The prevailing
valuations in the lofty US stock markets are increasingly becoming a
bone of contention. Wall Street calmly asserts stocks are
reasonably valued, since it has a huge vested interest in keeping
people fully-invested. But with valuations soaring following a
massive rally and weak third-quarter earnings season, they are
dangerously high and portend great downside risk. Stock topping
valuations abound.
Since investing is
all about buying low then selling high, the price paid for any
investment is everything. Buy good companies at cheap
prices, and you’ll multiply your wealth over time. But buying those
very same good companies at expensive prices radically stunts future
gains. While cheap investments have great potential to soar as
traders recognize their inherent value, expensive ones have already
exhausted their upside.
And it’s
valuations, not absolute stock prices, that define cheap and
expensive. Valuations are where stock prices are trading
relative to their underlying corporate earnings streams. The
less investors pay in terms of stock price for each dollar of
profits, the greater their ultimate returns. Valuations are most
often expressed in price-to-earnings-ratio terms, with stock prices
divided by underlying corporate earnings per share.
This concept is so
easy to understand, yet the vast majority of investors ignore it.
Imagine purchasing a house for a rental property that has expected
annual rental income of $30k. How much would you be willing to pay
for it? If you can get it for $210k, 7x earnings, it will pay for
itself in just 7 years. That’s a great deal. But if that same
house is priced at $630k, 21x, it will take far too long just to
recoup the initial cost.
The stock markets
work the same way, with each dollar of profits completely fungible.
And the US stock markets have a century-and-a-quarter
average P/E
ratio of 14x earnings. That’s fair value for the stock
markets as a whole, paying $14 in stock price for each $1 of
underlying corporate earnings. This makes a lot of sense, as stock
markets exist to “lend” capital from those with surpluses of it to
others running deficits.
The reciprocal of
14x earnings is 7.1%. That’s a fair rate of return for those with
excess savings they want to invest, and a fair price to pay for
those who want access to that scarce capital. 14x facilitates
mutually-beneficial transactions for each side of the capital
trade, so it’s right where stock valuations have naturally
gravitated towards over the very long term. Cheap and expensive are
defined from that baseline.
Half fair value,
or 7x earnings, is very cheap historically. Buying good companies’
stocks trading at 7x earnings is a virtual guarantee of massive
wealth-multiplying future gains. Conversely double fair value, 28x,
is exceedingly-dangerous bubble territory. Buying the same good
companies’ stocks at 28x dooms invested capital to many years of
lackluster gains at best, and catastrophic losses exceeding 50% at
worst.
There’s nothing
more important for investors to understand than general-stock-market
valuations. They move in great third-of-a-century cycles I call
Long Valuation
Waves. These are divided into secular bulls and secular bears
that each last about 17 years. Valuations start out cheap
near 7x, gradually expand to or through 28x in the first-half
secular bulls, and then consolidate back to 7x in the second-half
secular bears.
Unfortunately the
US stock markets remain mired deep in the valuation-contracting
secular-bear phase of their LVW today despite their epic
cyclical bull of recent years. How can that be true when the US
stock markets have more than tripled since
early 2009? The flagship S&P 500, despite its massive gains,
still remains below its
real
inflation-adjusted peak from the end of the last secular
bull way back in March 2000!
The last
cyclical bull peaked in October 2007, and ominously the US stock
markets are trading at far-higher valuations today than they were
back then. This first chart looks at general-stock valuations as
seen through the lens of the benchmark S&P 500, or SPX. Our
methodology is simple, conservative, and easy to replicate. At each
month-end, we record some key data from all 500 SPX component
companies.
Each individual
stock price is divided by that company’s latest four quarters of
accounting earnings per share as reported to the SEC, yielding
individual P/E ratios for all 500 SPX components. This is classic
trailing-twelve-month methodology, involving hard historical
data and no guesswork on future profits. Then all 500 of these P/Es
are averaged, both simply and also weighted by individual companies’
market capitalizations.
Here are the
results since the topping of the last cyclical bull, with SPX
valuations recently surging up to lofty nosebleed levels. Contrary
to Wall Street’s endless claims that the stock markets aren’t
expensive today, prevailing valuations are actually way up at
dangerous bull-slaying levels. The SPX and therefore US stock
markets are trading at topping valuations today, which is a
super-bearish omen going forward.
While I’m eager to
see November’s valuation data, this month isn’t quite over yet. So
our latest SPX valuation data is from the end of October. And that
proved pretty ominous, with the
market-capitalization-weighted-average price-to-earnings ratio of
all 500 SPX component stocks rocketing 17.5% higher on a
monthly basis to 25.5x earnings! These elite companies’
simple-average P/E ratio was right in line at 25.6x.
This was a huge
jump in valuations in such a short period of time, an
exceedingly-rare event. It had two primary drivers. First, the
mighty S&P 500 rocketed an epic 8.3% higher in October, its best
month since October 2011! Assuming constant corporate profits, any
stock-price gains translate directly into proportionally higher
price-to-earnings ratios. Up the P/E ratio’s P by any percentage,
and the P/E will match that gain.
But that only
accounts for about half of October’s extreme valuation ramp.
The other half came from a weak third-quarter earnings season.
While there were certainly some great results from elite technology
companies, the great majority of SPX components saw flat-to-weak
profits year-over-year. There were mounting worries of a
bifurcated economy, the tech giants thriving while most of the
rest of the companies struggle.
Lowering the E in
P/E naturally forces valuations higher as well. And it’s pretty
amazing lower earnings actually came to pass. It’s not overall
corporate profits that feed P/E ratios, but earnings per share.
The great majority of elite SPX companies actively manipulate EPS
higher through stock buybacks. If overall profits can be
spread across fewer outstanding shares, the EPS will rise which will
force valuations lower.
And thanks to the
Fed’s extreme zero-interest-rate policy held in place since the dark
heart of 2008’s stock panic, corporations literally borrowed
trillions of dollars near artificial record-low rates to use to
buy back their stocks. As of the end of Q2’15, total buybacks over
that past year alone had exceeded $555b! And a whopping 3/4ths of
the elite SPX companies, the biggest and best in America, bought
back their stocks.
These campaigns
are explicitly designed to simultaneously boost stock prices and
earnings per share, which creates an illusion of growth.
Companies can even mask declining earnings by buying back enough
shares to more than offset the drop in profits spread across them.
And this outright earnings-per-share manipulation that lowers
valuations makes this past year’s valuation ramp even more ominous.
A year ago in
October 2014, the elite SPX component companies had a
market-capitalization-weighted-average P/E ratio of 22.8x.
Weighting all components’ P/E ratios by their market caps ensures
smaller companies with outsized valuations don’t disproportionately
skew the overall average. And the SPX ended that year-ago October
at 2018, which was actually pretty close to the 2079 closing out
October 2015.
With the SPX
merely climbing 3.0% in that year ending October, it’s incredible
that valuations still shot up by 11.5% despite those massive stock
buybacks! This implies corporate earnings have peaked this
past year, which helps explain these grinding toppy stock markets.
If companies fail to even maintain their profits, then today’s lofty
stock-market valuations based on future earnings growth look
even more threatening.
Trading at 25.5x
earnings last month, the SPX was right on the cusp of
exceedingly-dangerous bubble territory at 28x earnings! No
valuations remotely close to this had been seen in over a decade.
Even back in October 2007 when the last cyclical bull peaked, the
SPX valuation was considerably lower at 21.3x earnings. Yet stocks
were still expensive enough to roll over from cyclical bull to
cyclical bear.
Valuations are the
key arbiter of those great bull-bear cycles in the stock markets.
When stocks grow expensive by historical standards late in mature
bull markets, the odds mount that a new bear market looms. And
investors lulled into a dangerous sense of complacency at these
critical times by Wall Street’s perpetually-bullish rationalizations
of why stocks should rally forever face devastating bear-market
losses.
After that last
cyclical bull peaked in October 2007 at merely 21x earnings, the
mighty S&P 500 would plunge 56.8% over the next 1.4 years in a
brutal cyclical bear. Investors owning the best-of-the-best elite
American companies constituting the SPX saw their capital more
than sliced in half because they failed to heed the warning of
high valuations. And today’s are more extreme, nearly 20% higher
than that last bull top!
Remember that for
a century and a quarter, the average P/E ratio of the US stock
markets has been 14x earnings. The white line in these charts
reveals where the SPX would need to trade to match this historical
fair-value baseline. And as of the end of October, this number is
way down under 1150. With the US stock markets so expensive,
the downside as these lofty valuations inevitably mean revert is
massive.
The stock markets
would have to drop 45% based on current corporate earnings
per share, even boosted by the gargantuan ZIRP-spawned stock
buybacks in recent years, to merely return to fair value! This is
an interesting number, because the typical decline in cyclical stock
bears following cyclical stock bulls at this stage in the market
cycles is 50%. The recent stock topping valuations are very
menacing indeed.
For years, Wall
Street has endlessly claimed these lofty
Fed-levitated
stock markets are justified based on underlying
corporate-earnings fundamentals. For years, Wall Street has
applauded the manipulative stock buybacks that artificially boost
earnings per share. All this has led to extreme complacency,
with most investors convinced this long-in-the-tooth bull market can
continue indefinitely. Boy will they be surprised.
And even worse,
the downside target for the next S&P 500 bear is actually much lower
than fair value. At this stage in those great Long Valuation Wave
stock-market cycles, valuations actually ought to be much closer to
10x earnings. This next chart, which zooms out to encompass the
entire secular bear since 2000, illuminates this enormous
downside risk created by the Fed’s brazen artificial stock-market
levitation.
The US stock
markets remain mired deep in the same secular bear that started back
in March 2000. How can that be when the S&P 500 peaked at 1527 back
then and recently soared to 2131 in May 2015? If the March 2000
apex of the last secular bull is adjusted for US Consumer Price
Index inflation, which is even
lowballed for
political reasons, it works out to 2122 in constant May 2015
dollars. That’s a staggering revelation.
For 15.2 years,
the US stock markets did nothing but grind sideways at best
in real terms! For all the sound and fury of the Fed’s
extraordinary stock-market levitation of recent years fueled by its
unprecedented
third quantitative-easing campaign, all it accomplished was
returning the stock markets to their last real secular-bull peak.
But not even the Fed’s epic money printing could create a solid
corporate-profits foundation.
October’s
near-bubble 25.5x SPX valuations were last seen 11.3 years earlier
in June 2004. And those were right on the major secular-bear
stock-valuation downtrend shown above with the thick blue dotted
line. That valuation downtrend is exceedingly important, and actual
valuations oscillated around it as usual in secular bears until late
2012 when the Fed launched and expanded its infamous QE3 campaign.
QE3 was radically
different from QE1 and QE2 because it was open-ended, it had
no predetermined size or end date like its predecessors. Top Fed
officials deftly used this ambiguity to manipulate psychology among
stock traders. They continually implied the Fed was ready to
increase the size of QE3’s debt monetizations if the stock markets
suffered any material selloff. The Fed was jawboning stocks higher.
Stock traders
interpreted this endless dovishness exactly as the Fed intended,
believing an effective Fed Put was in place for the stock
markets. So they rushed to aggressively buy already-high stocks,
ignoring all conventional indicators of risk including valuations.
That Fed-sparked stampede into stocks fueled the massive breakout of
the SPX above its 13-year-old nominal resistance near 1500 back in
early 2013.
As the
stock-market valuations rising sharply in the Fed-SPX-levitation era
since 2013 prove, the huge stock gains weren’t the result of
improving earnings fundamentals but merely Fed hot air. With
profits failing to grow enough to justify those lofty stock prices,
the fundamental foundation of recent years’ powerful stock bull
was totally rotten. Stock valuations were driven to near-bubble
extreme topping territory.
And with the Fed’s
easy-money policies that inflated the stock markets ending, the
chickens are going to come home to roost. The Fed concluded its new
quantitative-easing bond buying with money conjured out of thin air
in October 2014, and it seems to be on the verge of ending its
zero-interest-rate policy kept in place since December 2008 that
fueled those epic corporate stock buybacks seen in recent years.
And with the vast
bullish psychological impact of QE and ZIRP fading, stock-market
valuations are going to mean revert back to their secular downtrend
in place before the Fed goosed the stock markets. The whole purpose
of secular stock bears is to force the markets to grind sideways for
long enough to give corporate earnings time to grow into the
extreme stock prices seen at the end of the preceding secular bull.
This massive
17-year secular-bear grind is accomplished through smaller cyclical
bears and bulls within that span. Secular bears consist of a series
of cyclical bears that first cut stock prices in half,
followed by cyclical bulls that double them back up to breakeven
again. Since 2000, we’ve seen two of these full cyclical-bull-bear
cycles. And as today’s dangerous stock-topping valuations prove,
the next bear is imminent.
Thanks to the
Fed’s gross market distortions in recent years dragging stocks so
far outside of normal trends, this next bear is going to be a doozy.
Secular bears begin with stock valuations near or above bubble
levels, and end with them around half fair value at 7x earnings
before the next secular bull can be born. At this late stage in
17-year secular bears as the valuation downtrend shows, P/Es should
be near 10x.
Based on current
corporate earnings, which Wall Street
constantly claims are excellent, the SPX would have to plunge
over 60% from here to 820! Even if profits start
miraculously growing in this tough world economy, it’s hard to
imagine them rising enough in the next couple years to push the SPX
much over 1000 at 10x earnings. The Fed’s artificial stock-market
levitation that so stretched valuations will prove disastrous.
Today’s stock
topping valuations couldn’t be more dangerous at this stage in the
great secular bull-bear cycles. SPX valuations are way up near
bubble levels now thanks to the Fed, leaving vast downside to
where they ought to be nearly 16 years into an indisputable ongoing
secular bear. Investors need to be very careful in buying very
expensive stocks today despite Wall Street trying to convince them
otherwise.
And frighteningly,
the corporate-earnings and therefore valuation situation may be even
worse thanks to the gross Fed distortions of recent years.
Corporate sales, which can’t be manipulated like earnings, have been
weakening. Companies can cost-cut their way to profits for a while,
but they can’t fire everyone and eventually have to see revenues
improve to grow profits. Even stock buybacks are a temporary
stopgap.
As the Fed starts
the long road to
normalizing rates after it ends its zero-interest-rate policy,
the virtually-free money companies have been borrowing to buy back
stocks will vanish. Higher borrowing costs will lead to plummeting
share buybacks, which will end the manipulation of spreading overall
profits across fewer outstanding shares year after year. So
valuations could stay high or even climb higher from here.
The stock markets
would be extremely expensive at 25.5x earnings even late in a
secular bull market, but they are an accident waiting to happen this
late in a secular bear. Investors ought to prepare for a new
cyclical bear market that will at least cut stock prices in
half. The biggest risk is not perceiving it in time, as bears
unfold slowly over a couple years to keep investors lulled into
complacency for as long as possible.
Investors and
speculators alike can trade these stock topping valuations by being
ready to liquidate their long stock positions as the stock markets
inevitably roll over. Sliding stock markets can also be bet upon
directly through put options on the leading SPY SPDR S&P 500 ETF.
Alternatively, long positions can be added in gold (GLD ETF) and
radically-undervalued gold stocks, as
gold tends to
thrive during stock bear markets.
Whatever you do,
with stock markets at such a critical juncture it’s exceedingly
important to cultivate strong contrarian sources of analysis to
counter Wall Street’s perpetual Pollyannaish bullishness. That’s
what we specialize in at Zeal. For 16 years now, we’ve been
intensely studying and trading the markets from a hardcore
contrarian perspective. We buy low when few will, to later sell
high when few can.
You can put our
decades of exceptional experience, knowledge, wisdom, and ongoing
research to work helping multiply your wealth through our acclaimed
weekly and
monthly
newsletters for speculators and investors. They explain what’s
going on in the markets, why, and how to trade them with specific
stocks. With valuations so extreme at this stage in the great
cycles, now is a great time to
subscribe and get
informed!
The bottom line is
the US stock markets are trading at
dangerous topping valuations. Despite incredible buybacks
fueled by record-low rates courtesy of the Fed, corporate profits
are still so weak relative to Fed-inflated stock prices that stocks
still neared bubble valuations following third-quarter earnings.
This is a huge problem so late in a secular bear, when valuations
should be far closer to 10x earnings than 26x.
This has to end
badly. The gross Fed distortions of recent years artificially
extended a mature cyclical bull and delayed a cyclical bear, but
central banks can’t eliminate market cycles driven by valuations.
The overdue bear market is still coming, and will be far worse
starting from such lofty and overvalued conditions. Stock topping
valuations at these extremes this late in a secular bear are
exceedingly dangerous.
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