THE FIRST quarter of the new decade is at an end and stock prices have done well to withstand a barrage of negative shocks including political upheaval in the Middle East and north Africa, a devastating earthquake and tsunami in Japan, not to mention the ongoing sovereign debt crisis in the euro zone’s periphery.
The equity market’s performance in the face of such seismic events has seen the bulls argue that the resilience is not a function of complacency but of relatively inexpensive valuations, while even those with a less sanguine view are participating in the cyclical advance, confident in their ability to time the market and sell to less savvy investors at even higher prices. Are they April fools?
The turbo-charged bulls argue that stock prices are attractive given the dubious assumption that the market’s sustainable earnings power is in the region of $90 per share. Use of this number puts the equity market on roughly 14½ times cyclically-adjusted earnings, or roughly 1½ multiple points below the long-term mean, which implies that stocks are relatively cheap at current levels.
However, the analysis conducted to establish this estimate does not appear particularly rigorous and its relevance can be dismissed on a number of grounds.
The most damning indictment is the implicit assumption that trend growth in inflation-adjusted or real per-share earnings has accelerated from less than 2 per cent per annum to close to 3 per cent in the recent past, even though no previous one-time upward shift in the market’s sustainable earnings power is detectable in the historical data extending back to the 19th century, a period which includes several periods of rapid economic growth from the “Gilded Age” to the go-go years of the 1960s.
The unstated yet implicit assumption that real per-share earnings will grow at 3 per cent per annum in future is simply implausible. It means the corporate sector will capture an ever greater share of gross domestic income, a development that is not possible ad infinitum.
US data reveals that the growth rate of corporate profits is virtually identical to gross domestic income growth over the past half-century; both have increased at a real rate of more than 3 per cent per annum since the second quarter of 1960. However, current investors do not have a claim on economy-wide corporate profits, which includes all US businesses; they have a claim on publicly quoted per-share earnings.
Aggregate SP 500 earnings have tended to grow in tandem with the economy over long periods, albeit at a slightly lower rate, as America’s largest businesses have captured a progressively smaller share of total profits. More importantly, growth in the SP 500’s real per-share earnings has proceeded at a rate over the past 50 years that is almost 40 per cent below the rate of income growth over the same period or close to 2 per cent per annum.
This observation can be explained by new business start-ups, which account for more than half of US economic growth, and the subsequent capitalisation of the successful ventures with equity. Current investors do not have a claim on the profits of these new businesses, unless they dilute their existing holdings to buy shares in these enterprises. Consequently, earnings to which investors have a claim increase at a substantially lower rate than the growth in aggregate profits.
It should be clear that the perma-bulls’ estimate of the market’s sustainable earnings is nothing more than a product of sell-side fantasy, and the case for a trend earnings number of $90 per share is further undermined by the fact that the approximation pencilled in has increased at a double-digit rate over the past calendar year, which happens to paint market valuations in a favourable light despite rising prices.
More statistically robust analysis reveals trend earnings to be in the region of $65 per share, or almost 30 per cent below the bulls’ nonsensical estimates. The resulting price/earnings multiple is above 20 times, a level that in the past has always been followed by disappointing long-term returns. There have been 22 years since the start of the 20th century in which the stock market has closed the year with a price multiple on trend earnings equal to, above or less than one standard deviation below the current reading. The average annualised real returns over the subsequent three-, five-, 10-, and 15-year periods have been negative - a quarter, a half and less than 1.5 perentage popints respectively. The returns are dismal and the odds of earning above-average returns are equally uninspiring at less than one in five over three years, one in seven over five years, and zero over 10 and 15 years.
It is clear that the equity market is in nosebleed territory once again, though historical evidence does suggest that stock prices can continue to register solid gains in the short term.
The valuation bulls are clearly wrong, but continued participation in the cyclical bull market may have some merit if stocks can be offloaded to unsuspecting investors at higher prices. However, exiting the market in time and avoiding large capital losses typically proves next to impossible. The April fool could well be you.
www.charliefell.com
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