Sunday, December 23, 2018

Equity valuations have improved dramatically

With the price plunge which started in early October, the PE ratio of the S&P 500 (using Bloomberg's measure, which is based on 12-mo. trailing earnings from continuing operations) has fallen from a high of 23.3 last January to 16.48 currently. To put this into perspective, consider that today's PE ratio is below the 60-yr average of this measure (16.9), and it is about equal to the market's PE ratio just prior to the onset of the Great Recession. Relative to the current yield on 10-yr Treasuries (2.79%), stocks now boast an earnings yield (the inverse of the PE ratio ) which is 3.3 percentage points higher, whereas it was only 2 percentage points higher at the end of 2007, and it has averaged only 0.4% over the past 60 years. Looking ahead, the S&P 500 is priced to a mere 14.2 times 1-yr forward expected earnings. In short, and during the course of a year in which the economy has grown 3%, stocks have fallen from an arguably over-valued level to now outright cheap. And the Fed hasn't even begun to tighten monetary policy (though the market certainly fears they will).

Clearly, the market has lost a tremendous amount of confidence in the staying power of earnings and the health of the economy. Otherwise, stocks today would be a screaming buy relative to just about any other risk asset. Sure, there are lots things to worry about: Trump, China, tariff wars, a US slowdown, and another government "shutdown." But there is nothing preordained about how these worries will be resolved. Lots of things can change, and meanwhile the economy's fundamentals remain rather healthy (fabulous corporate profits, very low unemployment, rising wages, a reasonably strong dollar, unusually high consumer confidence, and very low swap spreads). It's not hard to be optimistic when the market is suddenly so pessimistic.

Chart #1

As Chart #1 shows, PE ratios last January climbed to a high of just over 23 on the strength of corporate tax cuts (and the promise of higher after-tax earnings). Now that the tax cuts are a reality and we've seen the growth in corporate profits, It makes sense for PE ratios to back off a bit. But to a level that is below the long-term average?

Chart #2

Chart #2 shows the difference between the earnings yield on stocks (the inverse of the PE ratio, and the dividend yield that would accompany stocks if corporations paid out all current earnings in the form of dividends), and the risk-free yield on 10-yr Treasury bonds, is 3.3%. Investors currently demand an additional 330 bps of yield in order to accept the perceived additional risk of stocks vis a vis Treasuries.   More often than not, however, the equity risk premium is far lower than it is today. During the boom times of the 80s and 90s, the equity risk premium was negative. Investors were so confident in the stock market that they were willing to give up yield in order to benefit from an expected price appreciation. Once again, investors are consumed by pessimism and fear.

Chart #3 

Chart #3 shows the latest estimate of after-tax corporate profits (this accompanied last week's revision to Q3/18 GDP figures). Profits surged some 20% in the year ending last September. Similarly, 12-month trailing reported (GAAP) profits grew almost 23% in the year ending last November. And now the market seems to be thinking that all of this will go up in smoke.

Chart #4

Chart #4 shows the ratio of corporate profits to GDP (using the ratio of the two lines in Chart #3). Profits have been running at the historically unprecedented level of 10% of GDP for most of the past 9 years. Maybe this is unlikely to continue; maybe profits fall back to 8% of GDP. That would still be well above the long-term average. Why shouldn't PE ratios also trade above their long-term average, especially considering the generally low level of interest rates?

Chart #5

Chart #5 compares the earnings yield on stocks to the yield on BAA corporate bonds (a decent proxy for all corporate bond yields). Corporate bondholders get first claim on corporate profits, with equity holders last in line. Since the yield on corporate bonds is safer than the returns promised to equity holders, it only makes sense for equity investors to accept a lower earnings yield—as they did for most of the 80s, 90s, and early 00s—because they expect to receive capital gains in the future (which in turn implies an optimistic outlook). The periods during which the reverse held (i.e., when earnings yields exceeded bond yields) were generally dominated by fear: e.g., the late 1970s, and the years following the Great Recession, and now. Today, the fact that earnings yields exceed corporate bond yields is a sign that investors are worried about the future and are thus willing to pay a premium for the safety of corporate bonds. (Note: This paragraph has been re-written from its original version to more accurately and correctly describe the message of Chart #5.)

Chart #6

Chart #6 compares the market's worry levels (the Vix/10-yr ratio) to the level of stock prices. We're deep within another bout of anxiety, and prices have fallen some 18% from their recent all-time high. It's not hard to imagine fear reaching even higher levels—commensurate with prior episodes of panic attacks—and prices even lower levels. But at today's levels prices are "vulnerable" to any good news.  Maybe the Fed will reconsider its plan to raise rates twice next year; maybe China will deal (actually they already are offering concessions); maybe the government shutdown won't prove any more painful than before. 

Some words of wisdom distilled from several famous investors: 1) The price of a stock is only important on the day you have to sell it. 2) One should delight when stocks become cheap, not despair.

UPDATE (12/24/18: 10:00 PST) Looks like the panic is close to reaching levels associated with the worst of past selloffs. Here's the latest version of Chart #6:


  1. Is the market more fearful of two more years of Trump or as JBG might say, the prospect that in 2 years we will lurch too far to the left and get a socialist for President?

  2. Too many on one side of the boat right now.
    In other words, the pendulum swings too far to either side at times.
    Maybe sheep being led to slaughter.

  3. Pundit on, Scott. The general opinion of the official financial faces is that it is foolish to even think of going long, let alone actually buy anything in the semiconductor business. That has always been a reliable sign that the chances of future success have been discounted to zero.

  4. Along with Scott's excellent analysis, this piece puts things in perspective:

  5. The advice will always hold true I recieved from the top brokers at Wayne Hummer in 1975 - the secert to investing is "buy low, then sell high." S&P 500 / VIX chart is clearly indicating stock values are a very good Christmas present.

  6. The stupidity of the Trump admin knows no bounds:

    So because stocks have dropped 17% we need a "plunge protection team"?

  7. Price to sales are way above the average - your argument only holds if margins don’t mean revert

  8. Scott- You've seen quite a few bulls, bears, and corrections I'm sure. I just don't get the hoopla surrounding this correction being referred to as blood in the streets. Agreed this is a good valuation reset but I feel it is a far cry from blood in the streets.

  9. Since the crash, the US market has outperformed the ROW by about 100%. This is just too far. We will lose relative to ROW, maybe 25%. Here's a couple of charts:

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  11. pangloss won't relent until he satiates his ignominious need for attention and another "correct call", heedless of the harm he inflicts on others. i wonder what circle dante would assign him to? chart after chart swirling in his head, pity the pitiful so consumed by vanity.

  12. Anti-pangloss, people read this blog and can draw their own conclusions-or do you assume that everyone is a sycophant and just follows one perspective? I find your comments puerile to the extreme. Seriously, grow up.

    Oh, and Merry Christmas!

  13. Merry Christmas Scott and God Bless Everyone!

  14. steve; first render sycophant appropriately in a sentence, then we can talk.

    oh, and puerile stands on its own. adding "in the extreme" is petulant.

  15. puerile stands on its own...
    I'm glad to see someone is standing up for non-quantitative adjectives. The worst is "most iconic."

  16. Love the numbered charts.

    One could argue Wall Street was richly priced until recently, but no more.

    There is a risk out there one that is little discussed.

    Mainland China is becoming an increasingly repressive society, and the Communist Party of China is inserting itself into state-owned and private enterprises at an accelerating rate.

    Multinationals have placed critical supply chains into what may be a highly unstable situation. As there is a permanent news blackout in China, as Westerners we really do not know what is happening inside the black hole.

    It is a curious day when the largest multinationals become apologists for the Communist Party of China. Strange bedfellows indeed. But when GM produces more cars in China than in the US, one cannot really expect GM to demand that Beijing honor commercial, property, or human rights. The world's largest investor, BlackRock, is heavily exposed to Beijing policies.

    Perhaps the stock market is recognizing this risk.

  17. There is so much to say, so much noise. You must condense hard to get close to just a mild conviction without letting your bull/bear pre-disposition steer your way of reasoning. Anything else and you will end up cheating yourself - and others. There are hundreds of bullish (and bearish) arguments and graphs, and eventually they will be right (we will most likely see a bounce up within days and bulls will have their day - for a few weeks). But this bear is not dead. If you boil the whole thing down to its essence it is a simple matter of the two things drives prices. One is right out ugly since the beginning of the year and the other turning negative...

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  19. Benjamin,

    You make a salient point regarding China. My bias would be for long-term optimism in China, but Xi Jinping power grab shows pretty well how things can go bad. Still, business ties between US and China are the best chance we have for moderating the risk of direct conflict.

  20. Scott, you’ve been correct about the excessive fear factor this entire recovery. So now, the withdrawal of the QE balance sheet is adding to it.

    As Warren Buffett says, ‘be greedy when others are fearful’. I’d love to be a fly on the wall in his office to see where he is deploying part of his 100 billion dollar cash pile.

    Merry Christmas!

  21. I should add... we have an idiot president ourselves. It seems more and more clear that the US is at risk of our own president doing something stupid. He's becoming even more likely to do whatever whim he has that day, not caring what his advisors say.

  22. I am very worried about the Federal Budget Deficit.

    It has exploded in the last 2 years.

    Trump has already removed all the over regulating, so that's good.

    We must immediately raise taxes or cut spending, military and Medicare. Even though we are right at the wrong point in the economic cycle for such actions. This out of control budget deficit is such a dilemma again.

    But at least, now that the Democrats have taken the house we will be treated to see how important that cutting the deficit right now is to our serious leaders and important media commentators.

  23. This is a great buying opportunity if you have a long term investment horion.

    I just poured more money into stocks.

    What a beatific gift.

  24. Valuing the market depends on what E you use.
    Yes, on an operating earnings basis the market is now
    fairly valued. But, on a GAAP basis it's still overvalued
    GAAP earnings of $140/share give you a P/E of 16.7
    while historically it's 14.5 to 15.

  25. Re: "I am very worried about the Federal Budget Deficit."

    I am worried about the federal budget deficit, but it does not rise to the level of a national emergency nor does it spell doom. I devoutly wish the federal government could address the deficit by cutting entitlements spending, because that represents almost 75% of total spending. That is the 800-lb gorilla in the living room.

    I don't think that higher taxes are necessary. In fact, I think they would be counter-productive. The best solution for the budget deficit is a healthier economy and less income transfer.

    For perspective, in any event, today the budget deficit relative to GDP (the only measure of the deficit that matters) is only 3.8%. At its peak in late 2009, the deficit soared to 10.2% of GDP. Over the past 10 years the deficit has averaged 5.32% of GDP, so today we're well below that average. During the worst of the Reagan-era deficits, the deficit reached 5.6% of GDP, and it averaged 3.9%. From an historical perspective the deficit is not anywhere near earth-shattering, though it remains a deep-seated problem.

  26. Scott, re: the federal budget...

    I'm becoming worried about how definitions are being distorted. Your numbers are accurate as far as what was reported. (About $850B deficit in a $22T economy, using round numbers.) But as Jeffrey Gundlach recently pointed out, the actual addition to the nation's debt wasn't $850B. It was $1.3T because of all the off-budget items.

    I don't know how much the off-budget items averaged over the past ten or thirty years but I strongly suspect the figure is greater now than during, say, Reagan's time. So I suspect the deficit really is something closer to 6%.

    In any event, your point still holds that it isn't a national emergency but it IS something we must address through cost reduction. Entitlements should be addressed but I would start with declaring a new foreign policy based on the principle of non-intervention. This could save an immediate $500B per year (and increase our standing in the world and in our own hearts). Of course we won't do this...

  27. Trump said stocks are cheap enough, and it’s time to buy. And stocks answered by rallying to the best one day point gain in US history. Best post-Christmas percent rally in history. And the Vix plummeted 16%. Vix/10 year ratio plummeted from 13. Jay Powell’s incompetent rhetoric gave us the market top. Would be poetic justice if Trump’s comments end up putting in the bottom.

  28. Natixis Chief Economist Joe Lavorgna said on CNBC this morning, "credit markets are totally seizing up, and its global."
    He was echoing the same comment from Dr John Rutledge made just a moment before.

    Scott, are we seeing a spike in the swap spreads?
    Global credit markets "totally seizing up" sounds like a dire statement from those 2 gentlemen.

  29. The P/E Ratio is the most common valuation metric,
    but does not make good ten-year projections,
    because earnings and profit margins are too volatile
    in the long run.

    Price / Sales Ratio works much better, and so does
    the Market Capitalization to GDP Ratio,
    which Warren Buffett has endorsed.

    Most important -- using only one valuation metric
    is a mistake !

    Of course the stock market correction
    did make the P/E Ratio look better
    in the past few months !

    That doesn't mean one should buy stocks!

    A recession could be coming.

    The "trade war" is ongoing, and
    there's little good news.

    If Trump was a smarter leader, the "trade war"
    would have been the US and a big coalition
    of ally nations -- who are all getting screwed by China's
    trade barriers and IP theft -- working together
    against China.

    No one rings a bell to warn of a recession --
    a stock market decline is the usual warning,
    but a decline is more often
    a correction in a bull market.

    I know the crowd here doesn't
    like my usual bearish view, so I offer
    this good news today:

    The only short-term timing indicator I follow
    turned bullish today, for the first time since
    early 2016, and I actually bought some stock
    on Monday, anticipating that would happen today, ***


  30. Re "credit markets seizing up." I think this is an egregious comment, in light of the fact that credit spreads are nowhere near levels that coincided with the actual seizing up that occurred in late 2008.

    Swap spreads are a mere 13 bps. In late 2008 they hit 170+. IG CDS spreads are somewhat elevated, but at 89 bps today, they are far below the 275 bps high of 2008. TED spreads are 40 bps today compared to 300+ in 2008.

  31. Thank you very much for the response. As I suspected.

    VIX fell again today, after being up 7% midday. Many Bullish Percents are in single digits. Late day rallies finally have institutional volume.
    Sure acts like a bottom. Maybe Don John was right again. We will just have to see.

  32. Johnny Bee Dawg; Was in my broker’s office early AM Christmas Eve doing tax loss selling and simultaneous reinvest in ‘similar’ securities, so as to be relatively neutral, position wise. He’s got a program that can do all simultaneously, saving me a lot of brain damage. Plus, there’s a lot to be said for personal contact. Got my last ‘reinvest’ Wednesday AM 20181226 early at low limit the amount of the Monday closing low, JUST before the big liftoff.

    SO happy.

  33. Am I missing something on the earnings yield v Corp credit graph? Your comment doesn’t seem to match the graph, maybe a typo / missing secondary axis?

  34. Unknown: thanks for pointing this out. I have re-written the paragraph that describes Chart #5, and I hope it is now more intelligible.

  35. I don't see anyone worrying about revenue declines, which is something to be watching going into a weaker period of growth. As long as debt and revenue are ignored, maybe this little spike in the market will help people double their 2018 performance.

  36. Scott,
    Fed Funds Futures on Dec 20 are lower than those on Dec 19.Is this causing something important for the economy or this is just Fixed Income market opinion, which may be wright or wrong. Thx.

  37. pangloss has been claiming since the crash that he loves them apples. still long pangloss?

  38. Marcusbalbus, certainly you realize Apple stock was trading in the low $20s back in 2009. Lol

  39. marcus ball bust: have you ever made any money investing?

  40. JBD, do you really need to ask that question?

  41. JBD: its clever how you hide your piercing intellect.

    steve: find peace, then stay there.

  42. oh, and ron t: your ignorance is endearing, but splits never bother the ignorant.

  43. The average annual rate of return on Apple stock over the past ten years through January 4th is 28.74%. That's a pretty endearing performance.

  44. The fact is that Apple has significantly exceeded the performance of the broader market over the same time frame This is in stark contrast to your snarky comment about Scott and Apple. Facts don't care about your apparent negative feelings towards Scott and his economic and market commentary.

  45. Scott- Your blog introduced me to Kina Grannis' music several years ago.

    Been listening to her music on Tidal and just bought her Hi-Res 24/44.1 FLAC album "Elements" Deluxe version from Pro Studio Masters.

    Excellent recording!

    Sounds fantastic through my KEF R3 stereo speakers!