Is the stock market cheap or overpriced? We hear conflicting pronouncements daily on CNBC and other media outlets. The pessimistic camp believes the broad domestic and international economic scene is weak and weakening and therefore, almost all common stocks are overpriced. Historical price/earnings valuation criteria in this negative environment for this group are mostly irrelevant.
The optimists believe things are difficult in the world economies, but not as bad as the pessimists contend and, therefore, every piece of bad news that is not as bad as feared is looked upon favorably as another small bud of improvement which is slowly beginning to blossom. The optimistic prognosticators think that emphasis on current macro economic data is yesterday’s market and that stock prices and their price/earnings ratios are cheap as we advance slowly toward an era of general prosperity bolstered by strong corporate profit growth.
The price/earnings ratio is a relative valuation measurement. It allows an investor to imprecisely measure the relative attractiveness of one stock, industry or general stock market against another. As the name price/earnings ratio implies, the ratio is derived by simply dividing a stock’s current market price by its earnings. The resulting ratio can then be used to compare the relative attractiveness of one stock to another stock usually within the same industry. With all other variables being equal, the common stock with the lower price/earnings ratio is more attractive to the investor than the common stock with the higher price/earnings ratio. All other variables are never equal.
In the price/earnings ratio calculation, price is always the known variable. It is the earnings denominator which causes the problem. Earnings can be and are reported by companies in many different ways. Companies can and do derive net income using many different accounting principles and rules making it difficult to consistently compare just one type of reported income. Sometimes the same company will use different formulas to derive net income from one year to the next. So, earnings, the denominator in the ratio, is an imprecise number, and different investors determine it differently. The result is investors derive different price/earnings ratios for a company, industry or stock market because they are using a different earnings denominator. There is always a debate as to which reported or projected earnings number is the best to use for the purpose of establishing relative attractiveness.
To complicate the issue a little further, the stock market is a forward looking mechanism, but investors like to use past historical data in determining future valuations. Is it more accurate in determining relative attractiveness to use past reported earnings or future projected earnings? The former allows the investor to derive a price/earnings ratio based on historical fact while the latter is an imaginary best guess number of the future, which often changes significantly, especially the further it is projected beyond the present. There is no correct answer to the question. Analysts use both methods generally favoring one methodology over the other depending on their assessment of the current investment environment.
Allowing for some variation in earnings determination, most Wall Street analysts believe the stock market is now selling for about 13 to 14 times past twelve month earnings and about 12 to 13 times future 2011 earnings. Historically since 1970 the stock market has sold between 7 times earnings and 28 times earnings. In the severe recession of 1973/1974 it sold close to a price/earnings ratio of 7. At the end of the dot com boom in 1999 it sold at about a price/earnings ratio of 28. Usually at some point in time stock prices revert to a historical medium price/earnings ratio of about 15 to 17.
If you believe the economy is on a recovery path, it is reasonable to project an improvement in earnings in 2011 versus 2010. The larger the earnings denominator the lower the price/earnings ratio and, therefore, the more attractive the general stock market, especially when compared to historical data with a smaller earnings denominator. Consequently the optimist says the stock market is under priced at about 12 times forward earnings as the economic recovery unfolds compared to a norm of 15-16 times.
Occasionally there occurs a time period in the history of our economy since World War II which is considered abnormal, atypical. This has been a rare event. Perhaps 1973/1974 and the subsequent six years of very high inflation and extraordinary interest rates is one such time period. The last several euphoric years of the 1990s, and the concomitant faith in high technology was perhaps a second atypical period when economic and or psychological behavior changed dramatically from the nation’s usual experience. It is our contention that 2007 to some yet to be determined future date marks the third period since World War II of abnormal deviation from the country’s usual cycle of lengthy, steady prosperity marred by short-lived modest economic and profit contraction. In “abnormal” periods a comparison of earnings and therefore price/earnings ratios to “normal” historical periods loses its validity. Atypical periods are marked by greater than usual changes in psychological behavior toward investments and a major shift in economic assumptions from the historical experience. Optimistic stock market prognosticators believe we have just gone through another typical cycle of expansion-contraction-expansion. They will concede the contraction was much sharper than usual but they believe that with typical fiscal and monetary intervention by the government the normal cycle of recovery remains intact. We contend we are in an abnormal time zone where the reemergence of expansion will be delayed and erratic during the next five to ten years. In assessing the stock market it is important to differentiate between these “normal” and “abnormal” periods. The current stock market rally is saying that price/earnings ratios in general are attractive in a “normal” expansionary phase of the economic cycle. Bullish investors contend that earnings in 2011 have a high degree of predictability along with investor psychology and, therefore, price earnings ratios should expand to reflect this return to a more predictable and stable environment. Thus, the stock market is cheap.
We think earnings predictability will be much less than expected by many on Wall Street for the next several years – our “abnormal” economic period. In our opinion the stock market will be primarily ruled by the macroeconomics of the next few years and an expansion in price/earnings ratios from current levels is not warranted under the emergency financial measures still being undertaken by many governments. The general historical norm, or greater than historical norm, price/earnings ratios will be delayed by the difficult macroeconomic environment.
A normal price/earnings environment envisions a normal stable period of prosperity in the country and world. We believe we are many years from reestablishing this environment. It is important to stress that such a lingering, difficult economic environment does not mean another collapse in stock prices or another immediate contraction in the economy such as occurred in 2008 and early 2009, but it does portend a stock market where current price/earnings ratios already very adequately reflect the past twelve month surge in corporate profits and the small improvement in U.S. and European economic data.
We are currently in a world environment where every country wants to export its way out of a sluggish economic environment. This simultaneous global objective puts pressure on currencies, raises the prices of commodities and could lead to trade wars. Most industrialized countries, including the U.S., are devaluing their currencies to make their products more competitive in the world market place. Manipulating or debasing of currencies also leads to trade wars and international financial uncertainty. They are policies of beggaring thy neighbor. Since the 1970’s the dollar has been the stabilizing currency in the world but with the United States’ huge federal deficit, stimulative monetary policy and weak economic recovery from the Great Recession its value vis-à-vis other currencies is being questioned. In other words, there is little prospect for currency stability in the near future as countries worldwide pursue their easier monetary policies.
Corporate profit margins are poised to begin a multiyear decline starting with the third quarter of 2010. Near historic earnings have been forced from declining revenues. This trend cannot continue and is near an end. We anticipate that the earnings estimates for 2011 and 2012 in the price/earnings ratio may be too high as we move into the next two years. A slow growth economy cannot sustain high growth in corporate profits. This dichotomy is not being reflected in future optimistic expectations for price/earnings ratios.
At some point, the gargantuan federal stimulus will need to be withdrawn from the U.S. economy. Instead of being a major factor in stimulating growth and support of the U.S. economy it will become a contracting force. The threat of unbridled federal deficits and monetary stimulus to the American economy is real and growing.
Improvement in the U.S. economy since June 2009 has mostly originated from major companies. These companies had and still have access to the capital markets. Small companies and small, but important regional banks, have been and remain shut out from the major flow of funds being created by the U.S. government. Outside of the few giant banks saved by the taxpayer bailouts, regional banks continue to fail at a high rate.
Housing will remain depressed for at least several more years and will not contribute to U.S. growth any time soon. Commercial real estate will not provide the stimulus to the U.S. economy that it has in past recoveries. The commercial real estate landscape is littered with over building.
The uncertainty regarding U.S. income tax policy after 2010 is not being adequately reflected in today’s stock market prices. Higher income taxes as expressed by the Obama administration regardless of their merits will likely inhibit economic growth in 2011/2012.
U.S. public sentiment has turned against free trade agreements. Politically the building of a global economy versus national interests will be much harder to sell. In such an emotional and politically charged environment greater global trade may be restricted and world economic growth stunted. Major and medium size companies have achieved a significant portion of their earnings growth by outsourcing their jobs and work to foreign countries while shuttering facilities here. Even during our current period of very high unemployment companies continue to outsource their work to overseas locations. Consequently, unemployment in the U.S. remains stubbornly high. Commerce department data show that employment at foreign subsidiaries of U.S. multinational companies grew by 729,000 from 2006 to 2008 while U.S. employment for the same companies over the same time period fell by 500,000 jobs.
The American consumer maintained his life style from 1990 to 2005 by increasing his debt. It did not come from wage growth. Increases in the American consumer’s net worth will be very slow during the next 10 years versus the 1990/2005 period. The U.S. standard of living will show little improvement in this new decade. The American middle class is under extreme financial pressure. The worst since World War II. 2009 showed the steepest one year drop in spending by the middle class since record keeping began in 1984.
State and municipal finances in the U.S. are in serious difficulty. Without financial aid the threat of bankruptcy for some states and municipalities is real. Because of their budget constraints these entities will be firing people not increasing their hiring. State and local governments in general for the next several years will be a restraining force on economic growth in the U.S.
The unemployment picture in the U.S., as detailed in our earlier position paper “Slow Growth, No Growth and Unemployment”, will not improve much into 2012. To reduce unemployment, corporations will have to create millions of jobs in the next two years which will at least initially hurt productivity and profit margins and earnings. It is our contention that growth in wage income will be very slow and will be a major factor in retarding U.S. economic growth.
The U.S. has operated at close to zero percent interest rates for the last several years. This has seriously hurt the income of retirees but it has helped major corporations borrow trillions of dollars at very low cost. It has not helped small businesses. The money so far is not available to them. It was hoped that very low borrowing costs would stimulate investing and spur the economy back to its old normal levels of growth. This has not happened. In time it should, but corporations are nervous about the instability and lack of predictability in the present world financial and economic environment. U.S. corporations have accumulated huge amounts of cash but most of it is overseas and will not be repatriated to U.S. shores to stimulate U.S. growth and job creation under current U.S. tax policies. Corporations in the U.S. continue to focus on overseas countries for their expansion.
Politically the mid-term elections may produce grid-lock in Washington. Many view this as good. In fact some investment funds restrict their investments to periods of political stalemate. Ordinarily we would not disagree with the thesis that political gridlock has its economic benefits, but in this turbulent time strong political leadership would be better. Instead we have serious political polarization.
The government and the Federal Reserve frequently like to point out that inflation in the U.S. economy is almost non-existent. This is not true. Inflation appears to be running at about a 2% annual rate. The government’s inflation numbers are lower than 2% because of the decline in housing prices which accounts for about 40% of the inflation index. With the expected new round of monetary stimulus by the Federal Reserve it is very possible that both inflation and interest rates will rise and a defacto devaluation of the dollar will occur. All are destabilizing events. The government’s weak dollar policy has encouraged currency and commodity speculation. Broad commodities indexes have gained in price about 30% in the past year. These increases in commodity prices have not occurred solely because of increased demand. These increases will be seen soon in the price of finished goods if current monetary policies continue for another year or more.
The U.S., its states and its municipalities and many corporations are facing severe problems regarding their entitlement programs. The American worker has been promised over 60 years incredible health and retirement benefits. Their cost today is staggering. Retirement pensions and health care costs are perhaps the major problem causing are nationwide budget crises. The unfunded liability of these future obligations equals trillions of dollars and will affect our prosperity and future. No one has solved how to place entitlement programs on a solid financial platform without bankrupting the system. Many entities (countries, corporations, states etc.) are probably bankrupt once you account properly for their future entitlement obligations. Resolving the entitlement problem or continuing it in its present form will result in significantly altering and slowing future economic growth. Because no one wants to come to grips with the major dilemma, its negative impact on the stock market, future earnings and price/earnings ratios is out there somewhere in the future, but someday it will register a severe negative jolt to our way of life. The day is approaching and at perhaps a faster rate than we think.
Should today’s stock market sell at a price/earnings ratio reflecting normal times? The Dow Jones Industrial Average first hit 10,000 in March 1999. It crossed 10,000 numerous times since then. Most recently last month. However, look at the deep differences between the U.S. economy and the American consumer then and now. The times and conditions of both the economy and American consumer in 1999 versus now look almost idyllic compared to today’s uncertainties, continuing emergency financial measures to bolster economies and fears. Is there a disconnect between reality and the stock market? The stock market operates on the principle that adversity equals opportunity. We concur with this thought. In March 2009 the stagnating U.S. economy presented opportunity if you believed a recovery would soon begin. We anticipated a stock market rising from the ashes of early 2009. However, after 18 months and 4000 points we believe the price/earnings ratio of the stock market is back to reasonable price levels in light of the serious complex problems facing the country and industrial world. We are probably still in a secular bear market which began in 2000 and has years to go before ending. But during any long term bull or bear market there will occur extensive contractions in stock prices or conversely extended periods of price increases. We are in such a rally now. An economic recovery slow and steady has become the belief and force de rigueur in the stock market propelling prices upward. Consequently, the optimists believe price/earnings ratios can still expand back to normal historical levels and the current rally has the potential to climb another 15%. We have pointed out in this position paper that we believe we are in an abnormal period in our financial history. A period filled with uncertainties in number and severity which we have not faced since World War II. We do not think the economy or stock market will collapse, but we do believe growth in either or both will be a fitful struggle over the next few years. The current pricing/earnings ratio of the stock market reflects its recovery from March 2009. Any higher price/earnings ratio will begin to increasingly ignore or deny the serious problems we have enumerated above confronting the nation between now and 2015. We are in atypical times which do not warrant, as yet, a return to historical average price/earnings ratios. The risks in the economy as outlined above are serious and normal price/earnings ratios must be discounted to reflect our current unusual times. With a new round of massive federal stimulus commencing soon, the stock market could continue its rally through year-end, but the new stimulus will only exasperate the imbalances in our economy and increase the difficulty of getting it back to normal. The return to normalcy will not be painless. Regardless of further federal stimulus we foresee continuing slow growth in the economy and longer term problems, which could flare up at any time. Stock market risk exceeds the potential for reward in our judgment at this time and we will continue to maintain a conservative asset allocation which we began last spring, marked by under representation in common stocks.
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