OT market valuation:
Question: Is the market overvalued?
Discussion:
1. The LT range for the S&P 500, is to stay in a PE range of 10-20, with a LT average of 15. In recessions, it can be expected to hit a PE of 10. That's what has happened in previous recessions, and the consensus (since 9/11) is that a recession is now inevitable, with negative GDP growth in the next 2 reported quarters, at least. According to my latest issue of BW, the PE is now (using trailing 12M earnings) at 33.1. Wow. That means, based on a longterm pattern, we should expect the S&P 500 to get chopped by 2/3 or so, from today's levels (assuming profits don't go up in the coming recession, and the PE goes to 10).
2. But, it is not reasonable to expect the PE to go to 10, given the fact that valuations are powerfully influenced by interest rates, and interest rates (LT and ST) are now much lower than in the last several recessions. The yield on 10Y Treasuries is currently 4.5%. This is the level briefly touched in late 1998, and at no other time this generation, a level far below that seen in recent recessions. Inflation and interest rates were far higher in 1990 and 1980. The 1973-4 recession saw a huge upsurge in inflation. Today, the picture is much better. Fed Funds now at levels last seen in 1962. Mortgage rates at generation lows and declining. As a rough guide, the S&P 500 is fairly valued, given average economic conditions, at a forward PE equal to the inverse of the yield on 10Y Treasuries. The inverse of 4.5% is 22. Still above 33.1, but not quite such a horrible discrepancy.
3. However, economic conditions are not average, so that 22 PE is too high. Solving the equation 22/15 = X/10, X=15= fair value PE, given current interest rates and an expected recession. Those two variables (interest rates and the expected forward 12-month economic conditions) are the main variables controlling market valuations. 15 is more than twice as big as 33.1 Ugghh.
4. But wait. The market is a forward-looking indicator. No one cares about the past. And the PE of the S&P 500, using forward 12-month earnings estimates from First Call, is only 18.6. So, everything is OK. 18.6 isn't too different from 15, so the market is roughly fairly valued now.....assuming those First Call earnings estimates are right......
5. Let's look at that assumption. 33.1 is a lot different from 18.6. That difference in expected forward vs. trailing PE, implies a change in earnings for the S&P 500, from $30.42 to $54.14, which is a 78% increase. Another wow. Maybe two wows. What are the odds of that happening? The next two earnings-reporting seasons will report results during a time when the GDP is declining. Hard to see profits going up at all, in the next two reported quarters. The rosiest possible scenario is that we get a sharp V-shape upturn in GDP, consumer spending, business spending, infrastructure investment, and corporate profits, immediately after that. Still, it's hard to see how we get a 78% total increase in profits in the coming 12 months, if the first half of that period is flat-to-down. Real hard.
Conclusion:
1. Forward 12-month earnings expectations are still far too optimistic. They will be coming down.
2. The market is still overvalued. A reasonable expectation, given past patterns, is that the PE (using trailing earnings) needs to decline from 33.1 to about 15. This PE is derived from past patterns of how interest rates and recessions influence valuations. Other variables are ignored.
3. If stocks go up in the next 6 months, it will have to come entirely from an expansion in PEs, from today's historically high levels. In the period 6-to-12 months out, rising stock prices would have to come from an immense surge in profits, or a further increase in PEs. A profit surge of that magnitude is unlikely. If stocks go up, it can only be called a re-inflation of the Bubble. A re-inflation that is likely to be partial, and certain to be temporary.
4. A partial re-inflation of the Bubble is quite likely, given the coordinated global rate cuts by all central banks, a government back to BorrowAndSpend, the liquidity gusher, and declining oil prices.
5. So, I'm bullish now, but I'm not sure if I'm bullish enough to go back to LTB&H. A 50% increase in the Nas, or even a doubling, might just be a selling opportunity. |
