The Great PE Multiple Expansion Of 2011-2014: Why The Market Must Eventually Crater

by: David Stockman

The earnings season is all over except for the shouting, but the outcome doesn't remotely validate Wall Street's happy times narrative. Reported Q4 earnings for the S&P 500 companies (with about two-thirds reporting) stand at $25.02 per share compared to $26.48 in the year ago quarter. That's right. So far Q4 profits are down 5% but shrinking corporate profits is something that you most definitely have not heard about on bubble vision.

That's because the talking heads invariably reference "adjusted" or "ex-items" earnings, which, almost by definition, exclude charges for every imaginable business mistake and bonehead executive action--such as soured M&A deals and "restructuring" expense-- that could possibly cause earnings to go down. For the four-year period 2007-2010, as I outlined in the Great Deformation, the ex-items profit figure hawked by the Wall Street analysts was a cool one-half trillion dollars or 30% higher than the GAAP profits reported to the SEC on penalty of jail time.

But that's just the tip of the iceberg. The real truth coming out of this earnings season is that we have had a tremendous inflation of PE multiples during the last three years in anticipation, apparently, of the US economy hitting escape velocity and the overall global economy continuing to power onwards and upwards. As is evident from the financial news and "incoming" data, however, that presumption is not remotely correct.

So when Wall Street calls a great multiple expansion party that doesn't pan out--what happens next doesn't require a labored explanation. The untoward course of market action in the year after 1999 and 2007, respectively, speaks for itself. But the point here is that the eventual market correction this time could be a doozy. The magnitude of PE multiple expansion triggered when the Fed and other central banks went all in with ZIRP and QE has been enormous, and it has also gone largely unremarked upon.

Back in Q4 of 2011 reported earnings for the S&P 500 during the prior four quarters (NYSE:LTM) clocked in at $87 per share, and that compares to an LTM result of $104.50 reported to date for Q4 2014. In the interim, however, there has been a change in accounting for pensions that is worth nearly $3 per share. So on an apples-to-apples basis, earnings are up by just 17%. This amounts to not only a tepid gain of just 5.3% per annum, but even that was largely accounted for by share buybacks with borrowed money.

Yet under the Fed's all-out money printing regime it did not matter that even these modest earnings gains were coming from financial engineering rather than organic business growth. The S&P 500 index soared from 1100 at the beginning of Q4 2011 to yesterday's close of 2050--or by more than 85%.

Self-evidently, when the stock price index rises 5X faster than per share earnings, the PE multiple must soar. It did--rising from about 13.5X during the last quarter of 2011 to nearly 20X today. Absent the drastic upwelling of animal spirits embodied in the PE expansion, therefore, the S&P index would be at only 1375 today. This implies that upwards of 75% of the stock market gain since late 2011 has been due to multiple expansion alone.

^SPX Chart

^SPX data by YCharts

And that's the heart of the issue. Legitimate and sustainable multiple expansion of this enormous magnitude could only occur if the long-term outlook for economic growth had decidedly improved and the prospect for accelerating profit gains was warranted. But these outcomes are not remotely likely. So the gamblers and day traders in the casino have been essentially capitalizing hopium.

Stated differently, the huge multiple expansion since 2011 rests on the belief that central banks will keep juicing the economy with stock-boosting monetary stimulus until the macro-economy eventual responds, causing jobs, income, growth and profits to lift-off into the Keynesian nirvana of permanent full employment. Thus, the market has not been discounting incoming information; it has been merely pricing-in faith in the Fed.

But the actual incoming information embodies an altogether different story. And the first and most obvious point on that score relates to the lame rationalization that since interest rates are low the stock market multiple should be higher.

Quite the contrary. The current scenario is diametrically the opposite of what happened in the 1980s when there was a very legitimate case for PE multiple expansion. Owing to the eruption of double digit inflation in the late 1970s, the market PE multiple had dropped to 8X because reported earnings embodied a considerable element of pure inflation, and therefore were not entitled to be capitalized at historical rates. However, after Volcker had broken the back of commodity, consumer and wage inflation by 1983, the way was open for a sharp rebound of the corporate earnings capitalization rate, and the S&P 500 PE multiple did rebound to 15X.

In that era there still existed a "market" and it was correct in capitalizing earnings at a deep discount in response to the inflationary policies of the cowardly Arthur Burns and the clueless William Miller, but to also re-rate the value of current earnings once Volcker the Great had demonstrated a return to relatively sound monetary policy and more "normal" inflation rates.

By contrast, 73 straight months of ZIRP is not in the least bit normal or sustainable; nor is today's 1.8% rate on the benchmark 10-year treasury note. Indeed, the fact that the last Fed policy rate increase-a mere 25 bps--occurred 10 years ago is utterly abnormal, even freakish by the standards of prior history.

What has actually happened is that ZIRP was initially rationalized as a temporary policy to ameliorate the financial crisis, and, as such, it should never have been a basis to capitalize long-term corporate earnings streams. But once ZIRP was made quasi-permanent and is now intended to last 80 months at the zero bound, and persist at near-ZIRP for a "considerable" time after that--it provides an especially spurious basis for today's high PE multiples.

As far as the eye can see, corporate earnings will be facing rising interest rates. The 33-year plunge of the treasury rate is over except for the occasional spasm of fear-driven flights to safety. This means that the discount rate on future equity returns should be rising, as well.

Indeed, as a practical matter the aberrant period of ZIRP and financial repression that is now coming to an end has caused a sharp deterioration in the "quality" of corporate earning, even apart from the appropriate discount rate or PE multiple. The S&P 500 companies alone carry upwards of $3 trillion of debt, and the business sector as a whole sports nearly $14 trillion. Accordingly, as interest rates eventually normalize, reported earnings will fall significantly as interest expense balloons. For the S&P alone a 300 basis point increase in average interest rates would reduce earnings per share by upwards of $10.

10-Year Treasury Note

The same normalization dynamic as it relates to the dollar exchange rate will have an even larger adverse impact. The trouble with central bank financial repression is that it gives rise to deformations and malinvestments throughout the financial system. In this instance, the Fed's massive QE program drove yields on government paper and blue chip credits to sub-economic levels, thereby eliciting a massive and relentless scramble for "yield" among money managers and punters alike.

Accordingly, upwards of $10 trillion in off-shore dollar debt has been issued by foreign governments and companies, and most of it in the EM world including more than $1 trillion by China alone. But as the global economy moves into its post crack-up boom deflation phase, and EM economies, especially, experience the double-whammy of rising current account deficits and weakening exchange rates, the massive "dollar short" generated by the central banks during the last decade will go the way of all "shorts". That is, it will generate a desperate scramble for dollars to liquidate unsustainable dollar borrowings, thereby driving the USD exchange rate steadily higher.

For roughly 13 years after the turn of the century, the global boom generated by the worldwide convoy of central bank money printers drove the dollar down and the reported earnings of the S&P 500 upwards. Since upwards of 40% of S&P profits are earned abroad, that beneficent headwind will now become a powerful tailwind. A return of the dollar exchange rate to the early 2000s level, for example, would reduced current earnings by $10 per share easily.

DXY dollar index

Finally, there is the aberrant level of corporate profit margins, as well. That, too, is an untoward fruit of central bank financial repression. On the one hand, it caused a worldwide investment boom that emptied the rice paddies of China and elsewhere in the EM, driving down global industrial wage rates and leaving the US economy exposed to highly uncompetitive labor costs.

At the same time, it gave US businesses access to ultra-cheap debt to fund restructurings, downsizings and severance pay. Stated differently, the global money printing boom of the last two decades has made US labor expensive and debt capital cheap. That has been the driving financial force behind the relentless climb in the profit share of GDP shown below.

But like the inflation driven profits of the 1970s, the margin-driven profit gains of the last decade do not deserve to be capitalized at even normal rates-let alone historically top tick PE multiples. Profit margins are now nearly 2X the historical average, and even if they do not regress to the mean immediately, the odds that they can continue to rise are extremely limited.

In short, the $100 per share of S&P earnings recorded for the LTM period ending in Q4 2014 is the product of aberrant forces arising from an era of central bank bubble finance that is coming to an end. As share buybacks abate, interest rates normalize, the dollar rises and the worldwide deflationary adjustment gathers force, it is exceedingly unlikely that even the current $100 per share earnings level can be sustained.

What is quite certain, however, is that the huge PE multiple expansion of the past three years has nothing to do with honest price discovery. It is the bloated and unsustainable result of central bank driven inflation of financial asset prices and the relentless waves of carry-trade gamblers buying on the dip.

At some point soon the last home gamer will be led to the slaughter. Then the ultimate deflation will happen as PE multiples shrink back to reality.