I expect the next S&P 500 (SPY) trading range to be 1600-1750. We may stay in there until Mr. Bernanke's fate is known, in January 2014. This is one of those external events that have nothing to do with mathematical valuation, but is an essential component of asset pricing: confidence in the "Grand Argentier", French for Minister of Finance, i.e. the guy with the bucks. The only pilots who can be trusted at this point are Dr. Ben Bee (Bernanke), Super Mario (Draghi) and Abe (not Lincoln, Shinzo). Actually, I continue to believe that Dr. Ben Bee, as I dubbed him in my book, should get the Nobel Prize in Economics Science. In case you missed it, Household Net Worth is now greater than its previous peak in Q3, 2007, and leverage is lower too. Compared to the trough in Q4, 2008, Household Net Worth is up 28%, at an all-time high of $66 Trillion (and then some since this was the Q4, 2012 number) - and Debt to Net Worth is back down to 20%, from 28% in 2008. So what's $3 Trillion in QE, or even $16 Trillion in Government debt…
What's the probable scenario from here?
For one, the P/E Expansion Story. I was early on it, October 12, 2011. To summarize, look at the post WWII period. From 1946, which was a period when earnings troughed due to Post War conversion, to 1949, when there were strikes and a recession, Earnings more than doubled, and as a result the S&P 500 P/E went from 24 to 6, with the S&P 500 itself basically flat at around 15 (not a typo ...). It then took until 1957 for the P/E to gradually inch up to 14, and the S&P basically quadrupled to 55. From then on, until 1974, the P/E hovered in a range of 14 to 24. With the Oil shock, food inflation, and baby boom demand-led inflation, it broke down to trade between 14 and 7. It took the big Volcker recession of 1981-1982 to bring it back to 14 in 1983. While I have seen no explanation for this, I have my own: during that period, financial assets, stocks and bonds alike, were depreciated for fear of structural inflation. Then, after some hesitation, the previous range was restored of 14 to 24, with a spike to 30 in the Bubble years. The breakdown occurred again in 2003, and up until a month ago or so, the trading range was 10 to 16, with the trough occurring in 2011 (Source: Capital Max and here)
Which brings me to the real thing - The Earnings Yield, i.e. the reverse of the P/E, which with the advent of Modern Portfolio Theory and Capital Asset Pricing Model in the 60s, is to be compared to the risk-free rate, i.e. usually the 10-Year Note Yield for duration purposes. You can see the historical chart in my article of October 12, 2011. From 1980 or so to 2003, there was a very strong correlation between the two, which checks with the 14 to 28 P/E range of the period, similar to the one from 1957 to 1974. However, this correlation broke down in 2003, and is still broken - a P/E of 16.3 translates into an Earnings Yield of 6.1%, when the 10-Year is at 2%. Actually, on 12-month forward basis, the S&P 500 P/E is 14.3, for an Earnings Yield of 7%.
This implies that stocks were and still are cheap, the theory behind my series of articles entitled "S&P Target 1600", "There Will Be No European Liquidity Crisis", "Europe Shrugged, not Atlas" and now "S&P Target 2000". The current debate with those who "missed the boat" highlights the main squaring to the circle of herd investing. When stocks are down, nobody wants to buy. When stocks are up, nobody wants to buy - "show me what you can do for an encore". Here are some ideas to break the circle.
The question is why would P/E expand and why would the spread between the Earnings Yield and the 10-Year narrow? I am afraid you'll have to read most of my articles to find out about the man possible answers, but the real first question is "why the 2003 breakdown?" In my opinion, Sarbanes Oxley: it introduced the notion that company lied about their earnings, current and prospective, which was true as we found out not only in the Internet Bubble, but also in the 2008 Meltdown. This risk perception is very much still in people's mind - actually, in banks' mind as well if one is to figure out why they are holding Excess Reserves of $1.7 Trillion, compared to the $10 Billion or so (not a typo either) they were holding before the Meltdown. On this issue, please refer to my exchange with "Change is the Only Constant", and to Ben Bernanke's answer to this particular question yesterday. "Change", for one, called my attention to an interesting issue re risk. If Banks follow any of the William Sharpe risk models, he will soon join to other famous Nobel Prizes in Economics Science, Myron Scholes and Robert Merton, to show the dark side of statistics. Remember Long Term Capital Management, a.k.a. LTCM, which failed in 1998?
In my opinion, one of the reasons we may be "breaking on the upside" is that contrary to what I sense the consensus was until recently, people are now understanding that QE worked - Household Net Worth is at an all-time high, with no increase in inflation expectations - see table above. We are talking Households, meaning Real People, not just statistics. They should know.
It took a while for Europe to get it - Trichet had no clue, Draghi was the man. Interestingly, it was the Bank of Japan who had invented QE in 2001, under the name Ryoteki Kinyu Kanwa, but it was quite "quiet" about it, until it saw the actual results, kudos to Prime Minister Shinzo Abe. Ben Bernanke was smart enough to pick it up and elaborate on it in his speech in November 2002, entitled "Deflation: Making Sure It Doesn't Happen Here". I know this scares everybody, given that Japan's Public Debt is about 220% of GDP, but the picture makes more sense when one looks at the external debt, i.e. the total debt of a country held by foreigners. Japan's external debt represents 45% of its GDP, and $19,000 per capita. Compare this to the U.S.' 106% and $$52,000 per capita, and the U.K.'s 390% and $156,000 per capita. Japan should have no probable funding its QE, and foreigners will pitch in, for sure.
So now, everybody is onboard, which is the main reason why I think this is a long cycle. By the way, when you hear the controversy about "tapering", remember just one thing. Bernanke's goal was to reflate Household Net Worth. QE was just the means. He will not risk undoing the goal he painstakingly achieved, and will telegraph this until the markets understand. So will Draghi and Abe.
In my opinion, there is no question the Earnings Yield risk premium will normalize. The breakout last week seems to confirm that. I was a bit hesitant to forecast it, I must admit, as I prefer Walls of Worry to exponential spikes. So I am selling into exponential moves, but buying on dips. Example: selling ADA-Es (ADES) @ $34, buying Blue Nile (NILE) at $32 a few days ago.
What we need to understand here is that we have had a multi-year structural and societal change. Remember, when the S&P was created, in 1928, the average for that pretty strong year was $20. We did not get to $1680 in a full swoop. Well, we have now gone through the Internet Bubble that started in 1995 when the S&P was at $400 or so, the change in derivatives regulations which led to unbridled securitization and the Housing Bubble of the late 2000's, concurrent with SOX, BIS and all the other legislative changes. Furthermore we have come to realize that this is not a "one country" problem. Who knew about the PIIGS ten years ago, let alone Cyprus? But as we now say, it's a "global issue". I do not really buy the "global" thingy, the main economies still drive the numbers, and Japan is back in the game.
Now, to be clear, while I view this as a long term Bull cycle, no market is linear. I said earlier my favorite trading range, going forward, is 1600-1750. I will reassess if we drop below the Fibonacci level of 1600. In the meantime, I keep any stock I like with a P/E of 15 or less, especially if it is cyclical, and even more if it is Housing related, which continues to be my over weighted sector. Please note that while I publish the list of stocks that I own, to include the ProShares Ultra Short S&P 500 (SDS) and Russell 2000 (TWM) which I bought at the close in front of tomorrow's numbers and a long week-end, the following disclaimer clearly means what it says … For the record, as I hit the Send button, the S&P 500 is closing at 1650, with an Advance/Decline of 1251/1753.
On a final note, there is another way for the Earnings Yield to normalize, unpleasant this time: it would require rates to raise faster than Earnings. However, "usually" in a recovery, Earnings go up faster than rates, until inflation expectations pick up. It seems that the Fed is on the same page. We will cross that bridge when we get to it.
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