I've been hearing for several months now this endless debate between the bulls and bears about whether or not stocks are cheap. The talk includes whether we should be holding our noses and buying since earnings on the S&P 500 should come in between $92-98 and we are looking at a historically cheap PE of 11 when you look at today's market and apply historical valuations of stocks.
I thought about this for a while and have listened to a lot of various "experts" from one day to the next for several months. Then it finally hit me that I have formed a fairly strong opinion that their arguments are simply not very good. What is interesting about the bulls who posit that the Dow is cheap by historical standards is that their measuring metric goes back about 30 years to the beginning of the 1980s. That was the great bull run from around Dow 2,000 to nearly Dow 8,000 by the late nineties after Internet stocks became the new craze. Now historically stocks have traded with a trailing multiple to earnings of 13-15 during a period of economic expansion in the U.S. and a multiple of 11 would seem to be cheap.
Unfortunately, when you look closer at the arguments these bulls are making, they don't hold up. First, in the 1980s, the U.S. economy was growing at around 5% a year, and, equally important, inflation was in the high single to low double digits. Translation: The assets and underlying value of the commodities and materials bought and sold by companies were increasing in value each year while the companies also had strong growth rates because of the underlying strength in the U.S. and global economy. Now in the 1980s the average PE of stocks in a high growth environment where inflation was in the high single to mid-double digits was around 15. Next, let's look at the 1990s. Again, thanks in large part to the Internet boom we are looking at a growth rate in the U.S. economy of around 5% a year with a lower but still not insubstantial core inflation rate of around 4-6%. The average PE of stocks during this high growth and moderate inflation period was, again, around 15 (with the notable exception of the dot.com busts).
If we measure inflation using core inflation metrics with a focus on wages and housing prices we can clearly see that we are in a deflationary period. While some could argue the commodity moves we saw over the last couple years are an indication inflation is the biggest threat the fact that most commodities are down significantly and growth in the West is anemic suggests that deflation remains the biggest threat. Given that stocks are currently trading at around 11-11.5x earnings in a market where both the U.S. and global economies are now growing at slower rates and deflation is lowering the asset value of most companies, equipment and inventory, the question is what is the right multiple for stocks today?
Obviously there is no clear answer but consider this. Earnings estimates of $92-98 on the S&P are now coming down and it's not clear if the U.S. economy will grow at all next quarter or next year. Also, the emerging markets, with their tightening monetary policy, are experiencing lower growth rates as well. Finally, and notably different than this time last year, gridlock has taken hold in D.C. and the Fed is clearly unable or at least unwilling to attempt any kind of initiative like QE2. Any QE program would probably also be met with a much higher level of market skepticism than QE2 was since we have retraced all the gains in the market since summer of last year when the Fed initiated its bond repurchasing program and the economy has slowed to a crawl despite the Fed's best efforts. Also, the austerity that is coming to state and federal governments is not going to help growth in the short-term.
So given that a PE of 15 was what stocks had when the economy was expanding at a strong rate and earnings estimates were moving higher while assets were increasing in value because of inflation, it's likely the S&P 500 is too high to attract significant buyers. Once earnings estimates come down, and given the move in commodities alone, we may very well discover that the S&P is trading at 12-14x earnings despite no real growth being expected in the U.S. economy, a slowing global economy, and major macro headwinds present in places like Europe. Given this backdrop I see the market trading well within the 980-1080 range before investors will be willing to consider buying in the massive amounts likely necessary to stop the declines.
To conclude, the question of valuation is always tricky but it seems ridiculous to me to think that we will get any real buying interest at 12-14x this years earnings if people think earnings will be flat to down over the next year, and that scenario is looking increasingly likely. While the European drama is good theater, I think if stocks were really that cheap on a historical basis using conventional valuation metrics and were yielding, institutions would step up and buy just as they did last summer when the same European debt woes were at least equally concerning to investors. I think this would especially be the case today since yields in the short-term bond market are now basically zero as the two year treasury is trading below 1%. A market of value is often found when looking at low PEs. But be careful and think about what earnings may look like when the dust clears before you buy this argument that we are looking at a market with a multiple that is cheap enough to justify the kind of massive buying that it will likely reverse this vicious downtrend.