It is no secret that equity prices are elevated. The post-election rally pushed share prices back to levels we thought we would not see again for a long long time. Since reality has manifested in a way we did not predict, we need to take a moment to think about what might be taking place. We can point to a few potential explanations. (1) Investors have a short memory and are willing to bid the price of equities ever higher because the world lacks other viable investment alternatives. (2) All the money and credit printed by the FED during QE 1, 2 and 3 is now finally making its way into the equity markets. (3) Investors may be discounting higher GDP growth rates which will lead to higher sales and corporate profitability. (4) Investors are pricing in a substantial cut in corporate tax rates. Lower tax rates mean higher earnings and cash flow. Discount those cash flows at a low rate and we see ever higher equity prices.
When looking at the value of an asset class, it pays to look at share prices in a historical context relative to GDP. The relationship of equity valuation to GDP is one of Warren Buffets metrics for judging equity market valuation. The following chart shows the relationship between equity prices as an asset class and GDP going back to the 1950s.
Many have argued that the elevated equity price can be explained in part by interest rates. In the 1980s, equity prices were depressed and the yield to maturity for 30 US Treasuries was in the 15% range. Today, those same Treasury bonds yield a little over 3%. So there is something to that argument. But rates do not explain equity market valuation during the dotcom, tech bubble days of the late 1990s. During this time, 30 year Treasuries were yielding in the 5 to 7% range, yet valuation was higher than it is today. We think the only explanation for this period is emotion. People were over-estimating the profitability of the transformative technology coming to market. Our interpretation is that yes, that all other things being equal, a fall in interest rates should be associated with higher equity prices and valuation metrics like PE, EV/EBIT, P/S, etc. We also think social mood matters. If people’s mood is improving, they are more likely to be more confident about the future and therefore more likely to buy stocks
So what else can be learned from this chart. Valuations can swing wildly. It was just 9 years ago that equity traded below their historical mean valuation relative to GDP, now they are 2 standard deviations above. This does not mean one should be outright bearish stocks. It does mean however that one should be vigilant. When investor mood shifts, we could see an end to this secular bull market and much lower equity prices.
One of the signs that investors are ebullient is their willingness to take on debt to buy stocks. The above chart shows stock prices as measured by the S&P 500 have moved substantially higher as speculators borrowed heavily to buy stocks on margin. This once again does not suggest a bear market is imminent. It just tells us that when one happens, we are likely to see some margins calls which could make the selloff a bit violent.
The above chart compares the price action of the Dow Jones Industrial Average the open interest on the DJIA Futures contracts. It shows that speculators are net long at historically large levels. These kinds of levels suggest to us, that speculators are too long and that a correction might be just around the corner. Furthermore, the DJIA is rising in a wide, upward trend channel. What tells us is that we could see a 9% correction from here and the bull market would still be intact. This is the scenario we see playing out in the not too distant future. Once the selling starts, we are likely to see investors sell stock as they liquidate their Futures and debt positions. We think this phenomenon could turn a run of the mill correction of 2-3% into a 9% selloff. This would scare the pants off investors as they fear something worse could be around the corner. Just as the S&P 5oo hits the lower trend line, we think stocks will find a new footing from which to rise once again.
One of the reasons we think the bull market has more room to rise on the upside is the relationship of interest rates to the earnings yield on 10- years Treasuries. While earning yield is coming down, there is still a gap between it and the yield to maturity on 10-year Treasury bonds. The relationship between earnings yield and bond yield is not as strong today as it was in the 1990s, it does provide some potential fuel to equity prices.
It is also possible to see earnings rise over time as well. When business owner and managers become more confident, them make investments, expand production, hire people, etc. as they seek to meet customer demand. The following chart shows that small business owners are becoming more confident. If our thesis is correct, we should see increased confidence by business owners reflected in more economic activity and profits.
In the final analysis, we are still long-term bullish, but short term bearish as the equity markets look overbought to us. A shakeout would be just what the doctor ordered to shake our the weak and levered hands only to leave them behind in the next bull move. A correction might be good for the long term bulls. It is easier to buy equities with a PE multiple of 17 than it is to buy them at at a 22+ multiple.
