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Perma-shills
have been claiming of late that the stock market is now trading at an
enticing valuation. Their main evidence for this, as they are fond to claim,
is that the forward Price to earnings multiple is 12 times next year's
earnings for the S&P 500. And, of course, a 12 PE multiple makes stocks
cheap and the overall market a buy.
But
for investors who want to accurately assess that number, there are two issues
they should be aware of. First, the PE ratio isn't a good measure of the near
term direction for the market. And second, nobody knows what the forward
PE will actually be. Some pundits like to use that forward looking number
because, when corporate earnings are projected to rise -- as they almost
always are -- the PE ratio will look better.
So
let's get into some real numbers that will help determine if the market is
indeed cheap.
For
Q1 2010, the PE ratio on an operating trailing twelve month earnings basis
for the S&P 500 is 15.5. Historically speaking, the average PE ratio on
the S&P is about 15 times earnings. So therefore, if one isn't promoting
an ebullient guess as to what earnings will be in the future, the market is
currently just fairly priced on a PE basis. Also, the PE ratio on an
inflation adjusted average over the previous ten year period has ranged from
4.78 in December of 1920 to 44.2 in December of 1999. With such a wide range
of valuations, it is difficult at best to make a case to buy or sell stocks
solely on a PE basis. There are other factors like; the direction of
inflation and interest rates that are necessary to consider when evaluating
the PE ratio.
Some
market cheerleaders also like to use the inverse of the PE ratio called the
earnings yield when comparing stock prices to bonds. They say; with the
current earnings yield being 6.4% and the Ten year note yielding around 3%
that stocks are a great value. Again, there are problems here too. Firstly,
investors don't earn the earnings yield as they do with dividends. And as
mentioned, the earnings yield is merely the reciprocal of the PE ratio. The
fact that the yields on government bonds are significantly below the earnings
yield on stocks is merely an indication of the egregiously overvalued state
of the U.S. debt market.
Rather
than pick one or two statistics like the forward PE ratio or the earnings
yield to convey an opinion on stocks, here are several important facts that
will help you decide the future direction of the market.
A
good metric to determine the valuation of stocks is the dividend yield. The
current dividend yield on the S&P is a paltry 2.1%. The historical
average dividend yield is a much greater 4.36%. The lowest dividend yield was
1.11%, which was reached in August of 2000. The highest dividend yield was
13. 84%, this was achieved in June 1932. Therefore, on a dividend yield
basis, the market is currently significantly overpriced. To add salt in the
wound of those low yielding stocks, tax rates on dividends are scheduled to
increase significantly in 2011. Maybe that is the reason why all the cash
sitting idle on corporate balance sheets isn't being sent back to investors
in the form of dividends?
According
to the Investment Company Institute, mutual fund cash levels are at a decade
low. Cash levels as a percent of assets reached a cyclical high of 12% in
1991. Today, that ratio is less than 4%. With mutual funds already nearly
fully invested where will the money come from to take stocks higher?
The
Fed's balance sheet is at a record high $2.3 trillion. The unwinding of that
balance sheet will send interest rates on their $1.1 trillion In Mortgage
Backed Securities (MBS) soaring and will thus further damage the real estate
market, stifle earnings growth and depress GDP growth. The Fed must also find
buyers for all that MBS debt. This will crowd out investments that would have
normally been made into stocks.
Household
debt and the Gross National debt have never been at or above 90% of GDP at
the same time. For the first time in U.S. history, that is the case today.
Along with the massive deleveraging that still lies ahead for both the public
and private sectors, the Treasury must auction off close to $9 trillion in
debt each year to cover our ballooning deficits and to satisfy rollovers.
This will further crowd out investments that could have been better placed
into the stock market.
Once
you view the real numbers on PE ratios and dividend yields it is hard to make
an argument that stocks are cheap. And given the low levels of cash that
exist at mutual funds and the crowding out of private investments that is
taking place from the government, investors will find it difficult to assume
the market can produce a sustainable rally of any real significance.
The
only disclaimer here is if the Fed embarks on another doubling of its balance
sheet in an attempt to crush whatever life is left in the value of the U.S.
dollar. Then, in that case the market may rally in nominal terms. But you had
better own precious metals and the companies that pull the stuff out of the
ground if you want to earn a positive return after inflation.
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global
Advisors : 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone:
800-485-1220 Fax: 800-485-1225
A
15-year industry veteran whose career began as a trader on the floor of the
New York Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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