There’s more to this market than just easy money. People imagine that the only reason the stock market is going up is because of extraordinary policy accommodations by the Federal Reserve Board. And the thinking goes that when the crutches are finally removed, the patient will fall over. It’s a cynical view to think that monetary accommodation is the only thing driving the markets. The implied obverse of that coin is that if we just keep money free, we’ll all get rich. We have all seen how that story has played out. That’s not to say that I don’t adhere to the advice to not fight the Fed. Easy money and negative real interest rates have had powerful effects on risk assets. But strong fundamentals are underpinning these markets. Even with broader indices above or testing new nominal highs, valuations, based on earnings, sales, and dividends are cheaper than previous market heights. And there is still trillions of dollars in dry powder sitting on the sidelines.
Bull markets generally commence at oversold conditions and conclude with market multiples having more than doubled. By March 2009, the S&P 500 Index1 was trading at less than 11 times trailing twelve month earnings. Since then, multiples have only risen by half, while earnings have doubled. Share prices generally move in the same direction as earnings over long periods as they are a mirror on a growing economy for the U.S. and the world. Corporations are in a much stronger place fundamentally than they were at the peaks of 2000 and 2007. Cash levels relative to assets are significantly higher. Debt levels relative to assets are significantly lower. And earnings growth is more balanced across sectors a far cry from 2007 when financials represented nearly one-third of the S&P 500 Index’s earnings.
For businesses, it now gets harder. Profit margins have peaked. Businesses have already cut costs to the bone and margins will not return to such lofty levels in this cycle. Fortunately the cyclical peak in profit margins is not a signal of impending doom. In more instances than not, stocks continue to climb far beyond the peak in profit margins. Businesses, to paraphrase the old commercial, will now go back to making money the old fashioned way. They’ll earn it. Revenues typically track the nominal growth rate of the global economy. Leading indicators in the U.S. are forecasting reasonable growth in the quarters ahead and China, still the world’s swing producer of growth, is reaccelerating. With fewer macro headwinds in sight, stock valuations are likely to climb higher.
Even if earnings were to disappoint, I believe the risk to the downside appears limited given that markets already appear priced for a letdown. I consider a metric developed by the Citi U.S. Equity Strategy team that looks at the present value of the stock market as if it were a perpetual annuity, using as a discount rate the 10-year Treasury rate plus a proprietary measure of the equity risk premium. It assumes that corporate earnings remain the same year after year. The present value of that perpetual annuity represents nearly 90% of the value of the S&P 500 Index implying virtually no annual earnings growth from now to forever. Companies have low hurdles for which to clear.
Enduring market strength does not have to ultimately represent a sell signal. Just knowing that markets are above or at nominal highs or that returns compared to past recoveries are strong provides no useful information to investors. Valuation data does, however, and it tells us that the markets are not overextended on a historical basis. The S&P 500 Index, trading at 15.4x trailing 12-month earnings remains 49% below its peak 2007 level and 22% below its 20-year average.2 Valuations on global indices tell a very similar story.
In addition, currently, stocks are as cheap to bonds as they have been in decades. The spread between the yield on the 10-year U.S. Treasury and the S&P 500 Index earnings yield is as wide as it has been since the late 1970’s. Equity earnings yields aren’t just high relative to overbought bonds but are high relative to equity history as well. I believe what this means is that investors may have a significantly higher potential claim on corporate earnings than they will receive in income generated in traditional fixed income securities.
So what happens when the Fed begins to stop the party? Markets will not take too kindly to the beginning of a tightening cycle. They never do. But the inevitable market freak out is almost always followed by gains in the subsequent twelve months. The worry point comes when the Fed stops tightening and not when they start. The good news for investors is that regardless of the Fed’s timing, this market is ready to stand on its own.
- The S&P 500 Index is a market capitalization weighted index of the 500 largest stocks in the United States. The index is unmanaged and cannot be purchased directly by investors.
- Bloomberg, 3/22/13