Prudence suggests that he have an adequate idea of stock market history, in terms particularly of the major fluctuations in the price level and of the varying relationships between stock prices as a whole and their earnings and dividends. With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers of the level of the market as it presents itself at different times. -- Benjamin Graham on stock prices, The Intelligent Investor, 1972
I cannot help but feel that irrational exuberance is once again upon us to some degree. The above quote from Benjamin Graham is one that particularly resonates with me at present as I set out identifying attractive investments while adhering to a fundamental, value investing strategy.
With base interest rates at near-zero, fixed income securities offer little appeal for investment presently. In the current relative value world, equities by comparison appear to be the more attractive proposition. But just how attractive are equities really at present? At the general level, are valuations justified by the facts as Graham might term it?
Equity markets are at, or near, all-time peak highs. The Dow Jones has surpassed its all-time high, while the broader S&P 500 benchmark is currently flirting with its own all-time high; equities are certainly at their most bullish since the recent financial crisis began in 2008. But perhaps the current valuation level is best contextualised visually - after all, sometimes a picture says a thousand words……
S&P 500 Index 1957 - 2013
As a value investor, I do not place any stock in technical analysis or charting. Nevertheless the chart above does provide a useful summary of the historical track record of the stock market (as measured by the S&P500), and therefore is relevant in arriving at a worthwhile judgement of the appeal or danger of investing at current prices.
Looking at current valuations versus what has gone before, the obvious question is why are stock prices back at historical peak levels, given that we live in a time marked by considerably higher unemployment levels, higher taxes, lower household wealth, depressed consumer demand and on-going deleveraging in both the public and private sectors? Such adverse conditions did not prevail during the previous peak price levels for stocks in 2000 and 2007, yet stocks are priced at similar levels. In this post, I outline what I believe are the two drivers behind current stock prices, one fundamental and one macro, and why upon investigation of these drivers, conclude that stocks are currently overvalued.
The fundamental driver - earnings
Earnings or EPS is by far the most closely monitored financial statistic on Wall Street, and consequently is the fundamental financial statistic that tends to impact stock prices the most. The chart below provides an extremely telling context for the current earnings environment:
US corporate and non-financial corporate profit margins 1947 - 2012
Currently, corporate profit margins (CPM%) are at an all-time peak, while non-financial corporate profit margins (NFCPM%) are not far off their all-time peak of 1950. Additionally, both corporate and non-financial corporate profit margins are currently well above their long-term mean levels of 6.2% and 4.1%, respectively.
In my view, current peak-like price levels for stocks are clearly driven in part by this peak margin environment. But if corporate profitability has never been better, does this then justify current stock prices, priced as they are at near all-time highs? To answer this question, further analysis of the main drivers behind present peak margins is necessary.
Driver #1 - Earnings substitution: 10-12 years ago, less than a third of companies in the S&P500 generated their revenue from overseas; today that figure is approximately 50%, so clearly there is less reliance on US consumers and businesses currently; Asian and South American economic growth and the emergence of what is expected to be a permanent middle-class anxious to cultivate Western tastes and consume accordingly, has provided additional revenue generation for US companies. This has offset the domestic fall-off in demand for goods and services; in fact, if you strip out the effect of foreign trade from American corporate profitability, domestic actually earnings remain weak relative to the historical track record. The mad dash to substitute emerging market business for weak domestic business, while successful to date, is just not sustainable in my view - as more and more companies to do this, it will naturally increase competition, and as these foreign markets mature, labour costs will increase also. This combination of increased competition and higher wages will inevitably lead to margin compression.
Driver #2 - Lower overheads: wages and unemployment levels have been a significant contributor to the present elevated state of US profit margins. According to statistics from the St. Louis Fed, wages as a % of US GDP are actually at an all-time low; and of course the US unemployment number of 7.7% presently (incidentally the lowest rate over the last 4 yours) is significantly above the long-term "full employment" rate of about 5%. The recession that commenced in 2008 facilitated asset-sweating on an unprecedented scale - fewer workers are working longer hours and for less pay to grind out improved productivity and profits for companies. This is clearly abnormal from an economic standpoint. Recently a (sell-side) analyst told me that margins were strong because corporates were now "lean and mean" post-crisis, but I really do not accept that. If the underlying economy has truly rebounded to the extent that corporate margins and stock prices would suggest (and as some analysts claim), there would already be higher employment as corporates compete to take advantage of improving demand and growth. This of course would actually lead to a reduction in margins as a whole, as companies increase hiring again to compete as the economy expands. This clearly isn't happening yet, and so corporate cost bases are able to remain artificially low, at the expense of workers.
Driver #3 - Low interest rates: for any reasonably well-capitalised or stable business, borrowing has never been done on better terms; interest rates are at historic lows, and so companies can refinance or pay down existing debt at advantageous rates, obtain new, cheaper working capital facilities and term loans, all of which reduces their cost of capital. Many companies are presently able to finance capital expenditures and maintain trading activities at favourable financing costs, with the lower cost of debt boosting bottom-line margins and earnings. Again, this is not a normal or sustainable economic condition, as rates must eventually rise, and when that happens, profit margins will contract as financing costs increase accordingly.
Mulling over each of these earnings drivers, I have to conclude that each are temporary and artificial (or at lease non-normal) in nature. Current profit margins are not indicative of corporates' normal earning power; the implication of this is that margins are temporarily inflated by the above factors. On this basis it is reasonable to believe that profit margins will revert back to their long-term mean, as economic conditions normalise; to be clear, this is not intended to be a prediction of any sort, rather something to be considered and factored into any prospective investment decision in the current environment, and in the context of the stock market history.
The macro driver- interest rates
The prevailing low interest rate environment has also impacted stock prices from an external macro perspective, as well as by enabling companies to improve reported profit margins as outlined above. Stocks (and risk assets in general) are priced off base interest rates or yields on government securities, such as 10 and 30 year US government treasury bonds. The yields on these securities remain at generational lows due to the co-ordinated and extraordinary monetary policies enacted by the major central banks to stave off a global depression in the wake of the recent crisis. These policies have involved direct and targeted central bank intervention in bond markets to assist governments running deficits exacerbated by the recent crisis. Such intervention has reduced the cost of capital generally, with benchmarks such as the 10 Year US Treasury yield falling to all-time lows. Such abnormal and extreme intervention has resulted in rising valuations for stocks and risk assets in a number of ways - valuations which by definition are not reflective of, or rooted in, normal economic and business conditions.
Central bank-sponsored purchasing of government bonds and other securities has clearly stimulated demand, but only in an artificial way. This activity acts as a back-stop for risky securities, as it provides a huge additional source of liquidity in capital markets that normally is not available, while the purchasing of bonds itself by central banks reduces the cost of capital for everyone else. From an investment perspective then, this reduction in the cost of capital is also a reduction in the return available on fixed income securities, leading us into a more pronounced relative value world - it necessitates that investors must adjust their return expectations downwards. I believe this has actually been the primary driver of equity valuations reaching their current levels. With this massive (and temporary) additional well of liquidity, and the consequent lower cost of capital and return expectations, investors have been prepared to pay more for stocks and other risk assets (including high yield or junk debt) not necessarily because they represent good value, but because they offer comparatively better returns than traditional, investment grade fixed income securities - and where we have such a focus on returns, this suggest that there is less of a focus on risk, i.e., the return of investment capital. Essentially, market participants are being forced to chase returns, rather than prudently seeking adequate returns while protecting the downside risk (permanent loss of capital). Hence, we have sub-6% yields on highly risky junk bonds, and stocks valued at previous peak prices.
Interestingly, it could be argued that while stock prices are back at peak (2007) levels, they are not at peak valuations. This might seem confusing, until we remind ourselves of that important distinction for investment espoused by Warren Buffett - price is what you pay, but value is what you get. By this, I am referring to the fact that the previous peak (2007) high for the S&P 500 was 1,565, which on peak index EPS at the time of $84.92, implied a PE multiple of 18.4x. Currently, trailing twelve months EPS for the S&P 500 is approx. €89 per share, implying a multiple of 17.5x based on Friday 15th March close of 1560. So we've got better earnings than the previous high, on a lower price for the index: this lower multiple compared with the previous peak must mean we've got more attractive valuation levels now, right?
Not really. As if we are cognisant that recent EPS of $89 per share is in fact attributable to temporary and artificially inflated profit margins as explored above, we know that current earnings are not normalised earnings. Therefore while the current market PE might appear to be a not-overly lofty 17.5x, the current valuation level is in fact distorted and indeed illusory. So what might the "true" valuation of the stock market be currently? That is not a question that can be precisely answered in my view, other than to say that when one considers the key economic and business factors impacting corporate profitability at present, it is entirely reasonable to conclude that the stock market, at the general index level, is more likely overvalued than undervalued. And an appreciation of this likelihood is important for the value investor when appraising businesses in the current environment. After all, the market is priced at 17.5x non-normal, inflated earnings!
Having considered here the relative attractiveness or danger of investing in the stock market at current valuation levels, in my next post I consider the question of what Graham's Mr. Market is telling those of us willing to listen.