During extended bull markets, rationalization becomes commonplace to justify overpaying for value. One such rationalization is the permanent shift in valuations higher due to changes in accounting rules, share buybacks, and greater adoption by the public of investing (aka ETFs.)
The chart shows the apparent shift to valuations.
- The “median” CAPE ratio is 15.24 times earnings from 1871-1980.
- The long-term “median” CAPE is 16.52 times earnings from 1871-Present (all-years)
- The “median” CAPE is 22.91 times earnings from 1980-Present.
There are two critical things to consider concerning the chart above.
- The shift higher in MEDIAN valuations was a function of falling economic growth and deflationary pressures; and,
- Increasing levels of leverage and debt, which eroded economic growth, facilitated higher prices.
The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising. It is also the point that valuations shifted higher.
You can see this shift occur more clearly when looking at when the government began to run a deficit consistently. Rising deficits directly correlate with weaker rates of economic growth.
The problem with the idea that valuations have permanently shifted upward is the market anomaly form 1990-2000 skewed valuations above the long-term medians. However, given economic growth remains mired at 2%, or less, over the long-term, average valuation ranges will begin to trend lower in the future.
The downshift in real economic growth disrupted the financial relationship of profits, future growth, and market value.
Slower growth drives P/E downward.
Since the “Financial Crisis” lows, much of the rise in “profitability” has come from cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, which connects to a consumption-based economy, remained muted. Now, the “economic shutdown” has crushed revenue growth entirely.
Since 2009, the operating earnings per share of corporations has risen by just 158%. However, the increase in earnings did not come from an increase in revenue. During the period, sales (which is boosted due share reductions) grew by a marginal 41%.
However, investors have bid up the market more than 365% from the financial crisis lows of 666.
Therefore, since future economic growth is expected to be slower, it is only consistent that the future average for the market P/E will be lower. The new normal growth rate (i.e., slower) for the economy will drive slower overall earnings growth. Such slower growth will drive market P/E lower, just as previously higher growth supported the market’s P/E at a higher level.
The inflation rate also drives the level of market P/E, but it occurs within the range driven by the growth-rate environment. Higher inflation drives P/E lower; deflation drives P/E lower. The level of P/E peaks when the inflation rate is low and stable. Thus, while the growth rate drives the level of the P/E range, the inflation rate drives the relative position of P/E within the range.
Figure 6 illustrates these effects. The bar on the left illustrates the range for P/E under a historically average level of growth. The bar to its right illustrates the range for P/E under slower growth. Not only does the range downshift, the expected long-term average P/E also downshifts. This has major implications for analyzing the stock market.
Going forward, we should expect a new paradigm. Slower growth drives the ranges for P/E lower, which will affect future assessments of fair value. Keep in mind that, had real economic growth averaged 2% instead of 3.3% over the past century, the historical average for P/E would have been near 11—not 15 or 16. In the future, the fair value for P/E when the inflation rate is low will be 13 to 15. With average inflation, expect P/E to be near 11. During periods of high inflation and significant deflation, expect the low range for P/E to be 5 to 8.
The chart below shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. You will notice that secular bull markets tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend to end around 23-25x earnings or higher.
Given 13% unemployment rates and a recession of nearly 20%, earnings will likely revert toward $80/share. Such a decline will push current valuations to historically high levels, assuming prices remain elevated.
No matter how many valuation measures you use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low for a buy and hold strategy… but not for a trend-following strategy.
The Fed
Why Full Employment Won’t Create Inflation:
Let’s assume for a moment that the economy returns back to the same historically low unemployment rate we were enjoying at the end of 2019. As shown in the chart here:
This is crucially important to understand why the Fed’s actions are “deflationary.”
In order to generate “real inflation,” economic growth must be strong enough to support employment that exceeds the rate of population growth. That employment must ALSO be productive (manufacturing-based) employment which leads to higher wages. (Service jobs are deflationary as they go to the lower cost of labor.) Higher wages lead to increased consumption which allows producers to increase prices (inflation) over time.
This has not been the case for nearly 40 years as technology continues to reduce the demand for labor by increasing productivity. This is the “dark side” of technology that no one wants to talk about.
Why Debt Won’t Create Inflation:
Inflation cannot be achieved in an economy saddled by $30 Trillion in debt which diverts income from consumption to debt service. This is why “monetary velocity” began to decline as total debt passed the point of being “productive” to become “destructive.”
Monetary velocity tells the story.
What is “monetary velocity?”
“The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Velocity is useful in gauging the health and vitality of the economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.” – Investopedia
The decline in velocity coincides with the point that consumers were forced into debt to sustain their standard of living.
The problem for the Federal Reserve is that due to the massive levels of debt, interest rates MUST remain low. Any uptick in rates quickly slows economic activity, forcing the Fed to lower rates and support it.
With the economy set to push a $4.2 Trillion deficit in 2020, the deflationary pressure alone from the deficit will continue to erode economic activity. As noted, even if the Fed does manage to get a spark of inflation, which would push interest rates higher, the debt burden will lead to an economic recession and deflationary pressures.
Why Printing Money Won’t Create Inflation:
For the last 12-years, this belief has remained a constant in the market. It stems from the idea that increasing the money supply is inflationary as it decreases the value of the dollar. There is indeed truth in that statement when considered in isolation. However, when the money supply is increasing, without an increase in economic activity, it becomes deflationary.
The chart below compares the money supply to GDP growth and our composite economic indicator which is comprised of inflation, wages, and interest rates, which all have a direct correlation to economic activity.
Summary – The Federal Reserve’s new policy tool is nothing more than a “do anything” excuse. The reality is the Fed has no actual ability to create employment, control inflation, or create economic prosperity. The only thing they do have the ability to incent employment and economic prosperity.
While many suggest the current situation is “unprecedented,” it really isn’t. Japan has been an ongoing experiment for nearly 30-years with the same economic outcome the U.S. is currently experiencing.
Furthermore, we have much more akin to Japan than many would like to believe.
- A decline in savings rates
- An aging demographic
- A heavily indebted economy
- A decline in exports
- Slowing domestic economic growth rates.
- An underemployed younger demographic.
- An inelastic supply-demand curve
- Weak industrial production
- Dependence on productivity increases
The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.
US Economy
- The NFIB small business sentiment report painted a mixed picture of the US recovery.
- CapEx expectations remain stable.
- More firms expect to boost prices. It’s worth noting that the US dollar weakness will be putting upward pressure on import prices, which will impact many small firms.
- Businesses are having a tougher time filling job openings.
- Credit card balances are down substantially from a year ago.
- Growth in government-sponsored student debt continues to slow.
- Rent inflation continues to moderate.
- Gains in home sale prices have been lagging list prices.
- Demand for office space has collapsed.
- Expectations for a $1.5 to 2.0 Trillion stimulus to be passed in September. The bill would push the net US 2020 spending to $6.6 trillion.
- Job openings rose again in July, with the latest increase exceeding economists’ expectations.
- Consumer confidence is grinding higher again.
- Mortgage applications for house purchase remain elevated. But delinquencies are rising as well.
Job Report from Last Week
- Best and worst-performing sectors:
- Companies with the “lightest” workforce have been rewarded by the stock market, and there is a concern that many firms will not want to return staffing to pre-crisis levels.
- Permanent layoffs keep climbing
- High-frequency indicators point to a gradual recovery.
- Hiring activity increased slightly over the past few months.
- Job growth is strongest in the construction sector, but owners report difficulty finding skilled employees.
- A large increase in the number of available workers hasn’t improved applicant quality, which owners reported as a problem even before the pandemic.
- Capital expenditures remain depressed, which will affect future productivity.
- Owners don’t foresee broad sales gains under current conditions.
- Inventory replenishment is problematic, due to both low sales and supply chain issues, but this also sets up higher future spending.
- Main Street business see little reason for the Fed to worry about inflation.
- Credit seems available for those who need it, but most report little desire to borrow.
Bottom Line: Small businesses represent every sector so aggregate numbers miss some important differences. Restaurant owners probably aren’t having the same experience as technology firms, for instance. Some small businesses are doing fine. Small consumer-facing service businesses generally aren’t.
COVID Update
The median age of fatalities seems to be around 80. Deaths below that age level are highly associated with one or more conditions like obesity, hypertension, heart disease, diabetes, a weakened immune system, etc. Deaths among those under 20 are quite rare.
The estimated Infection Fatality Rate is close to zero for younger adults but rises sharply with age, reaching about 0.3% for ages 50–59, 1.3% for ages 60–69, 4% for ages 70–79, and 10% for ages 80–89.
According to CDC data, only about 6% of COVID-19 deaths were from COVID-19 alone.
In many countries, 50% to 60% of COVID-19 deaths are from care facilities. In some countries, it approaches 80%.
Market Data
- Insiders have been unloading shares.
- Number of young adults living with their parents highest on record — even surpassing the Great Depression.
- Over the past 10 days, the Up Volume Ratio on the Nasdaq has turned negative for the first time in 5 months, ending a historically long stretch of positive underlying momentum.
All content is the opinion of Brian J. Decker
