For several months I've been discussing the potential formation of a bubble in the US equity market as represented by major indices and index ETFs such as the S&P 500 (NYSEARCA:SPY) and Dow Jones Industrial Average (NYSEARCA:DIA), driven by the conjunction of both record quantities of excess liquidity and declining liquidity preferences.
Starting two or three weeks ago, a flood of analysts have been falling over themselves trying to characterize the current stock market as a "bubble," or variously as "bubbly." So has the bubble that I have presaged aging already started?
I believe that this talk of a current bubble in the stock market is exaggerated and mostly unfounded.
This Market Ain't A Bubble
Current consensus 12 Month Forward operating EPS for the S&P 500 is around 113. A reasonably conservative estimate would be 110. This implies a forward PE of 15.9. While this forward operating P/E is rich on a historical basis, it is not indicative of a bubble.
The analysis of historical P/E valuation does not change much if we base the P/E on trailing GAAP EPS. Assuming a trailing GAAP EPS of 94.00 at the end of the third quarter, this implies a trailing P/E of 18.6 versus a historical average of 15.5 since 1871 and a median of 17.4 since 1960. I believe that the latter figure is a more relevant basis for comparison. Either way, the current trailing P/E is not representative of bubble conditions.
Anecdotal approaches to characterizing the current market as a bubble does not work either. Let's assume for a moment that Tesla (NASDAQ:TSLA), Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR) are bubbles. So what? There are always a few bubbly stocks in any market.
Cherry picking high P/Es as a method of "analysis" does not work either. One article I read a few weeks ago claimed that US large caps were a bubble based on citing three or four stocks with P/Es in the high teens and the low 20s. But if you objectively survey the largest 50 US stocks by market capitalization, less than 25% have forward P/Es of over 15. And less than 10% have P/Es of over 20.
Here are just a few examples of the top stocks in the US by market cap and their forward P/Es: Apple (NASDAQ:AAPL) 11.1, Exxon (NYSE:XOM) 10.8, General Electric (NYSE:GE) 13.5, Chevron (NYSE:CVX) 9.9, IBM (NYSE:IBM) 10.3, Microsoft (NASDAQ:MSFT) 12.1, AT&T (NYSE:T) 12.9, Pfizer (NYSE:PFE) 12.7, JPMorgan (NYSE:JPM) 8.6, Oracle (NYSE:ORCL) 11.1, Wal-Mart (NYSE:WMT) 13.3. There is no bubble going on here.
In fact, the overall forward P/E for the 50 largest US large caps is less than 14. This compares to the forward P/E of the Nifty Fifty in 1972 which peaked at around 35. The top 50 US stocks by market cap also traded at a forward P/E of around 35 in 2000. Clearly, by any reasonable absolute or historical measure, there is currently no bubble in US large cap stocks.
And there is no generalized bubble in the US equity market as a whole.
Will Talk of Bubbles Prevent Them?
One potential consequence of all of this bubble talk is that it could actually serve to prevent one by placing investors on guard and getting them defensive.
However, if historical experience is a guide, I would not bet on this loose talk about bubbles actually preventing one from ultimately forming. People were loudly proclaiming bubbles in 1997, a full two years before the real bubble took off in 1999.
An important step in bubble formation is capitulation by various bears that were previously proclaiming a bubble and the simultaneous development of a narrative about a "new era" that justifies higher-than-normal valuations. Valuations are not much higher than normal now, so that sort of hyper-bullish argument would not even make any sense at present.
Bubble-Like Speculation About Profit Margins
If anything, the predominant narrative today is one of skepticism about the economic fundamentals and corporate earnings that underlie current P/E ratios.
To illustrate just one example of such skepticism, analysts such as John Hussman and James Montier have been arguing loudly that profit margins are currently in a bubble and will revert to their means of the last 30 years as soon as the US budget deficit as a percent of GDP declines. Unfortunately, while appearing theoretically plausible, this line of argumentation has virtually no empirical basis and is based on flawed theoretical constructs that were first developed in the mid 20th century by an obscure Marxist economist from Poland by the name of Michal Kalecki, and which have largely been discredited.
Contrary to Kalecki's theoretical speculations, and general popular belief, there is no consistent history of mean reverting profit margins for corporations. To the contrary, the available empirical evidence directly contradicts the theory. For example, profit margins remained very high throughout the 1950s despite rapidly declining budget deficits as a percent of GDP. Similarly, profit margins did not exhibit any mean reverting behavior in the 1960s and 1970s. In fact, contrary to the Kalecki theory, profit margins experienced a secular decline in the 1960s and 1970s through periods of both rising and falling deficits, but mainly through rising deficits. During the '80s, profit margins did not show any great mean-reverting behavior nor any tight relationship to budget deficits. During the 1990s, budget deficits plummeted throughout the decade while profit margins soared, in total contradiction to the Kalecki theorem. In fact, profit margins have not mean reverted at all in the past three decades regardless of budget deficits!
Profit margins have been in a secular uptrend for over 30 years through periods of both rising and declining budget deficits (as a percent of GDP). Furthermore, these increases in profit margins are based on empirically identifiable and likely sustainable developments such as globalization (capital and labor arbitrage), lower effective corporate taxation, lowered capital intensity of modern industry, cost-saving technologies, barriers to entry via intellectual property, oligopolistic industry concentration global branding and a host of other factors that have been empirically quantified in various detailed reports published by analysts such as David Bianco at Deutsche Bank, Tobias Levkovich at Citi and Dan Suzuki at Merrill Lynch.
Indeed, it may seem ironic to say so, but Hussman's and Montier's theories about declining budget deficits driving profit margins down, or even more simplistic mean-reversion arguments by commentators such as Doug Kass, are far more speculative and empirically unfounded than the much-maligned consensus forward EPS estimates that currently underpin the market value of stocks in the US equity market.
Speculation about a profit margin bubble in US stocks has become almost a bubble onto itself.
US stocks are currently not in any sort of generalized bubble. There are some signs of "frothy" behavior in a few isolated segments of the market. However, the stock market as a whole is still within 1 standard deviation of its historical mean in terms of forward and trailing P/Es.
When we stop hearing all the talk about bubbles and start to hear widespread talk about how much-higher-than-average P/E multiples are justified, then we can start to seriously suspect that a bubble might be in the works.
Before then, the possibility of a bubble forming in the US stock market is just that: A possibility. While I think the probabilities of the formation of a future stock market bubble are quite high, the fact is that it is not yet a reality.