- Investor sentiment has driven the stock market to new lows in 2016. However, investor sentiment is rarely reflective of market fundamentals (e.g. revenue and earnings growth). I calculate an increase of nearly 64% for the S&P between the period of Jan 2011 to July 2015. However over the same 4-year period corporate earnings have only increased by 25%. Even worse, from the beginning of 2009 the S&P has returned 186% whereas corporate earnings have increased only 49%. What gives? I’d be the first to admit these two metrics don’t move in lock-step by the same amount, however if earnings growth drives returns, why has the market gone up by so much more than earnings growth?
- Let’s explore what I would call an unusual divergence by looking at the market multiple. In the last 10 years, the market was probably its cheapest right after the recession where the P/E ratio (measured by Case-Shiller) was 15x. At the beginning of 2015, this same ratio stood at 26x. This meant that since the Great Recession, investors were willing to pay 73% more to own shares of the S&P than they were back then. Really? Have corporate earnings warranted that great of a premium since then beginning of the recovery? Possibly, but it doesn’t seem likely or logical once you consider our lackluster economic performance since that time. It has been better than other developed economies (e.g. Europe, Japan), but by no means worthy of a multiple greater than 25x! So if you consider all of that, possibly the question worth exploring for further evaluation is if the current hysteria around the latest market collapse should be getting this type of attention? Could it be that the market has been overpriced all along and what we are currently experiencing is a normal market correction? After all, weren’t we due?
What really drives the economy?
I suggest you view an incredible explanation of how the economy works by Ray Dalio because the following explanation deserves more time than I have here. But think of what drives the economy–spending. Companies sell their goods and services and generate revenues. These revenues are use to expand through investment (also known as CAPEX) in fixed assets and human capital. These investments are funded with cash or credit in order to result in greater production of goods and services. Two-thirds of the US economy is driven by consumers who purchase these goods and services with cash or credit which then drive revenue which drives earnings–so on and so on. By GDP standards, this cycle has been chugging along at a fairly pedestrian pace. Corporate earnings are a part of GDP. The stock market is separate from GDP and only really reflects investor sentiment about the machine I just described.
What could cause the market to go up so much more than corporate earnings?
Consider that monetary policy, until recently, has been “accommodative”. This is proven by ultra low interest rates and even more dramatically, asset purchases. These tools encourage something that could have harmful effects. Low interest rates encourage spending because the cost of borrowing is cheap. Asset purchasing puts cash in the hands of banks that can then use that cash to make loans to consumers. The collateral affect is the “psychological effect” on investors to assume more risk relative to what they would normally assume. An increase in the proportion of risky assets in an investor’s portfolio was encouraged because interest rate sensitive assets pay much lower returns comparatively. This “demand” for return found in risky assets pushes the overall level of asset prices up. This is why I believe the S&P P/E ratio inflated so much during the time period of 2009 to 2015.
What happens when you remove the elixir?
I liken this to caffeine fast. For all you coffee drinkers, you will appreciate the analogy. I would like to suggest that the US economy is now being weaned off of the elixir of easy monetary policy. The reversal of monetary policy prior to an economy stable enough to repeat the cycle above on its own (without assistance) is potential disaster. The US economy has to be slowly weaned off its dependence on easy credit and low interest rates to purchase goods and services. The reality of the cost of future debt obligations in a higher rate environment starts to fuel unrest for the borrower and thus decreases consumer demand for those same goods and services. This results in a pullback in capital spending by businesses looking to “soften” the blow of anticipated decreased revenues, and ultimately slows (or stops) job creation. This creates a drag on GDP and if no growth happens for two consecutive quarters it is called a recession.
Let me be clear, in my opinion, I do not believe the US has yet reached this last stage. However, I do believe there is plenty of evidence to show the US stock market was due for a correction to put market valuations more in line with reality. Since, 1920 the market has averaged a P/E ratio in the mid-teens (call it 15x), so unless corporate earnings increase by a large measure or the market falls further stay tuned for continued volatility. This is hardly a bad thing though as the universe of bargains is increasing with each market downturn. Wise investors will do well to take a deep breath and circle the wagons. The most prudent investors I’m working with currently have been making deposits for bargain purchases. During the Depression, Sir John Templeton purchased 100 shares of all the NYSE listed stocks trading at less than $1 each to help catapult him to his fortunes. Investors should consider that chaos creates opportunity.
Suggested Reading to turn emotion into understanding: