Inflection Point: (Part 1)
The Long Term Equity Valuation Cycle
Most market participants would probably be inclined to agree that the markets move in somewhat cyclical fashion, but that’s about where the agreement ends. Practitioners of cycle theory include those who ascribe to what’s known as “Elliot Wave Theory” with Robert Prechter’s “Elliott Wave Theorist” being the most followed (https://www.elliottwave.com/Investor-Research/Elliott-Wave-Theorist). Others include those using some quantification of Astronomical and Astrological Cycles such as lunar, solar, planetary, or eclipses to make forecasts, such as Arch Crawford (http://www.crawfordperspectives.com/) and Steven Puetz (http://www.uct-news.com/).
Personally, I have consumed a large portion of my adult life seeking to find an observable, mathematically calculable, reliable, stable, and PREDICTABLE cycle in the equity markets. Wouldn’t it be great to know in advance when the next top is due or the next bottom? Here’s what I found: Looking backwards and modeling historical data, there was ALWAYS a statistically decent cycle-based model of the past. ALWAYS. The problem was, in my experience over thousands of tests, the model of the past NEVER predicted the future. NEVER. Cycles just don’t show up when you need them.
Cycles become more useful when we don’t focus on examining the time interval “in between” certain events – which vary widely. The variation between extremes, however, is reasonably stable. For example, in the charts below, which came from a very comprehensive and informative website called “Multpl” (http://www.multpl.com/), it can be observed that certain elements of long run cyclicality can come in very useful. Any index, stock, or asset is fundamentally valued “as the present value of future cash flows”. The Standard & Poor’s 500 Index (SPX) is often measured by its Price/Earnings Index (PE). Literally measured as Price divided by Earnings of its constituent companies. The Higher the PE, the more it costs per dollar of “reported earnings”. The charts below illustrate some very useful ultra-long term trends in both Earnings and P/E ratios.
The chart of Long Term Earnings, which has The DARK GREEN, LIGHT GREEN, and RED parallel lines provides some truly amazing, yet SIMPLE insight: Over nearly 150 years of existence, the growth in real earnings of the SPX has been roughly 1.5%, compounded annually, a rate which has accurately connected the EXTREMES in PEAKS with subsequent PEAKS and the DEPTH of TROUGHS with subsequent TROUGHS. This closely mirrors the long term growth rate in corporate productivity.
Current SPX earnings are reportedly $113, right AT THE HISTORICAL EXTREME PEAK EARNINGS trend line. Is there ANY reason to believe that somehow, after nearly a century and a half, earnings growth will suddenly accelerate? On the contrary, yesterday’s missive, “Can Anyone Win A Trade War?” (https://markonomics101.com/2018/07/09/can-anyone-win-a-trade-war/), suggests one of the many negative ramifications of an escalating trade war ought to be pressure on the earnings of large Multi-National Corporations for whom global commerce is an increasingly larger portion of their revenues and bottom line. If earnings were to revert ONLY to the median (in Red), and PEs were unchanged, that would, by ITSELF, lop off 40% of the SPX’s fundamental value, or more than 1000 points.
Price to Earnings Ratios (PEs) are probably the most commonly known and best understood barometer of valuation. In general, low PE stocks have lower growth and are usually more mature, but PE alone doesn’t paint a very complete picture. Currently, the SPX sports a PE of 24 which is well above the long run average of about 12 to 15. In general, PEs are calculated using the trailing 12 months “reported” earnings. However, that methodology is very misleading, especially at turning points such as the EXTREME TROUGH that occurred in 2009. In those situations, PEs can become very artificially high because EARNINGS are temporarily depressed or affected by accounting conventions such as large, one time write-downs. To prevent distortions like this, noted Economist Robert Shiller has created the “Cycle Adjusted Price Earnings” Ratio or CAPE (also known as Shiller PE) using the average of the trailing 10 years. Shiller’s PE comes in at an excess of 32 and has only been higher very briefly during the excesses of the internet bubble in 2000. This measure of PE, too, suggests that NOT ONLY are Earnings at risk, but the amount investors will PAY per $1 of earnings is also at risk. In fact, the Shiller PE is roughly DOUBLE its historical average. So, if the market were simply to go back to its long run valuation average, the target level for the SPX would be 16 (Shiller PE) times $70 (SPX earnings) or 1,120. That would represent a DROP of at least 60% from today’s close of 2774!
One could argue that PEs are abnormally high because the returns offered on competing investments such as Treasuries are historically low. That would be accurate. Again, from the fabulous website Multpl (http://www.multpl.com/10-year-treasury-rate), the ultra long run picture on yields of Ten Year Treasuries shows that rates have been consistently falling for an unprecedented 36 years since peaking in 1982. But can’t rates go lower? Of course, its a market. Anything can happen. But the other chart, which gives us a market-based guide of inflation expectations suggests that the extreme lows for this LONG, LONG disinflationary Cycle is over.
“Treasury Inflation Protected Securities” (or TIPs) appreciate to compensate the investor for inflation as measured by the Consumer Price Index (or CPI). TIPs provide a small cash yield, or “Real Yield”, but augment the cash yield with gains in the securities which match inflation. The Monthly Chart of TIPs shows a very, very BULLISH pattern threatening to break up to new highs. Keep in mind, however that BULLISH for Inflation and BULLISH for Tips equates to BEARISH for PEs, BEARISH for Yields, and BEARISH for Equity Valuations.
Evidence of building inflation is everywhere: gasoline prices, skyrocketing rents and housing prices, and now additional tariffs to make imports MORE EXPENSIVE! Retaliation by our trading competitors reduces trading volumes and thus earnings of multi-national Corporations such as those that make up the SPX.
If this is truly an historical “Inflection Point” as we suspect, then the constant positive reinforcement created by continually declining interest rates, accommodative Federal Reserve Policy, and corporate earnings environment that have SPX earnings at an extreme cyclical peak will give way to a vicious down turn in the cycle. Escalating ” Trade Wars” also have the potential to dramatically negatively impact both domestic and international equity values.
The “Inflection Point” Series continues with a look at Commodities and Precious Metals next. Spectacular gains may very well await those who recognize this Inflection Point is taking place early and adapt to the new environment on the horizon.