This Market Top Is A Strange Animal

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With occasional blips the P/E of the S&P 500 has been above 20 since 1994.

Three different periods explain the high valuation: 1994-2000, a period of astonishing innovation.

2001-2008, a stimulative war, lower taxes and lower interest rates.

2009-2016, TARP, Stimulus Bill of 2009, three Quantitative Easings.

A weird situation has developed, earnings have uncoupled with stock prices, with stock prices increasing and earnings decreasing.

I come back to my pet subject of the extraordinary long time the S&P 500 has had a P/E above 20. The fact that I see so little written on the subject is unsettling. This is an exceptional period in the valuation of the stocks, and everyone is taking it for granted. It wasn't so long ago that everyone took ever increasing real estate prices for granted.

Again I am using Robert Shiller's jiggered data, which takes a ten year average of the earnings, and so gets rid of extremes. The straight data mostly just confounds the picture. Earnings will pick up again, so a momentary very low or negative earnings number can make the P/E (Stock Price per share/Stock Earnings per share) incomprehensible.

Here's the problem: the P/E has been above 20 since 1994, or 22 years. This is multiple times the previous record of a measly six years, 1963 - 1969. I find this aberration should be dealt with more, if only so we might understand how the underlying dynamics will play out, and if it ends, how it will end. Or maybe it's different this time, as they always say at the end of a stock market bubble.

Years in which the S&P 500's P/E has been above 20

1898-1902 - 4 years

1928-1930 - 2 years

1963-1969 - 6 years

1993-2015 - 22 years and counting.

Three Blocks of Time

My analysis is that this extraordinary run of a high P/E does not bear a single explanation, like a 22 year period of extraordinary earnings. That would have been the best possible rationale. As it is, I divide it into three blocks of time. The first block of time, 1994 through 2000, is pretty easy to explain. Innovation had its day in the sun:

1) The build out of the Internet, the fiber-optic cable and related hardware together with all the software for the internet from browsers to portals to websites created phenomenal activity.

2) The widespread use of cell phones and related networks (towers, connecting cables).

3) The personal computer, which began in the 1980s, saw it reach maximum saturation in the 1990s.

You will recall all the times that Alan Greenspan spoke to the Senate of much higher productivity than he ever expected. These innovations explain that productivity. This is the period which makes the most sense of the three blocks I have identified, earnings are increasing with stock prices.

The second block of time, 2001-2008, is a little more difficult to explain. One would have thought the bubble bursting in 2000 would be enough to bring on a 1929-like share price crash to earthly levels, but no. The P/E which reached its high point of 44.20 in December of 1999, stayed well above 20 straight through to 2008. Amazing. Here are some reasons why:

1) Operation Iraqi Freedom was stimulative, as wars tend to be.

2) And just when the Wall Street Journal thought taxes would go up to pay for the war, Bush and a Republican Congress went the other way and cut taxes. So, a double dose of stimulation.

3) Interest rates came down, and I remember reading articles about how zero interest rate car loans would be stealing demand from future years. Also stimulative.

Finally, it all ends rather badly. The housing market crashes, and the derivatives market makes the whole thing even worse, so AIG has to be bailed out as well as Wachovia, Washington Mutual and Countrywide Financial. Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) also got the preferred stock treatment that the big banks got, but on the road to recovery, the government itself seems to have become the highwaymen, got rather greedy, and Treasury, which had taken them into receivership, decided it would take all of Fannie Mae's and Freddie Mac's profits, the so-called sweep. They have never come out of receivership, in essence making Fannie and Freddie into a de facto government agency. This has prevented them from restoring their retained earnings so they failed stress tests recently. This situation is in the courts, and while the courts may ultimately upbraid Treasury, and put these institutions back on track, you're going to need a strong stomach. Court decisions so far have not been favorable.

But returning to the crisis of 2008 the P/E only dropped below 20 for fourteen months reaching a bottom of 13.32, and it only blipped below its long time average of 16 for six months. The whole thing looks like a mere aberration, a blip, and it has been above 20 ever since.

Then, of course, the government took action, and we have the third block of time:

1) TARP protected the banks.

2) The Stimulus Bill of 2009 was a program of $700 billion of spending. Taxes were lowered again, and the bill created some $50 billion of highway work for those projects that were "shovel ready."

3) Interest rates dropped to near zero.

4) Three programs of unusual Quantitative Easing were initiated by Fed Chairman Ben Bernanke in the face of a broken Congress, which did nothing further in the way of spending, probably the preferred method of stimulation. At billions per month, sometimes $80 billion in a month, the Fed bought in the three programs a total of $4.5 trillion of mortgage bonds. The owners of the mortgage bonds received that $4.5 trillion of cash, and they were faced with a problem. What do with the cash?

With interest rates at zero, investors had trouble finding suitable vehicles to place all of that cash, so the stock market received a lot of that money, and has created, I believe, a bubble. And there you have a good part of your explanation. And so there you have a story of the last 23 years of high P/E's. But there is more to tell.

The Goldilocks Economy

A high P/E can be a helpful thing to a central banker like Bernanke. With a rising stock market, the populace feels wealthier, their 401k's statements are fun to read, and so they spend more. It has helped the housing market recover, for instance. People, who feel poor, will not buy a new house.

And the beauty of a low-growth, high unemployment economy, is that business has all time low costs. Low cost of money. High unemployment has meant there is no pressure on job costs. And for a while, earnings increase without any wage increase hindrance. All good for the economy in recovery, and good for stocks.

But there is a dark side to low-growth, no-growth Goldilocks. Earnings eventually will stagnate because you need high employment to drive sales. For a truly robust economy you need a healthy middle class to do the buying that creates demand and jobs, and for Wall Street, the growth in earnings. And this has started to happen.

No, not the robust economy with the surging demand of a healthy middle class. GDP growth is 1%. No, I mean the other thing. If the middle class is not robust and not doing the buying necessary to drive the economy, then eventually you have stagnating revenues and earnings. And that's what we have - stagnating earnings. According to Robert Shiller's spreadsheet, earnings peaked in September of 2014, nearly two years ago.

Date Index Earnings






































































So Things Really Are Different This Time - A Liquidity-Driven Stock Market Peak

Typically, earnings are increasing as stocks are increasing. Earnings increased quite significantly during the bull run from 1920 through 1929. There was some up-and-down along the way, but earnings again were increasing again from 1927 through to the peak of September 1929. The Crash occurred the following month, October. Earnings peaked in December 1929, which makes sense if you think of the stock market as a forward-looking, discounting mechanism.

Earnings were increasing up to the 1966 top; same for the 1973, where earnings increased for another eight months after the top. Earnings were also increasing up to the 2000 market top. And this seems to be the case for all the data we have, but it is not a huge data set, a mere 145 years.

I have developed a term for economic anomalies like this one, where earnings are going south and stock prices are hitting new highs. Oxymoronomics. (Preferred pronunciation is oxy-moro-nomics). Mind you, even though I have developed a pronunciation which is easy on the tongue, the "moron" is still in there.

This is the first time in that 145 years where earnings are going south, while all the major stock market indicators are hitting all time highs. Stock market mavens are telling us earnings will be increasing later this year, which would make the activity in the stock market congruent with the earnings. That would be a good thing.

Perhaps for deep learning, it is not sufficient just to go back to The Great Depression, on which Bernanke is an expert. Casting about for a like situation brought me round to the moment that John Law first brought paper money to France in 1720. John Law's initial paper money proposition developed when he was Scotland. He proposed that the lord of a very big estate could create smaller denomination mortgage notes, which people could exchange instead of coins. The estate's value was well-established. The idea evolved. Fiat currencies were not far behind. In the nineteen century paper currency was tied to gold. That was eventually discontinued in the twentieth century. A currency was then tied to the economy's overall size. Money supply to GDP.

So, at the same time John Law became the finance minister for France, he was also put in charge of what we in the English speaking world call The Mississippi Company (Compagnie française pour le commerce des Indes orientales), which consisted of all of the French possessions in North America (what subsequently became the Louisiana Purchase). There was not much that came from that property, none of what the Spaniards brought home from South America - gold. But there was little to buy with this new found paper money but stock in The Mississippi Company, which they all did. Shares skyrocketed, and then confidence waned, and the shares fell.

John Law knew the shares were too high, and he tried to bring things in line - he closed the window to buy and sell shares, which was a disaster. He opened the window again, another disaster. He insisted all gold be traded for paper money (that did not work, of course). He knew things were out of control, but he couldn't put the genie back in the bottle. Shares cratered. The Mississippi Company became The Mississippi Bubble. He was lucky to escape with his life. And paper money was set back years.

And now we come to Janet Yellen, she's a bit in John Law's shoes, how to create a soft landing. Yet more and more she needs to keep her lips to the balloon that the stock market has become.

The Confidence Game

The problem with a fiat currency, and for that matter, for all markets, is that they are a bit of a confidence game. Most of the time this works reasonably well - as long as the economic output is in line with the stockpile of currency. There are various terms for the money supply M1, M2, and so on. But maybe in the end, we should be looking at sum of all financial assets.

When these things are out of line, then there can be collapses back to a more normal situation. We are getting signs of this kind of a lack of alignment. Both Bill Gross and El-Erian, formerly of PIMCO, separately have come to the conclusion that it would be best to move assets to safe havens. Gross has suggested gold and hard assets, El-Erian has suggested stocks that don't trade frequently.

Unfortunately, collapses can be quite painful. In 1933, the German people voted in a strong man who subsequently became a dictator. That is the scale of the downside risk if a central banker gets it wrong.

Not to put it all on the central banker. During the Great Depression, you had Congress raising the top tax rates from 25% to 62.5% by a Republican Treasury Secretary, centimillionaire, Andrew Mellon, to balance the budget. Bad timing. We hear little about balancing the budget these days. You also had a terrible trade policy with Smoot-Hawley, in which tariffs were raised. More bad timing. And the Federal Reserve did not provide liquidity, which Milton Friedman has written about. Everything guaranteed to make the depression not only deep, but long lasting.

Bernanke's Extraordinary Risk Gamble

Ben Bernanke used every weapon in his arsenal to defeat the economic woes in 2008. He lowered the discount rate to .50%. It currently sits at 1%. For reference, it stood at 6.25% in 2006. Then he did a more controversial thing. He used what the Federal Reserve calls Large Scale Asset Purchases (LSAP), and what the press calls Quantitative Easings (QE). In three easings, the Fed bought $4.5 trillion in treasury securities and mortgage-backed securities of Fannie Mae and Freddie Mac.

The seller of those bonds was faced with a problem, which was how to deploy the cash they received from The Fed for their bonds. Just about everyone today knows that banks are paying close to nothing in interest for deposits. And that is the situation across the wide spectrum of interest bearing instruments. So, a lot of money has found its way into the stock market, and so you have this unique situation where the stock market is reaching new highs while earnings are not confirming this (so far). It is not an earnings-based stock market peak; it is a liquidity-based bull. A new animal, and to my mind, a very strange animal.

The risk is this: mortgage bonds are relatively stable, since their pricing in normal times is closely connected to the interest they are paying. The stock market is a much more volatile investment instrument. So, The Fed has increased risk in the national portfolio, if you will, when it substituted stodgy, non-volatile investment bonds for much more volatile stocks.

One can hope over time that these imbalances can be closed without a horrible crisis. The mortgage bonds The Fed has bought will mature, and its balance sheet will come down. If the economy picks up, then the gap between the stock market and earnings will close.

Are Stocks Really High? Is there confirmation?

I have focused on the S&P 500 as a proxy for the entire market, but Warren Buffett does just that. He takes the market cap of the entire market and divides it by the GDP to see just how high the market as whole is doing. Below is a graph from the Federal Reserve which shows this going back to 1950.

I offer this commentary: Notice that the market seems basically underpriced for years and years, from 1950-1995. And it has been basically overpriced since 1995. So, if it is underpriced for 45 years, it could very possibly remain overpriced for decades. Though one needs to realize how dramatically overpriced it was in 1999-2000. But given these huge waves, it would be fatuous to call a hairpin turn at this point.

Goldman Sachs says another measure suggests stocks are high. David Kostin of that firm says, "The historical relationship between return on equity (ROE) and price/book (P/B) shows investors penalize falling profitability with lower valuation." And adds, "However, despite the steady 200 bp decline in S&P 500 ROE to 14.1% during the past 8 quarters, P/B has actually expanded to 2.8x and is above the 40-year average of 2.5x." Look here for more.

Interestingly, the firm Goldman Sachs itself has been suffering stagnant revenues for the past few years at $34 billion, but with declining earnings. So, it has suffered some fall back in its stock price, and that is what I am speaking to for the market as a whole.

What Do the Investment Advisors Say Now?

Jeremy Grantham called the market high-priced in 1997, when the P/E went above 33, where it had not been since 1929. He lost a lot of customers as the P/E went to an unprecedented 44 in 1999, then, of course, it went down.

In February, he's calling it "very overpriced" but not a bubble. See here for more.

Mohamed El-Erian says the market has been driven by liquidity, which is the point of this piece, so he advises to stay away from publicly traded stocks, and keep an equal portion of cash in a barbell strategy he speaks of here.

He is also concerned about a market uncoupled from earnings.

His former teammate at Pimco, Bill Gross, has expressed concern about the market:

"I don't like bonds; I don't like most stocks; I don't like private equity. Real assets such as land, gold, and tangible plant and equipment at a discount are favored asset categories."

Read more here.

The Future and Investment Advice

Since the stock market bottom there have been a couple of 10% corrections. There was a pretty significant decline 2011, but there has not been a full-on 20% bear market since 2008-09, so we are probably due. A re-pricing of stocks to lower P/E's is possible. The presidential race could cause such a decline either before or after the election, but it seems to me the real risk is still China. Look here to read how the Chinese have used debt to meet the government's economic goals. There may be limits to the use of debt for the Chinese as well as Americans.

On the positive side, it has been a while since the innovation machine has turned out lifestyle changing devices. The smartphone came on in the last decade. Perhaps the next wave of invention is already in news. Apparently, the Jetsons are on the way. We will see drone-cars in the not too distant future. It will come on like all such inventions. First the rich will get them, and then everyone. These will drive the economy for years. That's my take.

The happiest remedy to the current situation would be one in which GDP and company revenues and earnings increase and bring down the high valuation of stocks. But sometimes innovation and federal spending do not come to the rescue in the nick of time.

Unfortunately, it looks like the election, whoever gets elected, will not have the confidence of the people, and so much of our economic life relies on confidence, so an election in which neither candidate has strong backing could very well trigger a re-set of stock market prices to very much lower prices. And while the norm of the P/E is between 15-16, it could, like a golf ball, scoot past the cup, and drop to single digits, where it sat during the 1970's and 1980's.

On the other hand, as I stated above, the market was undervalued for decades, it may remain overvalued for quite a while. Whatever happens, the current situation where stock prices are uncoupled from earnings is not a healthy situation. We will hope for the best possible resolution, though it looks a good time to build cash, and rejoin the stock market when prices are tied to earnings.

Disclosure: I/we 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.

Additional disclosure: Thank you for your comments. I was chagrined to find an article that I had worked on (on and off) for a couple of months had such an obvious flaw. I have re-read it, but sometimes when you have read something so much, your brain fills in missing words. I have tried to the links the way you want.

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