"We've long felt that the only value of stock forecasters is to make fortune tellers look good." - Warren Buffett
With indexes hitting new highs, investors are wondering if the market is expensive. There are essentially four factors that determine market prices - interest rates, earnings, the timing of those earnings, and expectations. Let's begin with interest rates.
Current Interest Rates Are Unsustainable
Below is a chart showing 10-year Treasury rates from 1953 to today. Over this time period, a normal range appears to be between 4 - 8%. The 10-year rate stood at 1.83% at the time of this writing. We know that interest rates are being kept artificially low by the Federal Reserve. Manipulation like this cannot last forever, and therefore, the current rate is unsustainable. It will rise in the future and pull asset prices down.
Profit Levels Appear Unsustainable
Earnings have rebounded since the Great Recession. As the graph below shows, after-tax corporate profits as a percentage of GDP are at an all-time high and far above the historical norm.
Profits have surged as a result of margin expansion. However, profit margins are typically mean-reverting due to the nature of competitive and economic forces. Therefore, it would seem that this too is unsustainable.
Expectations Appear High
Despite abnormally high profit margins, current expectations are relying on those margins to improve even further, as shown below.
Is this being realistic? In a recent Forbes article, contributor Chuck Jones noted that S&P 500 revenue growth for 2013 is expected to be 3.2%, while earnings are expected to grow 8.2%, including double-digit year-over-year growth in earnings in the third and fourth quarters of 2013, as shown here:
This chart looks quite optimistic given current global economic risks. Mr. Jones believes so too and thinks that expectations will come down over the course of the year. It would be no surprise to see analysts lower their expectations. The investment blog Greenback'd posted a very good write-up that showed that analysts are almost always overly optimistic except in recessionary environments when they are overly pessimistic. The following chart shows the historical progressions of analysts' earnings expectations over the years.
So Is the Market Expensive?
All of the data above would indicate that it is likely that the market will have a much tougher time moving upward than downward in the future. However, historical norms are all backward looking. Only the future matters, so let's examine the situation some more. We know that interest rates will rise in the future. There is nowhere else for them to go. We do not know exactly when they will rise, though there are cues. We also do not know how high or low earnings will be in the years ahead. If the market is going to continue going up, then the question we must ask is will earnings be high enough for prices to increase despite the inevitable gravitational pull of increasing interest rates? If not, then we could be facing another lost decade.
Up to this point, we have established that profits and profit margins are at all-time highs, but why is that so and can they continue to expand? In July 2011, BlackRock issued a report entitled Can Investors Continue to Profit from Corporate Margins? In this report, they cited the low cost of debt, increased technological innovation, the rising share of world output from emerging markets, and a drop in capital expenditures as the primary sources of recent margin expansion. Let's examine those factors.
Low Cost of Debt - Unsustainable
As previously noted, interest rates are artificially low because of the actions taken by the Federal Reserve. This has led to margin expansion as corporations refinance and retire debt. The low cost of debt has also improved the balance sheets of riskier firms. As a result, there has been an upward bias in corporate credit ratings over the past few years. As the economy recovers and the Federal Reserve discontinues its liquidity operations, then we can expect this trend to revert. Federal Reserve Chairman Ben Bernanke says that short-term interest rates will stay near zero until unemployment falls to 6.5%. Forecasters don't expect this to happen any sooner than 2015.
Rising Share of World Output From Emerging Markets - Sustainable
BlackRock states that, "Committed bulls hold that the transfer of manufacturing activity to emerging markets will defer the mean reversion of profit margins for a considerable time period." I would not disagree with that argument. Deloitte stated in a 2012 outsourcing survey that, "all business processes are expecting to see increases in the use of outsourcing and offshoring in the near future." However, one could argue that this is merely one factor among many that are equally as important.
Government Subsidized Demand - Unclear
Leading up to the Great Recession, profits grew primarily because of credit expansion, which allowed consumer spending to outpace wage growth. Now, the government is essentially subsidizing consumption via Social Security and Unemployment Benefits. BlackRock noted that, "Since 2000 transfer payments have accounted for more than 25% of the growth in disposable income." It is hard to imagine politicians cutting entitlements any time soon, but it is possible that they will have no choice if spending continues to outpace tax revenues. That being said, it could take a long time to reach that point.
It may even be long enough for the American household to bounce back. It looks as though consumer deleveraging is beginning to bottom out, but it is not yet expanding. In 2012, consumers with credit scores above 720 saw their revolving balances increase, but others still have a way to go as shown by the charts below.
Low Capital Expenditures - Unsustainable
Capital expenditures have been much lower in recent years because of economic and regulatory uncertainty. As a result, businesses have been focused on cost reduction rather than investment. BlackRock stated:
Coming out of the Great Recession, good corporate citizenship has taken the form of underspending. A kind of pack behavior can be seen among CFOs who seem bent on outdoing each other on cost-cutting, with little regard for longer-term consequences… We believe this broad pattern of underspending is likely to change only when it begins to result in missed opportunities, or at least the perception of such.
This report was, of course, issued in mid-2011. I believe that business confidence has been slowly but steadily rising since. Therefore, one would expect capital expenditures to normalize sooner rather than later, thereby limiting some margin expansion.
What Does It All Mean?
The market is currently expecting further margin expansion, but it is not clear whether or not it is possible to achieve those gains. In order for it to be possible, spending has to remain strong, interest rates must remain low, and capital expenditures have to stay under control all while input costs remain stable. That is a lot to ask for, but market participants seem optimistic.
Warren Buffett said that the market value, "of all publicly traded securities as a percentage of the country's business-that is, as a percentage of GNP… is probably the best single measure of where valuations stand at any given moment." At its peak in 2000, that percentage stood at an astounding 150% according to the St. Louis Federal Reserve. As of October 2012, it was right around 100%. At what point does Buffett say is the best time to buy? Around 75 - 80%. Though this may not be the very best buying opportunity, we are clearly not in a state of irrational exuberance.
One could argue, as Howard Marks did, that expectations are still not maxed out. He claims that it would only take one more good year for the market to get retail investors rushing back in, at which time we would be in the midst of a full-on bull market. It is possible, but there are infinite possibilities and speculating on the actions of speculators is not the same as sound investment.
In conclusion, I cannot tell you with any certainty that the market is expensive. There are many warning signs, and I tried to illustrate them here for your consideration. Personally, I do not believe that it is time to abandon the stock market. I sense the risks, but I will continue my search for value opportunities with caution to never over reach.