In September 2012, with the S&P 500 Index (SPY) bouncing around its pre-crisis high of 1565, I authored The S&P 500 Today Versus The 2007 Peak, which painted a relatively bullish picture of the market despite the still uncertain market backdrop at that time. With the broad domestic stock market closing at a new all-time high of 1675 yesterday, it is important to re-examine the data in that previous article given the 110 point rally and gauge value in the broad market bellwether. Examining today's valuation versus the pre-crisis peak through differences in reported earnings, financial statement trends, index composition, and economic growth should be instructive for Seeking Alpha readers as they ponder the way forward for the U.S. stock market.
When the index was at its 2007 apex, trailing twelve month earnings were $89.35 per share, producing a P/E ratio of 17.5. With trailing earnings today at $103.12 per share, the market is trading at an earnings multiple of 16.24x. If the S&P 500 were trading at the same earnings multiple as at its 2007 peak, the index would be at 1805, roughly 8% higher than the current record level. When I authored this article last September, extrapolating the previous peak market multiple to earnings at that point translated to an 18% market discount with the same arithmetic. Obviously, the year-to-date market rally (total return of 18.8%) has outpaced earnings growth, increasing the market multiple.
Some might be quick to point out that too high of a multiple was placed on the market at its 2007 peak, especially given that in hindsight we know that the market was overvalued given the looming risks. At a 17.5 P/E multiple, the market multiple at its 2007 peak was just a turn higher than the long-run average multiple of 16.5x. Of course, investors do not buy stocks for trailing earnings, markets are inherently forward looking. Is today's earnings multiple discount at 7% to the historical average fair?
Economic growth in late 2007 was decelerating, and the Treasury yield curve was inverted, a yield curve positioning that has historically been a harbinger of economic recessions. While the Federal Reserve had begun its first cuts of the Fed Funds rate one month prior to the S&P 500 making its high, it had only been reduced to 4.75%. With the 10-year at 4.67%, the market was pricing in additional cuts as growth was expected to slow. Markets were shaken by the collapse of two Bear Stearns hedge funds in June of that year, marking the unofficial start of the subprime crisis. The risk premium applied to asset valuations would prove to be too low as the crisis expanded into a deep financial and housing sector driven recession.
Today, economic uncertainty remains high as financial markets brave a historic withdrawal of extraordinary monetary accommodation in the United States. We remain several quarters away from our first increase in the Fed Funds rate. Halfway around the world, a decelerating China, which has driven global growth over the trailing decade and maintains a heavy hand in global commodity markets must also navigate its evolution from an export-driven economy to one in part driven by an emerging middle class. Across the Yellow and East China Seas, Japan is embarking on its own unique quantitative easing as the aging economy struggles to shrug off two decades of lethargy. While the focal point for global risk markets has pivoted from Europe recently, political upheaval that thwarts future austerity could always return crisis to the continent as Europe struggles to collectively grow its economy. Throw in the omnipresent geopolitical risk which has most recently flared in Turkey, Brazil, and Egypt, and there are plenty of global factors to occupy an investor's mind. Whether risk premia are sufficient this time around given this level of uncertainty will be borne out over coming periods.
While global economic uncertainty abounds, household wealth in the United States (graphed below) has recently returned to its all-time highs, fueled by gains in the stock market and rising real estate values. The key to future economic gains domestically will be whether personal consumption, buoyed by these wealth gains and encompassing 70% of economic activity, can offset necessary retreats in government spending. Moderating unemployment will aid consumption. While the economic expansion remains anemic, it does not appear that we are approaching an inflection point where we will see a contraction. While the market was reaching its all-time high in October 2007, the economic recession, as dated by the National Bureau of Economic Research, would begin just two months later.
While the past six years have seen a dramatic reshaping of the economic landscape, the market index has transformed as well. In the table below, investors can get a feel for how the top constituents of the S&P 500 have evolved since the market peak. At a P/E ratio of just 15.2x, the twenty companies in the S&P 500 with the largest market capitalization are trading at a 19% discount to the earnings multiple of the top twenty constituents at the pre-crisis market peak. As I demonstrated in Equal-Weighted S&P 500 and the Apple Impact, it is very important to gauge the relative value of the top index constituents. The top 20 constituents above comprise nearly 30% of the S&P 500. If the 19% discount to the average price-to-earnings multiple of the top twenty constituents in October 2007 compressed to its former level without any price change on the other 480 constituents of the S&P 500, this index would advance by another 100 points.
Financial Statement Analysis
The S&P 500 is not only trading at a lower earnings multiple; the index looks favorable relative to its peak based on a number of other financial metrics. The index is trading at lower multiples of book value, sales, and EBITDA in addition to earnings. The index also now provides investors with a higher dividend yield. The index constituents have better liquidity and are operating with much less debt than prior to the crisis.
I believe that this last subsection on leverage and liquidity might be the most important. If we were to be faced with the same type of systemic shock as we saw in 2008, companies would weather the storm much better both because of the improved health of their respective balance sheets and also the regulator mandated higher capital buffers in our financial system. If there is less downside today as compared to the previous peak, shouldn't there be a reduction in the market discount rate?
Below is a graph of the earnings yield of the S&P 500 (trailing twelve month earnings/price) graphed against the 10-year Treasury over the trailing fifty years. While this article compares earnings multiples in the current market versus the 2007 peak, they almost must be framed against the "risk-free" rate. In this longer time series, the recent increase in Treasury yields is but a blip, and the earnings yield of the stock market, which is still slightly higher than its long-run average even at the current nominal market peak, remains at a historically high premium to Treasury yields.
The market risk premium - the stock market earnings yield less the 10-yr Treasury yield, stands at 3.54% today. This metric was just 1.04% at the 2007 market peak as graphed below. Some readers will certainly contend that this relative comparison does not necessarily mean that stocks are cheap, but rather bonds are historically rich. I agree with the latter assessment, but the relative comparison matters to me as I decide where to allocate dollars in today's market environment. Despite the increase in bond yields over the past two months, real returns in fixed income will remain low if not negative, which to me continues to favor equities in this environment.
The risk premium available in equity markets provides adequate compensation to investors for the multitude of global risk factors mentioned earlier in the article. However, as I wrote in 10 Investment Themes for Mid-2013, the easy money in this cycle has been made and gains in the equity markets will not come as easily as the first time I wrote this article in September 2012. The equity risk premium has compressed in part due to an increase in the market discount rate from rising yields. Fixed income, which has traditionally been the haven for money when equity markets are nearing their peak, offers historically low forward returns as interest rates normalize. Taking money completely out of the market and into cash offers negative real returns when adjusting the near zero nominal returns for inflation. While domestic stocks are less attractive today at the all-time high and amidst slowing earnings growth, they still look modestly more attractive than other domestic asset classes with relatively more attractive valuations available abroad and in underperforming emerging markets.
With domestic equity markets at all-time highs and domestic bond markets just coming off all-time high prices as well, investors should evaluate their respective risk tolerance, portfolio liquidity needs, and asset allocation mix against the specter of low future returns in many asset classes as the Federal Reserve withdraws monetary accommodation. We are not at the cyclic peak in the stock market yet, but gains will moderate. Investors should consider beginning to rotate money to higher quality parts of the stock market less sensitive to a potential correction. If yields in fixed income markets continue to sell off, investors who wish to protect their downside should look to monetize their domestic equity gains and rotate into a combination of short duration fixed income and more attractively valued international equity markets. While the latter asset class comes with more risk than the domestic equity market over long-time intervals, a combination of this asset class with negatively correlated fixed income as a counterbalance could lead to a return profile preferable to the domestic equity market over forward periods.