The Market's Underlying Problem

Sep.26.12 | About: SPDR S&P (SPY)

As the S&P 500 crossed 1450, the great debate on whether the market is cheap or expensive, on whether it's a good time to buy or sell, continued.


On the surface, a 1450 print doesn't seem to be incredibly expensive as seen through historic lenses, it comes to around 16 times trailing earnings P/E. Using Shiller's P/E (NYSEARCA:CAPE), things seem a bit less attractive at 22.2 times earnings, which compares to the past as shown in the chart below (source: Online Data Robert Shiller).

Click to enlarge

Now, these earnings multiple measures are in the context of very low interest rates, which make stocks much more competitive with other alternatives. This shows in the present debate regarding dividend stocks. With the 10 year bond yielding 1.68%, it's not a surprise that stocks yielding 2% (the current S&P yield) are somewhat attractive, as they also carry with them the possibility of increased dividends down the road.

The problem

As we've seen, valuation itself is not outrageous. However, there is one large problem. The present market valuation is hugely misleading. Much like during 2007/2008 the market's valuation was also incredibly misleading - and the earnings multiples were close to where they are today.

Why is this so? This is so because back in 2007/2008, the economy was reliant on debt expansion in the private sector at a $2+ trillion pace. And today, it's reliant on debt expansion in the public sector at a $1.4+ trillion pace. Both of these are unsustainable, and without this debt expansion the underlying economy - and underlying profits - stands at a much lower level.

So the market today is, in a way, very similar to the market during 2007/2008 before the equity collapse. The main difference being that the Fed is printing money and will probably print even more. When the Fed prints money to buy assets such as MBS, whoever sells those assets replaces them with other assets, both similar and sometimes, higher risk. This means that the Fed buying gets mechanically translated into demand for almost every asset.

The bet

What this all means, is that contrary to a normal market, the bet that exists in the market today is no longer really a bet on the underlying profitability of the quoted stocks. It's more of a bet on how authorities will behave. Will these authorities cease printing money? Will these authorities try to regain fiscal sustainability?

If the money printing ceases and austerity comes, then the profits that the S&P produces today will be gone, and the S&P will trade much lower. But if money printing continues together with the huge fiscal deficits, then the market can trade higher even if at some point we'll probably see inflation and a dollar collapse.


The market's valuation is illusive. Today's earnings level is being dictated by deficit spending which is running at unsustainable levels. Still, the market's behavior is now completely in the Government authorities' hands, both through deficit spending which keeps earnings at an elevated level, and money printing which seeks to make the deficit spending possible and to inflate assets directly.

In short, it's all artificial. Which doesn't mean it will end any time soon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.