One of the odd things about this bull market is the press fixation on the rather dubious bull case (not that the market won’t continue to be peppy for a while, but with fundamentals like the ones we have now, it can’t continue for long).
We’ve pointed before to an excellent Martin Wolf comment on how stock prices by long historical standards were high by a considerable margin. And Barry Ritholtz at Seeking Alpha has done a consistently fine job of parsing various data releases and finding them on the whole to be less than stellar (the most recent example here). A raft of commentators were skeptical of the Dow breaking the 13,000 mark. And more recently, we’ve had the truly downbeat reading of the well-regarded Jeremy Grantham, who while admittedly of a somewhat bearish cast, has never been this downbeat. He declared the world to be in the throes of global asset inflation, with remarkably few safe havens.
The latest bout of skepticism comes from two comments in the Financial Times, one from Henry Blodgett, the other John Authers. Both cast doubt on equity pricing. First from Blodgett who in “Reality will bite in spite of the bulls’ rosy view of earnings” challenges some of the common assertions about equity growth and P/E multiples:
US stock market bulls are looking at current equity valuations through rose-coloured glasses.
The bulls argue that earnings growth will settle in at a normal rate of, say, 10 per cent a year, “low” price/earnings multiples will expand and the market will deliver strong performance into the hereafter.
Coming on the heels of the past four years, this logic seems reasonable. But it isn’t.
To begin, a “normal” rate of earnings growth is not 10 per cent a year but 6 per cent – happy memories of the recent past lead many bulls to simply round up. More important, if earnings growth just “settles in” at this lower rate, it will be a miracle: earnings just don’t behave that way.
How do earnings behave? Typically, they shoot up at double-digit rates for several years, then collapse, then shoot up again, then collapse, and so on, until, over long periods, the peaks and valleys average out to growth of about 6 per cent a year.
According to Ed Easterling of Crestmont Research, the growth phase of the typical earnings cycle usually lasts about three to five years. Easterling analysed the period from 1950-2006 and found only one cycle in which earnings grew for more than five years straight (the mid-1990s). The retrenchment phase is typically shorter, but brutal: mild earnings recessions have seen a year or two of double-digit drops. The “adjustment” after the 1990s saw a single year in which earnings got cut in half.
How long has the recent streak of double-digit earnings growth lasted? You guessed it: five years. If the current consensus for S&P 500 earnings growth is accurate, we’ll tie the half-century longevity record this year and break it next year.
But records were made to be broken. So, what might cause earnings to collapse? A return to more normal profit margins. Earnings growth for the past five years has been driven not by extraordinary sales, but by extraordinary margin expansion. Corporate profit margins are now at their highest level in 50 years.
And profit margins, as legendary manager Jeremy Grantham likes to point out, are mean-reverting. In the past, each time profit margins have come anywhere near today’s levels, they have quickly dropped. Such a “reversion” alone would cut today’s profits by about 25 per cent.
The bullish take on profit margins is a familiar one: “This time it’s different.” This time, the theory goes, three billion low-paid workers in India, China, et al, have permanently tilted the balance of labour and capital in favour of capital. This argument overlooks a critical point: competition. When every company can outsource, doing so is not an advantage – it’s a necessity.
Today’s profit margins contribute to the weakest link in the bulls’ argument. Look at “forward operating earnings”, the bulls say, and you’ll see that the market’s p/e multiple is close to the century’s average of about 15 times. This “low” multiple, the theory goes, sets the table for higher valuations in the future.
The flaws in this logic are many. First, 15 times isn’t a “low” multiple – it’s an average one. Half the time, historical p/e ratios have been below that level. Second, the bulls base their p/e calculation on forward operating earnings, while the century’s average is based on actual, trailing earnings.
According to Cliff Asness, an American hedge fund manager, the long-term average p/e multiple on forward operating earnings is only about 11-12 times, not 15 times. So even if one ignores today’s profit margins, today’s p/e multiples are anything but “low”.
Third, calculating p/e ratios based on today’s profits means basing your valuation analysis on the “peak” of the peak-and-valley earnings pattern described above. Long-term average multiples are based on average profit margins, not peaks. Adjust today’s record margins to more normal levels, and p/es begin to look distinctly high. How high? Not quite as high as 2000, thankfully, but about as high as most major peaks, including 1929. So let us pray that it is indeed different this time.
Authers uses a simpler approach: he cites a survey of Chartered Financial Analysts, who harbor considerable doubts about this market. He also points out that this cautious consensus might be a contra-indicator:
Much of the world’s smartest money is currently congregated in Manhattan for the annual conference of the CFA Institute, the global gatekeeper of the Chartered Financial Analyst qualification. A poll of the delegates suggests they are sceptical about positive visions of world markets.
The survey is not scientific, but it is highly suggestive. Asked to put a number on the equity risk premium – the extra return investors should demand for the extra risk they take when investing in equities rather than government bonds – the average response was 3.4 per cent. That is almost exactly half the 7 per cent that was taken as the equity premium for most of the last century and still assumed by models used by business school students. Only 2 per cent of the CFAs thought the premium would be even as high as 6 per cent, barely any more than the proportion who thought stocks would actually trade at a discount to bonds.
Very few believed current historically low levels of market volatility could continue. Only 9 per cent thought this was “a consequence of lasting low economic volatility”.
Meanwhile, 47 per cent think low volatility is temporary and agree with the statement: “It isn’t different this time.” In the long-term, most believe the statistical rule of “mean reversion” will apply; long-term investors should exploit the tendency for markets to return to their long-term averages….