We are all Keynesians now.
It's no secret that P/E multiples are stretched. Historically rich valuations, however, should be viewed in context of today's highly supportive monetary environment.
The post-Volcker era has been characterized by measurably elevated P/E ratios. On an operating basis, for example, 12-month trailing multiples have averaged 19x over the past three decades and have rarely dipped below 15x. See Figure 1 below.
Figure 1. S&P 500 Vs. Standard P/E Multiples
Trailing multiples suggest something new and different about the post-Volcker era. Unadjusted earnings, however, can be deceptive. Bear markets often produce abnormally weak earnings, causing valuations to appear rich near important market bottoms.
Figure 2 presents an alternative approach. Here, P/E ratios are adjusted for earnings volatility using the John Hussman price-to-peak-earnings (P/PE) method. This technique eliminates earnings shortfalls that often occur during market downturns. The idea is to emphasize earnings capacity over reported earnings. Adjusting the "E" to prior-peak levels produces a normalized multiple, reflective of bottoms as well as tops.
Figure 2. S&P 500 Vs. Normalized P/E Multiple
From a P/PE perspective, equities approached historic cheapness in 2009, reaching a normalized multiple of about 9x. Yet even on a normalized basis, the modern period is the richest on record. The average of normalized multiples in the post-Volcker era has exceeded the average of any prior three-decade period by a minimum increment of nearly 4x. Median P/PE ratios tell a similar story: earnings-based valuations have become persistently rich.
So, why are modern P/E ratios so obviously elevated?
The quick answer is low interest rates. But nominal (and real) interest rates were also very low in the 1940s and 1950s. And the post-Volcker period featured relatively high nominal (and real) interest rates from time to time.
Another factor is the technology bubble of 1995-2000, which helped push normalized multiples above the old ceiling of 20x for a five-year period from 1997-2002. This valuation spike, however, does not explain the brevity of time spent in valuation troughs during the modern era.
A broader, more pervasive explanation is the Fed's increased reliance on the wealth effect as a transmission mechanism to the real economy. During the market crash of 1987, Alan Greenspan promised to support the economic and financial system. Ben Bernanke took the notion to new levels, utilizing equity prices to influence economic trajectory on a routine, non-emergency basis.1 Janet Yellen has little choice but to follow suit. Because the wealth effect works in both directions, it becomes increasingly difficult to "exit" or "normalize," once the path is taken.
Increased reliance on equity prices should come as no surprise. The Fed has been operating under a dual mandate of price stability and full employment since 1978. When the interest rate mechanism is exhausted, the wealth effect is perhaps the only lever available to promote full employment.
Meanwhile, the US economy is more leveraged today than in the past. It now takes nearly four units of total debt (household, corporate and government) to produce a unit of GDP. Prior to 1986, less than two units of debt were required to generate a unit of output.
Leverage, of course, is a two-edged sword, magnifying good times and bad. Today's leveraged economy has become increasingly vulnerable to market and/or economic downturns, suggesting that today's monetary environment may persist well into the future.
So what's an investor to do?
Given the growing importance of equity prices in monetary doctrine, investors should expect higher valuations at market bottoms, and perhaps also at market tops. If the "greatest crisis since the 1930s" produced a single-digit normalized multiple for only three short months, then routine market corrections are likely to bottom at much richer levels - perhaps in the vicinity of 15x normalized earnings. With respect to market tops, the old ceiling of 20x may no longer apply.
Shocking? Not really. If monetary policy is adding 5x to the old range of 8x-20x, then the new range is 13x-25x. The precise figures are conjecture, of course. But like many topics in finance, the notion is worth contemplating despite its difficulty to prove.
The purpose here is not to pinpoint an exact range of multiples, but to stretch the dialogue beyond historic parameters. If a monetary premium exists - as we think it does - don't be surprised by a multiple of 25x.
Absurd, you say? Consider the extreme case of Japan, where interest rates are now negative after two decades of near-zero levels. To stimulate the economy, and perhaps also to protect its own capital from negative interest rates, the Bank of Japan is buying - you guessed it - equities.
If one acknowledges a monetary premium in Japan, one should acknowledge the same in the United States, where short-term interest rates have been pegged below the rate of consumer price inflation for nearly a decade. The difference is a matter of degree. If central bankers are behaving outside of normal parameters, equity prices may also defy the old gravitational laws.
Figure 3. Government yield curves
Monetary conditions, of course, have always influenced equity valuations. But today's reliance on wealth effect has intensified the relationship. Equities are now more than ever an object of monetary inflation. In an abstract sense, central-bank activity has imbued common stocks with a currency-like characteristic. And since currencies have theoretically infinite P/E ratios… well, you get the point. An equity multiple of 25x, or higher, is not irrational in the modern monetary environment.
This is not to say that valuation premiums are permanent. The current monetary environment will eventually pass. It's also possible - though perhaps implausible - that monetary accommodation ceases to work in the familiar way.
While grappling with these thorny issues, investors must learn to deal with today's elevated valuations, and the lower margin-of-safety that implies. Paraphrasing Milton Friedman: We are all momentum investors now.
1 A third round of quantitative easing, "QE3," was launched in September 2012 with the S&P 500 approaching record highs and GDP well above its pre-crash peak.
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. I have no business relationship with any company whose stock is mentioned in this article.