In September 2012, with the S&P 500 Index (NYSEARCA:SPY) bouncing around its pre-crisis high of 1,565, I authored, The S&P 500 Today Versus The 2007 Peak, which painted a relatively bullish picture of the market despite the still uncertain market backdrop at that time. With the broad stock market gauge hitting new all-time nominal highs last week, it is important to re-examine the data in that previous article given the further 600 point rally over the past four years, and calibrate current value in the broad market bellwether. Examining today's valuation versus the pre-crisis peak through differences in reported earnings, financial statement trends, index composition, and wealth, employment and inflation levels that are influencing monetary policy should be instructive for Seeking Alpha readers as they ponder the way forward for the U.S. stock market.
When the index was at its 2007 apex, trailing twelve-month earnings were $89.35 per share, producing a P/E ratio of 17.52x. With trailing earnings today at $107.57 per share, the market is trading at an earnings multiple of 20.16x. If the S&P 500 were trading at the same earnings multiple today as at its 2007 peak, the index would be at 1,885, roughly 13% lower than the current market level. When I authored a version of this article in September 2012, extrapolating the previous peak market multiple to earnings at that point translated to an 18% market discount with the same arithmetic. I rebooted the article again in July 2013, and this relative valuation pointed to a market that was trading at an 8% discount. Earnings have climbed post-crisis, but prices have risen even faster, elevating the market multiple.
Even with the market more aggressively priced in 2016, some readers might be quick to point out that too high of a multiple was placed on the market at its 2007 peak, especially given that in hindsight we know that the market was overvalued, given the looming risks. At a 17.5 P/E multiple, the market multiple at its 2007 peak was just a turn higher than the long-run average multiple of 16.5x. Now we are over 20% higher than the average multiple. Of course, investors do not buy stocks for trailing earnings, markets are inherently forward looking. Is today's earnings multiple fair or not? That is what this article will try to discern for readers.
Economic growth in late 2007 was decelerating, and the Treasury yield curve was inverted, a yield curve positioning that has historically been a harbinger of economic recessions. While the Federal Reserve had begun its first cuts of the fed funds rate one month prior to the S&P 500 making its high, it had only been reduced to 4.75%. With the yield on the 10-year Treasury at 4.67%, the market was pricing in additional cuts as growth was expected to slow. Markets were shaken by the collapse of two Bear Stearns hedge funds in June of that year, marking the unofficial start of the subprime crisis. The risk premium applied to asset valuations would prove to be too low as the crisis expanded into a deep financial and housing sector driven recession.
Today, economic uncertainty remains high as financial markets brave the withdrawal of extraordinary monetary accommodation, decelerating Chinese economic growth, the potential fracturing of the European experiment, and heightened geopolitical risk. Slowing global economic growth and the disinflationary pressure of a unique demographic shift in the developed world has pushed interest rates materially lower. With this fall in global sovereign yields, U.S. equity and bond markets have both moved to near-record highs.
While global economic uncertainty abounds, household wealth in the United States (graphed below) has eclipsed its all-time highs, fueled by gains in the stock market and rising real estate values. Total household wealth is now 30% higher than in 2007, but gains have been concentrated in the wealthiest hands. Said differently, those with investible assets have reaped the gains of extraordinary monetary policy. The key to future economic gains domestically will be whether personal consumption, buoyed by these wealth gains and encompassing 70% of economic activity, can offset a more austere government tackling long-term structural deficits and reduced business investment in a less certain economic environment.
Household Wealth Trailing Fifteen Years
Source: Federal Reserve; Bloomberg
Moderating unemployment (graphed below) has further aided consumption, but we may be approaching natural rates of unemployment as we move under government reported levels of 5%. With less people entering the labor force as we approach a cyclical high in employment, continuing to grow domestic consumption will become more challenged than earlier in the expansion.
Above is the rosy picture of unemployment. The darker picture (below) is that despite this cyclical recovery, the labor force participation rate is still near generational lows. Despite the meaningful increase in females in the labor force over this time horizon, the retirements of the aging Baby Boomer generation are lowering the amount of workers relative to the overall size of the population. I believe that this demographic shift is a principal reason why we have not seen wage inflation. With limited pricing pressure on wages, and the disinflationary forces of lower import prices and lower commodity prices, the Fed has been able to stay extraordinarily accommodative, boosting asset prices. Limited real wage gains, sub-trend economic growth, and record asset prices are an unnatural mix. Which will move first?
While the past nine years since the 2007 peak have seen a dramatic reshaping of the economic landscape, the market index has transformed as well. In the table below, investors can get a feel for how the top constituents of the S&P 500 have evolved since the market peak. The top constituents are trading at a much higher average valuation today. Part of this has been driven by a tilt towards technology, with high multiple stocks like Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB) entering the index. Even when excluding the stratospheric multiple of Amazon, the top constituents are still 45% more expensive than the top holdings at the 2007 peak. How much does this matter? These top ten holdings make up 17.7% of the current S&P 500. For investors wanting broad market exposure to the market, equal-weighting may be a preferable option.
Financial Statement Analysis
The S&P 500 and its top constituents are not only trading at higher earnings multiples, the index looks expensive relative to its 2007 peak based on a number of other financial metrics as well. Margins and operating efficiency have fallen. The index does now provide investors with a higher dividend yield. The index constituents also have better liquidity and are operating with much less debt than prior to the crisis.
I believe that this last subsection on leverage and liquidity might be the most important. In the unlikely scenario where the market was faced with the same type of systemic shock as we saw in 2008, companies would weather the storm much better both because of the improved health of their respective balance sheets and also the regulator mandated higher capital buffers in our financial system. If there is less downside today as compared to the previous peak, shouldn't there be a reduction in the market discount rate? We have seen investment grade companies move to re-lever amidst historically low borrowing costs, but leverage is still meaningfully lower this cycle. Will we continue to see debt-financed share repurchases even at market highs?
Speaking of market discount rates, below is a graph of the earnings yield (trailing twelve-month earnings/price) of the S&P 500 graphed against the 10-year Treasury yield over the trailing fifty-plus years. While this article compares earnings multiples in the current market versus the 2007 peak, they almost must be framed against the "risk-free" rate, which is more than 300 bps lower.
The equity market risk premium - the stock market earnings yield less the 10-year Treasury yield, stands at 3.40% today. This metric was just 1.04% at the 2007 market peak.
Valuations are above historical averages and the level at the 2007 peak. The index has tilted away from financials and towards information technology. Market leverage on company's balance sheets is lower even as financing rates have fallen dramatically. To me, this relative valuation boils down to whether you believe that the current market's above-average valuation levels are justifiable given ultra-low interest rates. It is difficult to look at this data and make an especially bullish case. Disliking bond yields does not necessarily mean you have to like stocks. Forward returns are likely to be subnormal with bond and equity market multiples stretched. I am not calling for a big pullback in domestic equities, but forward returns are likely to be below long-run averages with above average volatility.
Please comment below on your own thoughts about the domestic equity market valuation near its new all-time high.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY.
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.