earnings (PEmax)

Payback model

If we use our payback model, we arrive at a fair value estimate of 2169.50 for the S&P 500 based on:

  • projected earnings for the next four quarters as provided by S&P;
  • a long-term growth rate of 5%, equal to nominal GDP growth in recent years; and
  • a payback period of 12 years, normally used for the most stable companies (with a strong defensive market position).

The LT growth rate required to match the current index value (3709.41) is 14.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was spiraling out of control.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk is elevated and we are likely to witness a major collapse in prices in 2021 unless inflation spikes upwards as in the 1970s to early 1980s.

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