The P/E Ratio of the S&P500 is Fair. Really?

May 28, 2013

The S&P500 gave back a minor 1% last week. Volume was light. Volatility jumped 12%, but was still hovering near multi-year lows. The equity market is still extremely over-bullish. According to the Investors Intelligence Sentiment Poll, about 55% of advisers are bullish, while only 19% of them are bearish. This is extreme. In fact, the difference between the two (bullish less bearish) is at the highest level since the market highs of 2007.

US economic activity continues to struggle to gain traction. The Chicago Fed National Activity Index, one of the most important LEADING indicators of economic health fell again last month, this time into even deeper negative territory. Existing home sales missed expectations, while new home sales beat. Initial jobless claims just beat their expectations. Finally, durable goods orders, ex-autos, beat consensus estimates last month, but he year-over-year trend is still unmistakably weakening.

The technical picture for the S&P has not changed. The equity market is extremely over-bought, by almost any commonly used technical measure. Does this mean that the market cannot get even more over-bought? Of course not. But the risks of a pull-back are considerably higher when the markets are as stretched, technically, as they are today.

Over last several months, a commonly heard theme—especially one advertised on mainstream media outlets—is that the stock market is fairly valued. Earnings are strong. Balance sheets are full of   cash, and companies are healthy and growing. And most importantly, the price to earnings ratio for the S&P is fair, implying that the stock market is not expensive.

Hence, it’s a good time to buy stocks.

But there is a very serious problem that’s being overlooked with the “P/E is fair” argument.

First, and less important, is the fact that the current P/E, according to the Market Data Center in the Wall Street Journal, is already over 19x. A year ago, it was under 15. And the 100+ year imputed median P/E for the S&P is only 14.50. So on this basis alone, the S&P500 today is not cheap. Arguably it’s about 25% (19 divided by 15) over priced.

Second, and more important, let’s examine the “E” or the earnings in this P/E ratio. Where are earnings, of the S&P500 as a whole, in relation to their historical averages? It turns out that S&P earnings are off the charts, literally. As a percentage of the US GDP, they have reached almost 11%.  Where should they be….historically? Closer to 6%. That means that earnings are now over 70% ABOVE their long-term historical average, which means that IF earnings revert back to this level—-and historically they ALWAYS have—then the S&P500 is about 70% over priced.

And that’s assuming we accept the elevated 19 P/E ratio!

So the next time you hear someone bleating about how fairly priced the S&P500 is today, think about what they’re really saying, whether they realize it or not. They are claiming that earnings that are 70% above normal will continue to be generated almost forever into the future.


Bubbles, Bubbles Everywhere

May 20, 2013

Another jump in stock prices in the face of severely deteriorating market and economic fundamentals? Why not. This time the S&P500 rose 2% on the usual feeble volume. So no, most everyday investors are not rushing in to buy near all-time highs, but the same investors, whether retail, institutional, or computer driven funds are running up prices. The conventional wisdom is that they know, just know, that prices are too high. But you ‘can’t fight the Fed’ and as long as QE continues, you’ve got to keep buying stocks. And besides, they’ve convinced that at the very first sign of trouble, this elite group of investors—-millions of them—-will be the first out the door, before everyone else, and escape any real damage.

Of course.

The US economy, meanwhile, continues to struggle. Business inventories failed to grow as expected. The Empire State manufacturing survey fell into negative territory; it was supposed to increase. Industrial production dropped much more than predicted. Initial jobless claims spiked to 360,000. Housing starts collapsed. And the Philly Fed survey was a disaster, falling deeply into negative figures instead of rising as expected. Only consumer sentiment and leading economic indicators beat expectations, but the main driver of the beats was the artificially engineered stock market rise.

At the same time corporate sales are failing to grow, on average, across the S&P and earnings are barely growing at all. This poor corporate performance is not what normally drives stocks to record high prices.

Technically, the US stock markets are very overstretched. On monthly and weekly charts, stock prices are bumping up against extremely high technical ceilings, and in some cases, cracking through them. Bearish sentiment has all but disappeared,  falling below 20% among investment advisors and bullish sentiment is well above 50%. This, according to long time investor John Hussman, means that the US stock markets are extremely overly bullish.

Other, bigger and more well known, investment experts are being more blunt. Bill Gross, who founded and co-runs PIMCO, one of the largest asset management firms in the world simply stated:

“We see bubbles everywhere”

And this is primarily due to the Fed’s QE programs, according to Mr. Gross.

Could prices rise some more, despite the extremely stretched conditions today? Sure.

But no bull runs last forever and history has proven that the greater the deviation above historical norms, the greater the ‘snap back’ that will always follow.

Aside from the highs in late 1999 and early 2000, US equity markets are more over-stretched than ever before.

Be careful.

Markets Disconnected from Reality?

May 13, 2013

The S&P500 inched up another 1.2% last week, on even lower volume than the prior week. Volatility, meanwhile, dropped back down only slightly, but back near to the lows of the year. Complacency, it seems, has fully returned to the risk markets. Everyone, apparently, has bought into the belief that you should “buy stocks and other risk assets because the Fed has pretty much guaranteed that prices will go up, and at the very least, not go down.”

This is not the first time this type of conventional wisdom has dominated the markets. It goes without saying that in NONE of the prior occasions did this belief hold true in the long term.

There were only a handful of US macro news releases last week. Consumer credit, even though it’s being pumped out liberally by the US government via student loans and auto loans, disappointed. Initial jobless claims beat expectations, and wholesale trade figures met expectations.

But the trend line in the US economy is clear. Without a doubt, the economic growth is slowing to crawl speed. The leading indicators in particular, when averaged over the last three months, are pointing to a substantial slow down in growth. Meanwhile, most of Europe is—without a doubt—already in serious recession. Japanese growth is very weak. And Chinese growth is collapsing, especially if you follow the difficult-to-fudge figures in shipping and utility usage. Pay very little attention to official results—leading experts around the world are finding evidence that Chinese growth has been massively inflated not just recently, but for the past 20 years.

Technically, while the US stock markets are still in an uptrend on the daily and weekly charts, they are extremely overvalued and extremely overbought. According to John Hussman and his research which spans the last 100 years, when both these conditions are met, losses—-not just low returns—-are virtually guaranteed to follow in the future.

So why are stock prices in the US soaring when the economy in the US has been slowing, not just lately, but for the last 12 months or so?

Well, anyone who claims to have the definitive answer is most likely wrong. While there are many plausible theories, nobody can know the exact answer with 100% certainty.

An internationally recognized authority on markets, Marc Faber, also doesn’t know for sure when he states:

“In the 40 years I’ve been working as an economist and investor, I have never seen such a disconnect between the asset market and the economic reality… Asset markets are in the sky and the economy of the ordinary people is in the dumps, where their real incomes adjusted for inflation are going down and asset markets are going up…”

But his opinion, guided by history, on what can go wrong must be respected:

“What was the trigger of the ‘87 crash when markets fell 21 per cent in one day? What was the trigger of the Nasdaq crash in 2000? What was the trigger of Japanese crash of 1989? What was trigger of 2007 crash that brought global stocks down 50 per cent?

We don’t know these things ahead of time, but something will always move markets up and something will always move them down.

…. Something could come along, geo-politically or otherwise. I would be very careful being overweight equities.”

And most importantly, we should pay attention to his conclusion:

“Something will break very bad.” 

 If history is any guide, yes it will……break very bad.



More Words of Wisdom

May 6, 2013

Just because a market is over stretched doesn’t mean that it can’t become even MORE over stretched. And that’s exactly what’s happening in the US risk asset markets, where for example, the S&P500 rose another 2% last week. Of course this happened on diminishing volume, as fewer and fewer real investors choose to participate in clearly growing bubble. This leaves the hot money, fueled by the Federal Reserve and channeled by Wall Street banks, hedge funds, and computer algorithms to pump the prices ever higher.

Sadly, many scared investors are sitting out of the stock markets and sheltering in corporate bonds, both investment grade and high yield. What’s sad is that even these relatively safe asset categories are also priced at bubble levels. This means that while these safer asset groups should fare better when the inevitable risk asset bubble bursts, they will not be immune to severe losses too. Whereas in the late 1990’s, the Fed engineered a tech bubble, and in the mid-2000’s it engineered a housing and stock market bubble, this time the Fed has managed to create the ultimate monster—a bubble in virtually every risk asset bucket. When the bubble bursts, there will be very few places to hide to avoid damage.

And while asset bubbles grow, the US economy continues to miss hopes and expectations for long-lasting and organic growth. Last week, personal income growth missed consensus forecasts. The Dallas Fed manufacturing survey BADLY missed expectations—-recording its biggest drop on record. The Chicago PMI also missed badly, falling below the critical 50 level for the first time since 2009. ISM manufacturing and ISM services BOTH missed their targets. Construction spending missed. Productivity growth missed, meaning that unit labor costs will be greater than expected (this will hurt corporate profits). Factory orders also missed badly. The one positive report of the week was a jobs report that was only slightly stronger than expected. Several ‘buts’ should be noted however. First, the better rise in payrolls was driven by low paying leisure and hospitality jobs; this is hardly an equal replacement to the manufacturing and managerial jobs lost in the 2008-2009 recession. Second, the payrolls report is a LAGGING indicator, not a leading indicator. Ominously, the ISM, the PMI, and the regional Fed surveys are leading indicators, and they’re all pointed down. So while the slight jobs beat was good news, it hardly matters when what’s around the corner looks like an economic hurricane.

Technically, the S&P is still extremely over bought and over bullish. Using virtually any type of technical analysis strategy, an investor must conclude that putting new money to work at this point would be the equivalent of ‘buying high’, the opposite of what a prudent investor OUGHT to be doing.

Over a year ago, we shared some words of wisdom from one of the most successful value-oriented hedge fund managers in the world, Seth Klarman of Baupost Group. Back then, Mr. Klarman warned an audience in Boston about the false and unstable foundation upon which the risk asset markets were rising.

Since then, obviously, risk asset markets have risen markedly, despite the risks highlighted by Mr. Klarman.

Recently, in a note in his investors, he highlighted several more kernels of truth. Among them:

“Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and highly leveraged financial institutions.”


“When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem,  this simply does not compute.”


“They know that a society’s wealth is not unlimited, and that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse.”

Clearly another collapse since the last meltdown in 2008-2009 has not happened in the US. But some Wall Street pundits are now trying to convince the public that this means that it may never happen again, so buy stocks now and forever enjoy the benefits.

But it’s equally clear that these same pundits spewed the same advice in the late 1990’s and in the mid 2000’s. In both times, the S&P500 DID end up collapsing by over 50%.

This time will be no different.