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Paulo Santos, Think Finance (377 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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It has been widely reported that today's market multiples are not incredibly demanding. Using $100 as an estimate for 2013 earnings for the whole S&P500 (SPY), this gives us a Price/Earnings ratio for the whole index of 16.5. High, but not bubblicious. It's certainly no Nasdaq in the dotcom era.

Taking into account this reality together with long (10-year) rates below 2%, many analysts boldly say that there is no bubble in the stock markets. The Federal Reserve certainly agrees. Indeed, some analysts, using the Fed model, which compares the S&P's earnings yield to long-term interest rates, might even say that the S&P is as cheap as they come.

So why talk of a bubble? Where is it?

The bubble is somewhat of an invisible bubble. The bubble is akin to the bubble that existed during 2006/2007 as the housing bubble reached its summit. Let me explain.

As people took on debt, they bought things with it. They bought houses, they furnished them, they bought cars. For the sellers of these things, their buyers taking on debt was the same as if they had the income to buy their stuff. There was just one difference. Taking on debt cannot grow versus income forever. There's a point at which people can't pay the debt back, and when that happens people won't be able to take on any further debt.

What happens when people start taking on less debt? It shows up for the sellers of the stuff these people were previously buying the same as a decline in the buyers' income would show up. Activity suffers. And when activity suffers, the first thing to plunge is profits, then the second thing that plunges is employment, as the sellers of stuff try to re-size (or downsize) to serve the new, smaller, market. That was basically the dynamic at work at the end of the housing bubble.

Now think about it for a while. The level of activity, as well as the level of profits were somewhat artificial. Those levels only existed because of the unsustainable increase in debt being taken on by the customers. If you were to look to the market's earnings multiple, you'd be looking at an illusion in terms of earnings. You'd be dividing the market's price by a level of earnings, which was not sustainable.

The same thing is happening now

The dynamic I explained, which happened back in 2006/2007, is the same that's happening now. The actors, however, are different. In place of the private sector taking on amazing sums of debt, now you have the public sector doing the same, along with the Federal Reserve printing money to make it all possible.

Since the dynamic is similar, the end result is also similar. Profits are at historically high levels driven by this debt-and-printing fueled economy. As we can see below, corporate after-tax profits as a percent of GDP, a notably cyclical variable, is at incredibly high levels (Source: Federal Reserve Bank of St.Louis)

(click to enlarge)

So here, again, talking about the Price/Earnings ratio for the whole market presents us with the same illusion as we had during 2006/2007. The price seems reasonable, because we're dividing it by earnings, which are artificial and unsustainable.

There is, however, a difference

There's just a slight difference in what I explained before. The private sector could not keep on creating debt forever as it was exposed to the possible defaults of its borrowers. The Federal Reserve, however, could conceivably continue on printing until it destroyed the currency. If that were to happen, the S&P could easily trade at 2000, 20000 or 1 million. The earnings could continue expanding in nominal terms to values now impossible to fathom.

This means that while we do have a bubble in the markets, this bubble can be made incredibly larger in nominal terms if the Federal Reserve so decides.

On the other hand, taking as an assumption that rationality will prevail and inflation will not be let out of control, this would mean that the earnings' cyclicality should overpower the market down the road, maybe as soon as this year or next. In other words, there is indeed a bubble and under rational expectations it might well pop.

That said, I believe that the Federal Reserve will be back to printing as soon as the market contracts 20% or so from any level it attains.

Another sign of a bubble, of course, would be the record margin debt levels about which I've written in the past.

Conclusion

While superficially there would seem to be no bubble in the stock market, the truth is that digging deeper, and taking into account the dynamics of debt creation and earnings cyclicality, the bubble pops up to be seen. The bubble is in the fact that earnings are cyclical, are at an historically high level and should be unsustainable in the absence of heavy debt-taking (presently being done by the State through its huge fiscal deficits).

Source: Where Is The Bubble?