According to Fortune magazine, the Fortune 500’s last cyclical peak, ending in the year 2000, showed earning of 444 billion on margins of 6.2%; no wonder the S&P500 was trading at a 30x price to earnings multiple. We all know what happened after that: in 2001 and 2002 earning plummeted. So the question is, what if we returned to those record levels of earnings? Would the S&P500 would return to 30x multiples?
Fast forward to 2006 when earnings of the Fortune 500 were 785 billion on margins of 7.9%. The quick conclusion I drew from these numbers is that we’ve been in a raging bull market for corporate revenue and earnings, but the stock market hasn’t kept pace at the same rate it did during the last cyclical peak. Today’s S&P500 price to earnings multiple is about 17.5x; if P/Es expanded at the same rate they did in the year 2000, the S&P500 would be at over 4,500. Perhaps this is more of a statement of the excesses of the year 2000 than it is about today’s valuations, or perhaps it means the excesses of the year 2000 has made us all gun shy.
Last week, the Wall Street Journal published an article featuring Vernon Smith, the Nobel Laureate Economist. One of the issues covered in the article was that market bubbles have tended to happen only once per generation because investors learn from their mistakes and become weary of creating bubble after bubble. The pendulum that swung to an extreme in 2000 is the same one that is tethered by the fear of those same investors today. This fear has made investors wise, but has also created a market that may be very reasonably valued. At 17.5x, the S&P is far below its recent P/E range of close to 24x over the last 10 years. Many analysts would rather look at the post WWII average P/E, which is much closer to our current level, but is it realistic to believe we are living in the same world we were in 1950?
Valuations are buffering the downside and providing a case for higher multiples, but there are other factors at work, chiefly that of supply and demand. One of my theses on the market over the last year has been there are too many buyers and too little stock. Companies flush with cash are buying back stock at a record pace, corporate take overs and private equity deals clutter the headlines, global prosperity and liquidity are intertwining markets and creating a broad base of wealth. Another factor contributing to the demand for stocks is retirement savings.
The New York Times published an article last week discussing a new paper published by the National Bureau of Economic Research on the effects of baby boomers extracting money out of saving programs for retirement. The findings were unexpected by many. For example, in 1984 less than 20% of Americans had access to 401ks; today over 50% do. Even more interesting is that in 1984 only 34% took advantage of their 401k to save; today over 81% do. What this says is that Americans have made actively saving for retirement a way of life, so much so that this study projects that by the year 2040 total retirement savings in America will have grown to 1.8 times GDP from .94 times GDP today. Demand of equities is strong and with increasing competition for shares there is a strong case for multiple expansion, or at the minimum, recognition that the market environment has changed sufficiently to warrant rethinking the time period looked at to determine relative valuation.