The U.S. stock market closed at yet another record all time high on Wednesday. But despite the seemingly unending investor optimism more than five years into the current bull market, some worrisome issues are continuing to build under the surface. Like all past bull markets, the latest episode will eventually come to an end and a new bear market will begin. It may begin tomorrow, sometime before the year draws to a close, or perhaps even longer. But once it begins, the next bear market has the potential to be even worse than the two previous downturns since the start of the new millennium.
Before going further, it is worthwhile to provide a brief historical context. Focusing on the S&P 500 Index (NYSEARCA:SPY), the first bear market in the current secular cycle began following the market peak on March 24, 2000 and continued for 561 trading days until bottoming on October 9, 2002 with a -47.41% peak to trough decline. The next bear market got underway following the market peak on October 9, 2007 and lasted for a relatively shorter 355 trading days until reaching a trough on March 9, 2009 with a -55.19% loss along the way.
Despite the staggering declines incurred during the past two episodes, it is more than possible that the next bear market may both last longer and result in a greater overall peak to trough decline.
Several different points support the potential for this outcome.
When breaking apart the data, stocks are actually just as expensive if not more so generally than they were at the market peaks in both 2000 and 2007. At first glance, this statement seems absolutely preposterous. While stocks may be more expensive today than they were in 2007, it simply cannot be possible that valuations could be higher today than they were in 2000. After all, the bull market that ended in 2000 was marked by some of the most absurd valuation readings in market history including a P/E ratio based on trailing 12-month as reported earnings running north of 30 times at the market peak, which of course is considerably higher than today's reading at just over 19 times. So how could it possibly be the case that stocks are generally more expensive today?
The answer is simple. Yes, the aggregate valuation readings on the S&P 500 Index at its 2000 peak are very high. But the source for these record high valuations was heavily concentrated in one single market sector in technology. And the valuations from the once high flying sector that made up a mind boggling 35% of total U.S. market cap in March 2000 (for context, it constitutes just 19% today) were extreme in their frothiness. When breaking apart the data and setting aside the technology sector and those industries closely related to it, multiples across much of the rest of the market were actually fairly reasonable. In fact, a fair number of stocks were even trading at meaningfully lower valuations in 2000 versus what we are seeing today.
To highlight this point in more detail, the valuations of the constituent members of the Dow Jones Industrial Average both at the market peak in 2000 and today are compared below. It should be noted that the list below includes those companies that were members either in 2000 or today, excludes companies that either do not have consistent data for comparison or experienced a major transformational change along the way (i.e. Eastman Kodak (NYSE:KODK) and General Motors (NYSE:GM) entering bankruptcy, etc.). Companies below are also grouped by the ten major GICS sectors.
Stock 2000 P/E Ratio Today's P/E Ratio +/- Difference Today vs. 2000
Chevron (NYSE:CVX) 10.6 11.9 +12.3%
Exxon Mobil (NYSE:XOM) 17.3 13.6 -21.4%
DuPont (NYSE:DD) 18.0 22.1 +22.8%
Alcoa (NYSE:AA) 17.6 39.5 +124.4%
International Paper (NYSE:IP) 17.1 21.5 +25.7%
3M Company (NYSE:MMM) 19.9 20.6 +3.5%
Boeing (NYSE:BA) 17.1 23.3 +36.3%
Caterpillar (NYSE:CAT) 12.8 17.8 +39.1%
General Electric (NYSE:GE) 40.1 21.9 -45.4%
United Technologies (NYSE:UTX) 17.4 18.9 +8.6%
Honeywell (NYSE:HON) 16.2 18.8 +16.0%
Walt Disney (NYSE:DIS) 39.5 23.0 -41.8%
Home Depot (NYSE:HD) 46.6 20.6 -55.8%
McDonald's (NYSE:MCD) 22.9 18.6 -18.8%
Nike (NYSE:NKE) 22.7 25.6 +12.8%
Coca-Cola (NYSE:KO) 37.5 21.8 -41.9%
Procter & Gamble (NYSE:PG) 29.7 21.3 -28.3%
Wal-Mart (NYSE:WMT) 38.0 16.0 -57.9%
Altria (NYSE:MO) 7.4 19.1 +158.1%
Johnson & Johnson (NYSE:JNJ) 26.4 19.6 -25.8%
Merck (NYSE:MRK) 25.6 38.2 +49.2%
Pfizer (NYSE:PFE) 40.7 18.0 -55.8%
United Healthcare (NYSE:UNH) 19.6 14.7 -25.0%
Goldman Sachs (NYSE:GS) 15.1 10.5 -30.5%
JP Morgan Chase (NYSE:JPM) 17.2 13.8 -19.8%
Travelers (NYSE:TRV) 9.0 9.1 +1.1%
Cisco (NASDAQ:CSCO) 99.7 16.6 -83.4%
Intel (NASDAQ:INTC) 36.1 14.7 -59.3%
IBM (NYSE:IBM) 24.8 12.3 -50.4%
Microsoft (NASDAQ:MSFT) 137.4 15.1 -89.0%
Hewlett-Packard (NYSE:HPQ) 33.3 11.9 -64.3%
AT&T (NYSE:T) 20.3 10.2 -49.8%
Verizon (NYSE:VZ) 18.1 11.0 -39.2%
When reviewing this list of valuation comparisons, a few key points stand out. First, the valuations from the cyclical core of the U.S. economy in the energy, materials and industrials sectors are higher today, in some cases considerably, than they were in 2000. Next, a large percentage of the companies that are meaningfully less expensive today than they were in 2000 were at the center of the technology, media and telecom (TMT) craze that engulfed the market in froth at the turn of the millennium. This list includes Disney, Cisco, Intel, IBM, Microsoft, Hewlett-Packard, AT&T and Verizon as well as General Electric to a certain extent as well. Those that remain are a fairly evenly split group. As a result, one could reasonably conclude that when extracting the extreme high fliers from the picture, stock multiples on an individual level are just as high if not more so today than they were in 2000 in a number of cases.
Of course, even if one stands by the notion that valuations are still reasonable today and should help protect against a severe market pullback, the evidence when comparing the multiples in today's market to that of 2007 quickly dispels this idea.
Stock 2007 P/E Ratio Today's P/E Ratio +/- Difference Today vs. 2007
Chevron 9.4 11.9 +26.6%
Exxon Mobil 11.4 13.6 +19.3%
DuPont 15.0 22.1 +47.3%
Alcoa 12.4 39.5 +218.5%
International Paper 16.2 21.5 +25.7%
3M Company 15.0 20.6 +37.3%
Boeing 17.9 23.3 +30.2%
Caterpillar 13.7 17.8 +29.9%
General Electric 17.2 21.9 +27.3%
United Technologies 16.8 18.9 +12.5%
Honeywell 17.3 18.8 +8.7%
Walt Disney 17.8 23.0 +29.2%
Home Depot 15.4 20.6 +33.8%
McDonald's 17.6 18.6 +5.7%
Nike 16.4 25.6 +56.1%
Coca-Cola 21.0 21.8 +3.8%
Procter & Gamble 20.5 21.3 +3.9%
Wal-Mart 14.9 16.0 +7.4%
Altria 16.3 19.1 +17.2%
Johnson & Johnson 15.4 19.6 +27.3%
Merck 34.1 38.2 +12.0%
Pfizer 11.5 18.0 +56.5%
United Healthcare 15.3 14.7 -3.9%
Goldman Sachs 8.5 10.5 +23.5%
JP Morgan Chase 10.9 13.8 +26.6%
Travelers 7.8 9.1 +16.7%
Cisco 22.0 16.6 -24.5%
Intel 19.9 14.7 -26.1%
IBM 14.8 12.3 -16.9%
Microsoft 19.9 15.1 -24.1%
Hewlett-Packard 16.5 11.9 -27.9%
AT&T 14.2 10.2 -28.2%
Verizon 17.6 11.0 -37.5%
In comparison to 2007, today's stock valuations are meaningfully higher almost across the board. The only exception comes once again from the TMT space, as many of these companies were still in the process of unwinding the excesses from the technology bubble even toward the end of last decade. What this demonstrates is that stocks can be trading at multiples that are considerably less than today's levels and still plunge into a major decline in losing more than half of their value as they did during the second bear market since the turn of the millennium.
But what about historically low interest rates justifying today's high valuations? Perhaps, but this is not a factor that can sustain historically high valuations indefinitely into the future. After all, the Fed's zero interest rate policy is not a permanent condition. At some point, interest rates are likely to rise either by the Fed's choice or by the market's force. And these valuations will need to adjust accordingly when that time comes.
Taking this a step further, what of the quality of today's earnings? Many companies are continuing to operate at or near historically high profit margins and have supported higher earnings per share, or "E", thus resulting in a lower P/E ratio through such nonproductive means as raising corporate debt to fund share buybacks. Such are not the conditions of sustained multiple expansion into the future or the foundation of healthy economic growth for that matter. Moreover, they suggest that if one were to remove these artificial influences when determining current valuations that stock price valuations are actually quite a bit more expensive today than what the current numbers might indicate.
In short, valuations are as high as they have been in the case of many stocks today. In the best-case scenario, it will serve as a headwind for many stocks as they attempt to advance further in the coming quarters. But if we were to enter into a new bear market, it suggests that stocks have that much further to fall before it's all said and done.
Here we go again. At the heart of the financial crisis in 2007 were major banking institutions promoting complex financial instruments and engaging in reckless lending activity that eventually culminated in the near collapse of the global economy once it finally emerged that a good portion of this debt was filled with rot. A reasonable person would think that regulators would not allow these same financial institutions that were rescued from ruin only by the extreme and extraordinary actions by policy makers to think about engaging in activity that would even be considered remotely comparable to what was taking place only seven short years ago in the middle of last decade. After all, if one had to be resuscitated from a terminal state by fault of their own actions and at the expense of others, should their not be a meaningful price to pay if not at a minimum an required shift to far more prudent and conservative lending practices?
Not so in a world where all is forgiven and forgotten in banking while the rest of the world's citizenry continue to toil away in a global economy that seemingly cannot regain any sustained traction. Instead, many of these same major financial institutions, some of which are now even bigger than they were before, have returned to many of the very same misguided and aggressive lending techniques that preceded the last crisis. But upon reflection, why would they not resume such behavior? After all, if one does not have to fear any consequence for their self promoting actions, no matter how harmful to others they may be, then the natural instinct for those that were inclined to engage in such activity in the first place is to do so again. Unfortunately, it will likely come at an even greater consequence to the rest of us the next time around once it inevitably blows up again.
One of the many illustrations of this return to aggressive lending and borrowing activity is the fact that NYSE margin debt, which is a measure of how much money has been borrowed to purchase stocks is now as much as 15% to 25% higher today than the peak levels that preceded the start of the last major bear market in 2007. Of course, the global economy did not necessarily need people to borrow even more money than ever to speculate in the stock market. And despite all of the risks that are being accumulated once again today, we don't even have a sustained economic recovery to show for it. A regretful shame to say the least, for the more margin debt and excess leverage that has to be unwound, the greater the market pain is likely to be in the end.
The game appears to have changed for good at the U.S. Federal Reserve. After 27 years of pursuing a policy strategy that involved the perpetuation of a wealth effect through rising stock prices to support and stimulate economic growth, it appears that this effort may have finally run its course and that a new focus may soon take its place. For while the Greenspan put may at one time helped foster a period of prosperity that included the longest sustained economic expansion in U.S. history in the 1990s, it is becoming increasingly clear that all of these efforts have come with the cost of pulling forward future demand and increasingly inflating asset bubbles in the process. And while the Fed's QE during the financial crisis did manage to rescue the global economy from collapse in late 2008 and early 2009, the clear lesson in the five years since is that rising asset prices do not lead to sustainably robust economic growth. In fact, the uncertainty associated with artificially inflating asset prices may be doing far more harm than good by stunting growth.
This may mark the end of a market era if indeed the Fed is finally coming to this realization. And if that is the case, not only are we almost certainly not likely to see any more QE once the Fed finally escapes from the current program it seems to want to so badly exit, but any future policy initiatives are likely to be far more targeted and purposely not designed to potentially inflate asset prices any further, which would only serve to likely flame the income inequality issue that is already building as the stock market reaches new highs while the economy continues to stagnate.
But suppose the above conclusions are wrong and that the Fed actually did want to support further increases in asset prices going forward. After all, they certainly do not want to see the stock market suddenly collapse, which is one of the reasons that they are being so deliberate with the tapering process. If this is indeed the case and the Fed wanted to intervene in an aggressive way in response to a future market calamity, exactly where are they going to draw upon the resources to accomplish this task? For at the outbreak of the financial crisis during the 2007 to 2009 bear market, the Fed's balance sheet stood at a relatively modest $870 billion, whereas today it has ballooned to $4.3 trillion and counting. The Fed has already created the potential for massive imbalances by allowing so much to accumulate in excess reserves within the banking system, so the idea of adding even more with a new program has the potential to push things over the edge.
With all of this being said, maybe the Fed will be willing to go all in once again when the economy falters. After all, what's a few trillion in money printing any more, right? Even so, the implementation of any future stimulus program does not mean that it will be targeted at increasing stock prices. After all, when dissecting market performance in response to Fed stimulus in the post crisis period, it is only when the Fed is engaged specifically in the daily purchase of U.S. Treasuries when the stock market levitates. All other programs have had a neutral to incrementally positive influence on the stock market at best. Thus, we could see the Fed respond to the next crisis with a new major stimulus program, and the stock market may continue to go down unabated.
Perhaps this notion of Fed stimulus not supporting stock prices seems unbelievable. Such a response would be understandable given the Fed has made it a religion to protect stock prices at all costs since the 1987 crash. But one has to look no further than China to see how major stimulus programs can blow right by the stock market. There is little question that Chinese policy makers have been aggressive in their own right with monetary stimulus during the post crisis period. But not only has this done little to support Chinese stock prices, their market as measured by the Shanghai Stock Exchange Composite has been in a full fledged bear market having lost more than -40% of its value over the last five years.
While China is certainly a different market than the United States, the above example does highlight the very real possibility of this outcome. Of course, Japan has also been engaged in stimulus programs that in many cases were even more aggressively designed to boost stock prices, and they remain mired in a long-term bear market that has lasted nearly a quarter century to date even despite the recent rally since late 2012. So in short, further Fed stimulus in the future does not necessarily mean higher stock prices by any means, as the composition of the stimulus is extremely important if nothing else.
Even with all of these considerations in mind, one simple fact differentiates today's market with that of the 2000 to 2002 and 2007 to 2009 episodes. During these previous two bear markets, the Fed was in a position to ease aggressively and did so. Today, not only is the Fed no longer in a position to ease aggressively, they may actually be inclined to tightening monetary policy. This represents an important differentiation in the support for stock prices the next time around.
The next bear market may be shaping up to be quite the storm once it finally arrives. Not only are valuations running high from a historical perspective across many segments of the economy, but many of the bad lending practices that could ultimately lead to a seizing in liquidity conditions and capital market shocks as a result are also manifesting themselves at the present time. And all of this is culminating at a time when the Fed is not only no longer showing the inclination to ease any further but is instead exhibiting the increasing inclination to tighten policy. This suggests that little may be there in the way of support once stock prices finally fall. Of course, the one thing the Fed is unlikely to want to see happen is a sudden, sharp fall in stock prices. As a result, they are likely to give markets just enough in any future bear market scenario not necessarily with the intent to induce it to rise but instead just enough to keep it from completely unraveling to the downside.
All of these forces lead to two end points. Once the potential for a decline of equal to greater magnitude exists once bear market forces fully take hold. Also, the fact that the Fed has little to offer in the way of future policy support coupled with the notion that they will likely be inclined to provide just enough to keep markets limping along suggests that the eventual bear market could last much longer than most any investor is anticipating as the natural bear market cleansing process is dragged out as a result.
Such are the conditions that causes any remaining investor that thinks well of the stock market to definitively turn against it and swear to never come back. Of course, such conditions also mark the path that will lead us to the dawn of the next secular bull market and the next great era of growth in this country. It is only a matter of allowing for the passage of time and enduring some pain along the way.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am long CVX, PG, MCD, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long stocks via the SPLV and XLU as well as selected individual names. I also hold a meaningful allocation to cash at the present time.