The US stock market, as measured by the S&P 500, is up over 11% so far in 2014. Coming after a 30% gain in 2013, this year’s positive returns have caught many professional investors off guard. The US stock market is a market of skepticism. It is a bull market that is unloved and considered by many to be complacent, “unhealthy,” and manipulated higher by unwarranted liquidity provided by the Federal Reserve. These negative feelings are not without merit, but as a general matter stock indices are not quite as unhealthy as the most negative bears would have us believe.
The most common stock market valuation metric – the price to earnings ratio – stands at historically high levels. The current twelve month forward P/E is 16 times which is above the five and ten year averages of 13.5 and 14.1. Many stock market analysts prefer to use cyclically adjusted measures to smooth over peaks and troughs of earnings over time. The “Shiller P/E” of the stock market is also flashing red. It currently sits at 27.19 and is far above the average of 16.5 times earnings. A case that US stocks are overvalued compared to their long term averages seems compelling.
If that sounds overly simplistic, it is. When one looks at any number that is the product of division, remember that the divisor or integer can be changed. Another market result could be that stocks “grow” into their multiple by posting an aggregate higher amount of earnings. That is, the stock market may price the future growth of companies into today’s prices without assigning higher prices at a later period of time. That is a rare scenario at best. Most often, contemporaneous earnings simply disappoint or valuations get too far ahead of fundamentals. For example, in this ongoing third quarter earnings season, 77% of companies have reported earnings above the average earnings estimate which were heavily reduced (halved) compared to where they stood at the beginning of the summer.
As a factual matter, P/E ratios can go much higher from today’s levels. A forward P/E ratio of 18 or even 20 in times of great cyclical growth, low interest rates, highly accommodative central banks, few policy risks, is not unthinkable. Does such a halcyon environment for stocks exist? The world is in an era of conflict on the border of Europe (Ukraine), terrorism in the Middle East (ISIS) and a festering health crisis (Ebola). In addition, central bank policy is highly accommodative because Europe and Japan are fighting deflation, demographic problems and lack of final demand caused by structural economic problems. These are not easy issues. US stock market bears have reason to be apoplectic over the incredible performance of US stocks since the S&P 500 hit a low of 666 on March 9th, 2009.
So why have US stocks performed well over the last two years? Certainly a part of the performance is due to the support of the Federal Reserve. That analysis is a bit of chicken-and-egg. It is unclear whether monetary policy caused US strength or the US grew in spite of non-traditional monetary policy. Nonetheless, US stocks have benefited from a better US economy (i.e., lower unemployment, zero bound interest rates, consistent corporate earnings, etc.). In essence, the Federal Reserve assured the market that it would not let financial institutions fail, not allow a large scale recession, and provide zero bound interest rates for a very long time. In total, these policies allowed corporate balance sheet restructuring while companies got very lean by cutting costs and simultaneously using liquidity and low rates to buy back stocks. Just look at the public statements of former Fed Chair Bernanke to see that he outright and purposely intended to inflate the prices of stocks. The fact that stocks went up, should be less surprising than it apparently is for many market participants.
When market prognosticators look at US stocks and claim them to be unhealthy, they are generally talking about technical indicators of strength and weakness. Here is the key to the S&P 500: it is a market capitalization weighted index. That means that the biggest companies account for an oversized percentage of the statistics associated with the index. Those companies include Apple, Exxon Mobile, Microsoft, Johnson & Johnson, GE, Berkshire Hathaway, Wells Fargo, Procter & Gamble, Chevron and Walmart. The smallest of those companies has a $ 240 billion market cap while the average S&P 500 market cap is $ 38 billion. Take note that blindly equating the S&P 500 to US stocks warps analysis. Yes, the indices are a handy way to talk about stocks and an even better way to trade futures and risk manage portfolios, but the entire story is not told by the index.
Looking at the 50 smallest stocks (by market capitalization) that comprise the S&P 500, some interesting statistics can be gleaned. The average market capitalization of the bottom 50 stocks of the S&P 500 is $ 5.2 billion and have an average forward P/E ratio of 18 which is quite a bit higher than the index overall at 16 times. Much ink has been spilled about how these smaller index constituents are far below their moving averages. That argument doesn’t hold quite as much water with (only) 28% of these companies below their 50 day moving average and 38% of them below their 200 day moving average. Firstly, these stocks are more volatile than the larger index leaders. Secondly, the bottom 50’s average distance from each of the constituent’s 52 week high price is only 15%. Meanwhile, as a group, they are on average 25% above their 52 week low. In admittedly generic technical terms, the bottom 50 seem fairly priced (not cheap) yet not overly unhealthy from a technical perspective. Again, this is a very simple analysis, but these companies are far closer to their 52 week highs than their 52 week lows with room still to grow.
Beyond technical indicators, the bear case for US stocks is easily made by the facts of geopolitical tensions, global economic weakness, dollar strength, the importation of deflation from abroad (currency war), and US political impotence. All of these issues are real and can have devastating effects on index levels, sector valuations and individual stock prices.
Ultimately, it is because investors and speculators alike have confidence based upon the trading gains over the last two years to maintain a long bias in US stocks. That is often called the “recency effect” and not a great way to analyze future stock market movements as it assumes largely what has already happened. To be clear though, the US is nowhere near a recession and with interest rates still very low, cash flows are not heavily discounted. The rally mode for US stocks is likely to continue over the near term as managers chase performance and the Federal Reserve signals that the US economy is healthy enough for gentle interest rates rises. As of today, the stock market is probably “overbought” but with announcements from the People’s Bank of China and the European Central Bank today, risk seems to be “on” again. At least temporarily. That set up can reverse quickly though and investors should particularly pay attention to revenue/sales numbers for US corporates in the next two quarters. That will be the real test to determine if US stocks are immune from global economic weakness. That is yet to be determined.