Mr. Sensitive

April 12, 2013

Stocks Are Too Expensive

Filed under: Uncategorized — lbej @ 12:45

The major equity averages scored yet another series of all-time highs this week, putting the Dow Industrials and S&P 500 within sight of 15,000 and 1,600, respectively.  Four years ago the Dow was below 7,000—we were closer to zero than to the levels we’re now approaching.  So is the U.S. economy really twice as strong as it was in April 2009?  Heavens, no.  But are large U.S. corporations twice as strong as they were in April 2009?  More like five times stronger.  Balance sheets are pristine, margins are at record levels, organized labor is collapsing, and corporate political influence is scarcely less potent than during the Bush years.  All things considered, do the state of the economy and the might of corporations taken together justify the S&P at 1,600?  In a word—no.   But throw Helicopter Ben and his QE-infinity into the mix and now you have a more interesting proposition.

The S&P is trading at around 16 times trailing earnings; this is higher than the historical average, but it isn’t near the nosebleed valuation reached at previous market peaks (2000, 2007).  Furthermore, that P/E multiple is made more attractive when you consider the bubblicious state of the bond market.  Not only do 10-year Treasury rates below 2% drive investors into riskier assets looking to keep pace with inflation (2% won’t cut it, bogus CPI numbers notwithstanding), but the cash flow discount models often used to valued stocks take interest rates as a key input, with low rates producing higher valuations.  By that relative standard, an otherwise fully-priced equity market looks inexpensive.  But this market isn’t inexpensive, and I’ll tell you why.

  1. Rates will rise.  Low interest rates in the past were often a sign of the credit market’s confidence in the economy, but today’s low rates are a function of market manipulation by the Federal Reserve and other global central banks.  To this point, the ability of international corporations to outsource manufacturing to low-cost Asian markets has offset the impact of inflationary monetary policy, albeit only for manufactured goods.  If you think there’s no inflation at all, trying paying for college, going to the doctor, or filling up at a gas station.  The inflationary impact of artificially-low interest rates may be debatable; the fact that global currency debasement and interest-rate price controls aren’t sustainable policies is not debatable.  At some point, the market will set rates again, and those rates will be higher.  Fund flows and valuation models will take it on the chin as a result.
  2. All earnings-per-share numbers aren’t created equal.  The S&P looks cheaper than it is because many huge companies trade at 10 times earnings or less.  Just consider this list of blue chip stocks:  Apple, Intel, JP Morgan Chase, Exxon Mobil, Chevron, Goldman Sachs, Wells Fargo—all at less than 10 times earnings.  These aren’t the blue chips that have led the rally, though.  The leaders have been companies like McDonalds (19x earnings), Disney (20x), Johnson & Johnson (21x), and Home Depot (24x).  Energy stocks (Exxon, Chevron) should be cheap because earnings are highly levered to commodity prices.  Financials (JP Morgan, Goldman) should be cheap because we now know that nothing stands between the big banks and insolvency other than a handful of valuation assumptions.  Old tech like Intel, Apple and Cisco (12x) should be cheap because…well, I’m not sure they should be cheap.  But can large, mature, consumer-oriented companies like McDonalds and Home Depot really grow fast enough to justify their earnings multiples?  Absolutely not.  In fact, they can’t grow much faster than the global economy, given their size, and that means 3-5% or so.
  3. Finally, earnings growth driven by margin expansion (cost-cutting and outsourcing) can’t continue indefinitely.  Big corporations can’t find revenue growth in the developed world, in no small part due to their own commitment to hold down their employees’ wages.  If you can grow earnings at 10% annually, 16 times earnings is reasonable, and maybe even cheap.  But what if you can grow revenues at only 5% (the long-term rate of global GDP growth) and you can’t grow earnings faster than that because there are no more costs to cut?  And what if you pair that with a P/E multiple above 20?  How does 16 times trailing earnings play in a low-growth, rising-rate environment?  We’ll find out soon enough.

Does all this mean stocks can’t continue to rise?  Not at all.  But the U.S. equity market is expensive at these levels, and buy-and-hold here would be stupid.  This market is for traders now.

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