We have written about the apparent long-term valuation cycles in the stock market, and one of our core beliefs is that right now the markets are in the midst of a long-term valuation contraction. As we have noted in our previous articles, that doesn’t mean the market can’t rise - it just means it is likely to rise at a slower rate than earnings grow. Typically such cycles have not reversed until P/E multiples were in the single digits. This past week, there was a different take on the phenomenon presented at Econoday:
Remember back if you will to the days of Y2K and earlier when Alan Greenspan was warning of “irrational exuberance.” Perhaps I was the one elbowing you in the Charles Schwab line. Those were times when there was an opposite play between profits and share prices, when share appreciation greatly exceeded profit growth as will be seen in the final graphs of this short take. The graph below shows the ongoing play between profits and shares.
The green bars are the same as the first graph, representing year-on-year S&P 500 profit growth. The orange bars are year-on-year changes in the S&P 500 index. The left side of the graph shows that the index was contracting even while profit growth was emerging. Growth between profits and stocks then matches up well in late 2003 and early 2004 before stocks begin to lag again. Stock growth has in fact lagged now for 10 straight quarters up to the third quarter where the bars are highlighted. The graph suggests, at the least, that speculative excess is not a threat to the stock market.
Possibly. It depends on what you consider to be rational behavior. It is one thing to think 15 is a low multiple when the valuation cycle is going up, and quite another to think it is low if multiples are headed lower.
At any rate, the chart shows that in only 3 of the last 22 quarters, the market grew faster than earnings on a year/year basis. The fact that there were a few shows that one or two in a row does not invalidate the multiple-contraction thesis. So that’s our story. And we’re sticking to it.