Originally published on ecpofi.com on 3 January 2014.
Real Earnings- and Dividend yields (10-year rolling averages) as of 31 December 2013
The S&P 500 index increased 2.64% since the previous report was issued on 3 December. As 10-year average real earnings only increased 0.17% during the same period, the real earnings yield dropped 2.48% (10 basis points) to 3.91%. As a result, the earnings yield remains the lowest it's been since December 2007 and is now 33.92% lower than the average since 1978. Removing the 1998 to 2000 period (when market prices were "off the charts") the current earnings yield is 37.29% lower than this adjusted average.
As the 10-year average real dividend only increased by 0.17% since early December, the 2.64% increase in the S&P 500 index drove the real dividend yield down by 2.36% (4 basis points) to 1.47%. This remains, as is the case with the real earnings yield, the lowest since December 2007. The current real dividend yield is now 44.13% lower than the average since 1978 and 46.86% lower than the adjusted average (which excludes the 1998 to 2000 period).
The Spread as of 31 December 2013
The spread, the difference between the 10-year average real earnings yield and the 10-year U.S. treasury yield, narrowed substantially for the second month running. Having dropped 16.20% from October to November, it dropped 24.75% from early December to end December on 0.91%. This narrowing of the spread was driven by the 2.48% reduction in the earnings yield and a 8.07% (23 basis points) increase in the 10-year treasury yield since early December. The last time the spread was below 1.00% was in April 2011. Though the spread narrowed by 69.54% (208 basis points) during 2013, it remains significantly higher than the negative 0.85% average since 1978.
2013 was a remarkable year for U.S. equities by any standard with the S&P 500 index increasing almost 30% to record the best year for 18 years (1995). This increase was however not driven by an increase in earnings (which increased "only" 6.37% on a 10-year average basis during the year). Nor was it driven by a reduction in the 10-year treasury yield (which increased 69.54%). Rather, the price increase of the S&P 500 index was driven largely by an expansion of the P/E multiple which increased by more than 20% during the year. In addition, the S&P 500 has significantly outpaced any improvement in the real economy. For example, the S&P 500 to GDP ratio is rapidly approaching record territory:
- The S&P 500 to 10-year average GDP ratio is now approaching the previous high from Q1 2007.
- The S&P 500 to 4-quarter average GDP has now surpassed the previous record from Q1 2007 though it is still lagging the all-time record high set in Q2/Q3 2000.
What then caused this expansion in the P/E multiple during the year? In my humble opinion the Fed has managed, again, to create another stock market bubble in the U.S. through flooding the market with freshly minted fiat money (by way of monetizing Federal debt). In 2013 alone, the Fed expanded its balance sheet by more than US$ 1 trillion (yes, trillion!), an increase of more than 38%. Going a bit further back to 2009, the Fed has since expanded its balance sheet by almost US$ 1.8 trillion, or more than 80%!
While the 1994 to 2000 (+185%) and 2003 to 2007 (+64%) S&P 500 stock market rallies were driven by aggressive bank credit growth (with the full support of the Fed of course, read: the taxpayer) the 2009 to 2013 (+110%) rally was driven by the Fed alone (as it is "independent", it does not have to support public spending through monetizing the Federal debt, right?). I say this because Bank Credit outstanding only increased a grand total of only about 8.5% from the end of 2008 to the end of 2013 and by only about 0.4% in 2013. This bank credit growth is very low compared to the longer term average. Since the end of 2008 however, M2 money supply outstanding increased by more than US$ 2.8 trillion, or 34% plus change. The majority of the increase in money supply starting in 2009 was hence generated by public spending monetized by the Fed rather than banks creating credit (and hence money).
There can be no doubt that a big chunk of this new fiat money orchestrated by the Fed has eventually found its way into the U.S. stock market as reflected in an earnings yield for the S&P 500 index which is now almost 34% lower than the average since 1978. Regular readers of this blog will be familiar with this reasoning. Here's however a quick recap on the subject by professor Jesús Huerta de Soto (Money, Bank Credit, and Economic Cycles, 3rd ed, p. 461-462),
In an economy which shows healthy, sustained growth, voluntary savings flow into the productive structure by two routes: either through the self-financing of companies, or through the stock market. Nevertheless the arrival of savings via the stock market is slow and gradual and does not involve stock market booms or euphoria.
Only when the banking sector initiates a policy of credit expansion unbacked by a prior increase in voluntary saving do stock market indexes show dramatic and sustained overall growth. In fact newly-created money in the form of bank loans reaches the stock market at once, starting a purely speculative upward trend in market prices which generally affects most securities to some extent. Prices may continue to mount as long as credit expansion is maintained at an accelerated rate. Credit expansion not only causes a sharp, artificial relative drop in interest rates, along with the upward movement in market prices which inevitably follows. It also allows securities with continuously rising prices to be used as collateral for new loan requests in a vicious circle which feeds on continual, speculative stock market booms, and which does not come to an end as long as credit expansion lasts.
When reading the above, please note that money expansion generated through the Fed monetizing government debt ultimately has an indistinguishable effect on the stock market (and other asset prices) compared to money generated through increases in bank credit.
The S&P 500 index is not the only U.S. stock market index to post a huge gain for 2013; all but one of the U.S. stock market indices I follow on a regular basis surged during the year and have climbed way above the record highs from before the collapse of Lehman Brothers in September 2008:
On average, the indices in the table above increased by 32.2% in 2013 with a median increase of 34.1% (as of week ending 27 December), with the Wilshire US Micro-Cap Total Market Index surging a whopping 50.2%. All indices, except for the Wilshire US REIT index, are also significantly higher than their peaks prior to September 2008. Some of these all-time highs set by major stock market indices in the U.S. has led me to publish a series of "bubble charts" in recent days (e.g. here and here).
As stated above, Fed balance sheet expansion was, in my opinion, the major driver of U.S. stock market euphoria and returns in 2013. For 2014, the Fed balance sheet will increase by about 22% based on the Fed buying US$ 75 billion a month in longer term treasuries and agency mortgage-backed securities. Though a significant increase, it is nonetheless substantially lower than the 38% increase in 2013.
Therefore, unless money supply expansion generated by U.S. commercial banks picks up in 2014, the decrease in the growth rate of the Fed balance sheet combined with a significant slowdown in the growth rate of government debt (at 4.2% in Q3 2013, compared to 8.6% during the same period in 2012) will prove strong headwinds for money supply growth in 2014. And a significant reduction in money supply growth will be decisively bearish for equities. More importantly, such a slow down has been in the making for most of 2013 (e.g. see here) and if it continues the next stock market crash and so-called "financial crisis" is not too far ahead.
In conclusion, the combination of a high stock market valuation of the S&P 500 index, record increases in all but one of the indices in the table below, the significant increase in the 10-year treasury yield since May, the low personal savings rate, financial risk indicators hitting record lows, weak U.S. commercial banks equity to total asset ratios and a slowing down of the money supply growth rate which is already underway, means that I am now very bearish for U.S. stocks in 2014. Not to mention the debt crisis in both the U.S. and the EU (yes, they have not magically disappeared). There are simply too many indicators signalling the U.S. stock market is peaking or at least indicating a substantial probability that equities will not perform well over the next few years. In short, there is simply too much risk and too many things that could go wrong to justify being a longer term buy and hold investor in U.S. equities at this stage.
A significantly improving money supply growth rate could prove me wrong, but this would only serve to make the inevitable fall that much heavier.
Finally, here is a post from this summer titled Lessons Worth Remembering: Who Predicted the Bubble? Who Predicted the Crash? which is worth revisiting or reading if you have not already done so:
Mark Thornton some 10 years back wrote an article titled "Who Predicted the Bubble? Who Predicted the Crash?" where he discusses who predicted the 2000/2001 bubble and crash.
On pages 22 to 24 he writes the following which is worth noting given the current lofty price of the S&P 500 (even though it has fallen a bit during the last month) and the Fed's expansion of the monetary base and keeping interest rates low:
In general there were two categories of correct predictions. The first group was based on analysis of valuation. Using standard measures of stock market value such as the price-to-earnings ratio (P/E), economists such as Robert Shiller and a number of market analysts who were bearish in 1999 felt that the stock market was extremely overvalued and that therefore the stock market was experiencing bubble-like conditions and fated to steep decline.
Unfortunately, most of these forecasters did not provide detailed economic analysis of their predictions. The use of valuation measures is indeed a useful guide, but is essentially a tool of historical analysis-comparing ratios and percentages from one time period to another or against historical averages. The majority bulls always found some way to adjust the valuation measures to account for modern conditions and to make the stock market look undervalued.
The second group of correct predictions came from outside the mainstream of the economics profession. Most of these predictions came from the Austrian school of economics, including academic economists, financial economists, and fellow travelers of the school. These predictions begin in 1996 and continue until after the downturn in the stock market began, but most of the prediction occurred close to the peak in the stock markets. Given that the Austrian school is both small in number and marginalized in the profession, their dominance in making correct predictions seems like an elephant in the soup bowl. It is a particularly interesting finding given the Austrians' general disdain for forecasting and the mainstream's requirement for prediction.
It is especially noteworthy that the Austrian predictions all provided an economic explanation of the bubble and that their explanations were relatively consistent across the group. To generalize, they saw the Federal Reserve as following a loose money policy that kept interest rates before the rates that would have existed in the absence of inflationary monetary policy. Individual writers emphasized the willingness of the Federal Reserve to consistently bail out and rescue investors during the 1990s, thereby desensitizing investors to risk. As a result, a period of "exuberance" and wild speculation took place building into the hysteria of a stock market bubble. If the Austrian analysis is correct, this would suggest that the Federal Reserve is a significant source of financial and economic instability. It also suggests that the general bias to keep rates as low as possible can cause significant losses in the economy and that a better policy might be to let interest rates be determined by market forces, without the intervention of the Federal Reserve.
Those who discovered the "boom" in the economy, the "bubble" in the stock market, and predicted either a "bust" in the economy, or a crash in the stock market work within a tradition of analysis dating back to Richard Cantillon, whose book An Essay on the Nature of Commerce in General was published in 1755. The Cantillon tradition was carried forward and extended in the works of Turgot, Say, Bastiat, Menger, Wicksell, Bohm-Bawerk, von Mises, Ropke, and Hayek, and is now home in the modern Austrian school of economics, with which many of the successful predictors identify themselves.
The hallmark of this mode of analysis is an emphasis on entrepreneurship and the causes for prices to rise and fall, encompassing wages, rents, profits, interest, and the purchasing power of money. With respect to the business cycle, the Cantillon tradition shows that disturbances in the supply of money and credit, especially when a monetary authority expands the supply of paper money, changes relative prices in the economy. Artificial reductions in interest rates encourage investment and increase the valuation of capital assets. The resulting alternations in the structure of production (buildings, technology, and the pattern of industrial organization) are called Cantillon effects. This is the boom-a phase when resources are misallocated, both to malinvestments and misdirected labor. As relative prices correct themselves in the bust, resources are reallocated via such mechanisms such as bankruptcy and unemployment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.