Using $124 S&P 500 EPS for 2015, the forward PE of the market is 16.8x, which seems reasonable compared to the 17.1x average PE since 1989. Unfortunately this comparison is misleading for two reasons:
- The average since 1989 is inflated by the tech bubble of the late 1990s.
- It is also inflated by recessionary periods when earnings were depressed and investors looked forward to strong earnings growth as the economy recovered. That is not the case today, six years into an expansion. Profit margins are high; revenue growth is tepid. Profits rose 7% in 2014 and will rise around 5% in 2015, impeded by weak energy earnings.
How expensive are stocks, taking those two factors into account? Based on history, “very expensive.” Consider:
Since Q1 1989, using quarter-end price and our proprietary data on “pro forma EPS” (which exclude unusual gains and losses) we have the forward PE ratio for 104 quarters. As noted, the average is 17.1x. But let’s exclude the tech bubble (1997-2000) and six recessionary years (1991-92, 2001-02, and 2008-09). That leaves us with PE’s for 64 non-bubble/non -recession quarters, comparable to where we are today in the economic cycle. Of those 64 quarters, only four had higher PE ratios than the current 16.8x. The mean and median for the 64 quarters are only 14.8x.
The Fed Is “Behind the Curve”
The counter-argument is that interest rates have never been this low. What’s not to like about stocks offering a 2% yield and mid-single digit earnings growth when the 10-year treasury yields 2.2%? I have championed that argument in many reports on “dividend fountains” since the dark days of 2009, and it still has merit. Maybe PE’s will indeed remain lofty in a low-yield world.
But maybe not. Risks are rising. It makes no sense for Fed funds to be at zero as we enter the seventh year of an economic expansion that is clearly accelerating—see GDP, employment, unemployment, industrial production, ISM’s, etc. We are rapidly moving toward “full employment” – particularly given that Obamacare, the EPA’s war on fossil fuels and other policies have damaged the supply side of the economy. As we saw with the “taper tantrum,” Fed tightening may well cause indigestion in the domestic and international bond markets, producing unexpected defaults and global turbulence. After all, the ultra-low Fed funds rate of the early 1990s (down to 3%) and 2003-04 (down to 1%) caused destructive asset bubbles, so why shouldn’t a protracted zero rate regime have similar effects?
Adding to the risk are slow global growth and general economic mismanagement in Europe (excluding the UK), Japan, and many emerging markets. How long will Europeans accept 10% unemployment before they vote for extreme parties on the Left and Right? A bearish near-term scenario I laid out on December 16 has so far failed to materialize, as the Fed spread easy-money-talk foam on the global economic runway. But the Fed cannot do that forever.
I will freely admit that stocks still look like the best game in town. But it is important to avoid complacency, anticipate greater volatility, recognize that equity returns may be modest over the next few years, and accumulate cash now if you need liquidity. Don’t extrapolate the past two years. We are no longer in early 2013 when the economic expansion was two years younger and the forward PE was 14.0x, not 16.8x.
Copyright Thomas Doerflinger 2014. All Rights Reserved.