The relentless rise of the stock market has continued with a close this past Friday leaving the S&P 500 (SPY) at 1709. At this price level, an investor must ask - are we in a bubble or are stocks still a bargain? Not surprisingly, my answer will be - "it all depends." It really depends completely on whether interest rates are relevant to stock valuations.
The Bear Case. Using metrics which disregard present interest rates (like the Shiller 10 year trailing PE or the Tobin Q), stocks have clearly become expensive. At 1709, the S&P 500 is priced close to a price-earnings ratio (PE) of 20 (and a Shiller ratio in the mid-20s) which is well above historic averages. Dividend yield is now below 2%, which is also below historic averages and also suggests an overpriced market. Earnings growth has become anemic so that "growth prospects" do not justify these lofty multiples. To make matters worse, there are definitely clouds on the economic horizon in the form of Euro-Worries, a strengthening dollar, continued danger of deflation, and renewed concern about state and municipal finance. With Washington operating at a level of dysfunction which makes the Italian government look efficient and purposeful, we are certainly not lacking in reasons for pessimism.
The Bull Case. However, there is another side to the debate. Interest rates are still at extraordinarily low levels. Some pundits argue that interest rates are irrelevant to stock valuations but, as I have pointed out before, there are at least three important arguments to the contrary. First of all, interest rates are relevant to the discount rate used to calculate discounted future cash flow, and so are a fundamental building block in calculating the value of a business enterprise. The lower the interest rate (and, therefore, the discount rate), the higher the present value of a given cash flow stream and thus, the higher the enterprise value of a given company.
Secondly, and probably more widely appreciated, is the argument that investors will tend to allocate more of their portfolio to stocks when the earnings yield and the dividend yield of stocks are relatively high compared to the interest rates paid by bonds and money market funds. Low interest rates mean that stocks yielding 2 or 3 percent become attractive compared to bonds. Indeed, stocks have traded in a fairly narrow dividend yield range over the past several years with a great deal of market appreciation that can be accounted for due to dividend increases. Even at its current valuation, the S&P 500 has an earnings yield (the inverse of the price earnings ratio) of over 5% and it is hard to get 5% in the bond market without taking some combination of credit and duration risk. Finally, low interest rates enable "financial engineering" in the form of stock repurchases, debt refinancings, and cash for stock acquisitions all of which can increase per share earnings.
The Fed Model. In the 1990s the popular "Fed Model" compared the earnings yields to the interest rates of the 10 year Treasury bond; even with the recent run-up in interest rates, this metric would suggest a PE of roughly 37 (nearly twice the current market valuation). Nobody really believes that this metric should be controlling, but a very persuasive case has been made by Jan Timmer in this article that the after tax corporate borrowing cost is a useful metric for calculating earnings yield. Assuming a pre-tax interest expense of 6% (and there are many, many corporations that can borrow many, many dollars for less than 6%) and a tax rate of 35%, after tax borrowing costs would be roughly 3.9%, suggesting a PE of over 25, which would suggest that the market is roughly 25% undervalued.
There is no easy resolution to this debate, but one thing which is certain is that, as long as rates are low, there will be more and more financial engineering and it will reduce the available supply of equities and, at the same time, tend to increase earnings per share. Share repurchases increase earnings per share as long as the earnings yield of the company is more than the after tax interest income or interest expense associated with the cash used for the repurchases. With many companies earning less than 1% pre-tax income on balance sheet cash, the use of this cash for stock repurchases is accretive to earnings as long as the price earnings ratio of the company is less than 100! This is a powerful force that will continue to be mobilized because of the strong motivation of corporate managements to report higher quarterly earnings per share.
Higher Rates? A major concern is, of course, the expected duration of the period of extraordinarily low interest rates. We have already seen a strong market reaction to a run-up in rates and, if nothing else changed, higher rates would likely bring lower stock prices. The question thus becomes a predictive one. If higher rates mean lower price-earnings and price-dividend ratios, then valuations will be sustained only if earnings and dividends increase before or at least at the same time that interest rates increase. Will interest rates increase substantially before corporate earnings and dividends also increase? This becomes the critically important question in assessing intermediate and maybe even long term portfolio strategy.
Higher Earnings and Dividends? My take is that stocks are still cheap based on the current interest rate environment so that there is room for some increase in rates before stocks would become unattractive. Short rates are unlikely to increase soon and are also unlikely to increase unless and until there is strong and persistent evidence of some combination of real economic growth, employment growth and inflation. Corporate America has become more and more effective at capturing a higher proportion of economic activity in the form of corporate earnings. Thus, a relatively slow but steady recovery should enable corporate earnings to grow, although a stronger dollar will create a headwind for companies with exposure to overseas earnings. Financial engineering will continue to create lift for per share earnings, and the extraordinary balance sheet strength of America's corporations will guarantee a steady increase in dividends. By the time the short rate gets back to 2% (which may well be at least 4-6 years from now) corporate earnings (per share) may be 25-40% higher and dividends are very likely to be 50% higher. Thus, lower PE ratios and higher dividend yields will not necessarily mean lower stock prices.
The Danger of Stagflation. Of course, there is the risk that rates will go up rapidly and that there will not be any offsetting increase in earnings or dividends. The most likely scenario for nasty combination of events would likely be "stagflation" - the market's nemesis from the 1970s - a period of increasing inflation but little or no real growth. Of course, inflation may enable corporations to increase nominal earnings, but there is a nasty tendency for at least some companies to experience commodity cost increases which cannot be fully passed through. This scenario would almost inevitably be accompanied by a run up in oil prices which would simultaneously suck money out of the pockets of US consumers and drive inflation higher. Recent reductions in oil imports would mean that more of the higher payments for petroleum products would stay here in the United States, and this might mitigate negative macroeconomic effects. Nevertheless, the danger of this scenario is real and it suggests on overweighting in the oil sector to hedge against a repeat of 1973 or 1979.
Bargains. I do not think it accurate to describe the current market as a "bargain" but, on the other hand, I am still finding bargains in the market. There are many, many stocks which will almost certainly be a better investment over the next 5 or 10 years than any fixed income investment. Seagate Technology (STX) and Western Digital (WDC) have recently gotten cheaper and are priced for obsolescence. Johnson & Johnson (JNJ) is still not expensive given its balance sheet strength, resilience and product diversity. The mega-cap tech stocks, Microsoft (MSFT), Cisco (CSCO), Intel (INTC) and Apple (AAPL), are all priced at levels which make them attractive dividend stocks and are priced at multiples which ignore balance sheet cash and also price in an expectation of imminent declining earnings as described in more detail here.
Financial Engineering Saves the Day. We have come a long way from March 2009, and the next four years are very unlikely to be as kind to equity investors as the last four. There are, however, still some bargains to be had in this market. Short rates are not likely to go up any time soon, but further appreciation in this market will depend on earnings and dividend growth. Because of the enormous balance sheet strength of the big corporations and because the large banks will likely resume paying significant dividends soon, I am fairly confident about dividend growth. The path upward from here will increasingly require sustained earnings growth and we will all be reading the tea leaves (and the earnings call transcripts) to solve that puzzle over the next few quarters.
I still have an abiding confidence in the efficacy of financial engineering, and I think it will play a significant role in moving per share earnings higher as long as rates stay low. Share repurchase plans and cash for stock takeovers will remove shares from the market and, at the same time, push earnings per share higher. The incentive to employ financial engineering is a powerful one and this mechanism will result in a kind of "stealth" LBO in many US companies. When the market pulls back a bit, the number of repurchased shares per million dollars of repurchase activity will increase and cash for stock takeovers will become more attractive; this will tend to cushion market "dips" a bit. There is no sure thing in financial markets but, in the absence of a catastrophic financial event, the power of financial engineering will tend to make the smaller and smaller number of outstanding shares more and more valuable over time.