This post expands on the previous post. The chart above uses the normalized value of the S&P 500 index as the "P" and after-tax corporate profits from the National Income and Products Accounts as the "E", in order to calculate a PE ratio. In the previous post, I was examining equity valuations using a combination of profits, current equity prices, and interest rates. In this post, I leave out interest rates; that makes the degree of undervaluation much less, but it ends up telling the same story. Note that this very simple model of equity valuation correctly identified how cheap stocks were throughout the 1980-1998 period, and correctly flagged the grievous overvaluation of stocks in 2000.
Scott:
ReplyDeleteDo you think we should all send our wonderful president a BIG thank you note....plus all of our fantastic state and local politicians for spending $7 trillion dollars driving much of our corporate profits?
This would especially apply to home builders who just received a $3 billion dollar gift from taxpayers.
When profits are simply a function of taxpayer payments....are we really contemplating profits anymore?....does it make a difference if those payments are obtained form deficits?
Very nice graph. This shows valuations similar to the early 1980s and and early 1990s. I was a green young 'un in the early eighties but boy do I recall the bull market from '82 to august of '87. The market bottom of 1991 and the bull market to '95 particularly in bank stocks was a good time for me. I recall the bull markets in both of these decades springing from federal reserve policies and equity valuations similar to what we have had in the last few months continuing to today. If you could see S&P performance from '82 to '87 and '92 to '95 or '96 it would show very nice returns every year. It is my belief that we are seeing a rerun of those years that will not be exact but should rhyme nicely.
ReplyDeleteThe fed should not be raising rates for many months yet so there is little competition for stocks. Valuations should slowly improve as confidence in the economic recovery builds. I think Scott is right on.
Scott:
ReplyDeleteI don't know where you find the time for all of this posting, but I'm truly thankful for it.
You are arguing for equities and inflation. What happens to equities when inflation finally surprises the market?
My understanding is that stocks will take a hit as P/Es adjust downward - that is, as the earnings yield takes a hit just as bond yields do. Is there a way to estimate the magnitude and timing (quarters, not weeks or months) of such an event for stocks? Perhaps I should first ask; do you agree with this general premise?
In my opinion, the high CPI reading of over 5% in July of 2008 was a big reason the market tipped over at that time (although other factors conspired to greatly amplify the market impact). I would love to avoid what I think will be a mini-replay of that dynamic when inflation once again re-surfaces, but I'm not sure it's possible to get the timing right enough or how large the equity market impact will be. Any thoughts on that?
Clarification: In the third paragraph of my previous post it should say "as the earnings yields RISE just as bond yields do."
ReplyDeleteJeff: I have long been in the camp that says inflation is bad for equities. So why am I bullish on equities if I think monetary policy is inflationary? Well, I've got several reasons.
ReplyDelete1) I think the Fed is likely to make an inflation mistake because they won't withdraw reserves soon enough or fast enough. But so far they haven't been put to the test. Will they really end up making a big mistake? We'll have to wait and see. It's not a done deal yet. So while I and many others worry about inflation, those worries may prove overblown.
2) There is a theory that says that inflation shouldn't be a problem for equities no matter what. I don't agree completely with that, but for moderate amounts of inflation (less than 10% per year) perhaps that theory does hold. After all, equity values are the discounted present value of future earnings. As inflation rises, earnings should rise along with prices, and the discount rate should rise as well. Give or take a bit, the inflationary component of earnings could be largely offset by the rising discount rate. So equities probably can sustain a moderate amount of inflation, especially if it's well under 10%. So far we are well below that threshold.
3) I think the market is so pessimistic still that it is in effect already discounting things with a higher interest rate (see my first post today, in which I say that equities are priced to a 10-yr Treasury yield of 8.5%). So a rise in inflation may already be priced in, even though breakeven spreads are still tame.
4) Restating #3 above, earnings yields are already very high (8-9% according to NIPA profits and the S&P500), so the market is has a built-in cushion against higher yields.
5) The bulk of the U.S. experience with unpleasantly high inflation was in the 1970s. It was a truly awful time for the equity market. But perhaps a good portion of the damage was done as a result of Nixon's closing of the gold window and the unexpected and calamitous devaluation of the dollar that resulted. Confidence was shaken to its core. It was all so unexpected and unprecedented. Markets went hog-wild with speculation, and central banks were caught flat-footed. Maybe things won't be so bad next time around.
you are not considering the possibility that the boom crash cycle of the last 20 years may have pushed the equity premium higher.
ReplyDelete