Barry Ritholz of the The Big Picture blog recently said:
Indeed, we are in a Fed driven economy, and but for their interventions, we in the USA would very likely already be in a recession. As I have have stated to many times, but for the Fed, equity markets would likely be 20-30% lower (and I may be too optimistic with those numbers).
The folks at PIMCO seem to have a different view:
Based on our analysis, QE has not been the driving force behind rising equity prices in recent years. We found that since 2009, corporate profits have had a more direct relationship to stock prices. For clues on where the equity market is headed, we suggest investors focus on corporate earnings, dividends and cash flows and pay particular attention to valuations. At PIMCO, we acknowledge that the linkages between QE and stocks are complex.
The above quote was followed by this chart:
The chart seems to indicate that the stock market goes up when the Fed is easing and falls apart when it isn’t. Is that the whole story?
Cullen Roche over at the Pragmatic Capitalist blog has a different view about QE driving stock prices and produces a chart comparing reserve balances to the S & P 500 over the time frame of the financial crisis:
We’ve now had over 4 years of varying forms of QE so the data is quite a bit more constructive than at times in the past when most of us were just speculating about QE’s impacts. At first glance, the chart (above) below might lead one to conclude that there is a very strong correlation between between QE and equity market returns, but the data is not so conclusive upon closer inspection…
Since QE began in late 2008 there’s a correlation between reserve balances and stock returns of just 0.65. But that’s not a completely fair look at the data. There have been four distinct periods when reserve balances were surging or declining/stagnant over the last 4+ years. I’ve broken this down more clearly below.
What’s interesting here is that the correlation between stock returns and decreases or increases in reserve balances is not quite as clear cut as most presume. See below for returns during reserve balance increases:
9/10/2008 – 1/7/2009 (S&P 500 DECLINED by 25%)
2/11/2009 – 5/20/2009 (S&P 500 INCREASED by 6%)
6/24/2009 – 2/24/2010 (S&P 500 INCREASED by 22%).
11/17/2010 – 7/13/2011 (S&P 500 INCREASED by 11%).
That looks pretty much as we might expect. But things get more interesting when we look at periods when reserve balances were declining:
1/7/2009 – 2/11/2009 (S&P 500 DECREASED by -10%)
5/20/2009 – 6/24/2009 (S&P 500 INCREASED by 1%)
2/24/2010 – 11/17/2010 (S&P 500 INCREASED by 8%)
7/13/2011 – 9/26/2012 (S&P 500 INCREASED by 9%)
In other words, regardless of whether reserve balances were rising or falling, stock prices were mostly rising. Even in the face of substantial declines in reserve balances over the last 4+ years the S&P 500 has risen. Of course, there are a lot of moving parts in this data, but the correlation between stocks and reserve balances is not terribly clear when we get granular with the data.
While it appears that QE is driving stock prices higher (and it well may be), it’s more likely due to corporate profits. Of course corporate profits would likely not be where they are without the combination of high deficits and a significant balance sheet expansion by the Fed.
Before we get into valuation metrics, an interesting post from Alhambra Investment Partners may provide additional insight into what is driving stock prices. In How Much of Equity Prices Is Real, we find some interesting charts about margin debt:
The post continues with the following analysis:
During the episodes where the Federal Reserve was intent on increasing its balance sheet levels, and thus available bank reserves, margin balances rose far more quickly than during the interim periods where the Fed was largely inactive (under this definition, Operation Twist counts as an inactive period).
From January 2009 through January 2013, the pattern is unmistakable. Whether or not there is a direct line of “money” from the Federal Reserve to market makers to margin debt creation or the impacts of QE work through the psychology of investor expectations does not matter here (though it makes for very interesting conversation and conjecture that might be more relevant and important in the near future). What matters is that there is a high correlation between the Fed’s activities and margin debt levels, and that there is a further correlation between margin debt levels and stock prices.
Does this prove that market prices are not real? Of course not, but it provides both color and context in that debate. In my opinion, it adds to the weight of evidence that QE more than fundamental bases have been driving market machinations.
So it seems we’ve come full circle, perhaps QE does drive stock prices higher than they otherwise would be (By the way the Fed certainly thinks this is true).
The question you must ask yourself is whether you should invest in a market that is being driven more by “Fed Stimulus” than by fundamentals (realizing that we haven’t exactly proven the market is driven by Fed Stimulus). The old adage of Don’t Fight The Fed is certainly working right now and it usually does…until it doesn’t.
Back to the original question – are stock cheap or overvalued?
In 2000, a book came out titled Dow 36,000 – it marked almost perfectly the beginning of a bear market that has lasted over a decade and where stocks were essentially flat.
Today, in a Bloomberg opinion piece the author is back with a post titled “Dow 36,000 Is Attainable Again”. He makes the argument that stocks are cheap:
The heightened fears of investors are reflected in lower valuations. Currently, for example, the forward P/E ratio (based on estimated earnings for the next 12 months) of the Standard & Poor’s 500 Index is about 14. In other words, the earnings yield for a stock investment averages 7 percent (1/14), but the yield on a 10-year Treasury bond is only 1.9 percent — a huge gap. Judging from history, you would have to conclude that bonds are vastly overpriced, that stocks are exceptionally cheap or that investors are scared to death for a good reason. Maybe all three.
One way stocks could jump to 36,000 quickly would be for fears to subside and P/E ratios to rise. Assume that earnings yields fall to 5 percent. That would mean P/E ratios would go to 20, a boost of 50 percent in stock prices, assuming constant earnings.
I find it interesting that this opinion post comes out after the Dow hits an all time high, is it a signal? It’s impossible to know, but Glassman uses “forward earnings” as the input for the “e” in his P/E ratio and forward earnings are notoriously unpredictable.
A better measure is the Cyclically Adjusted Price Earning (CAPE) ratio, which is tracked by Doug Short at www.dshort.com. This measure attempts to smooth out earnings and adjust them for inflation. Short produces the following chart each month:
Short explains the rational behind the CAPE here, what follows is an excerpt:
(Benjamin) Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author ofIrrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected the 10-year average of “real” (inflation-adjusted) earnings as the denominator. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.
So where are stocks now in terms of the CAPE valuation measure? Short says:
For a more precise view of how today’s P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? The Financial Crisis of 2008 triggered an accelerated decline toward value territory, with the ratio dropping to the upper second quintile in March 2009. The price rebound since the 2009 low pushed the ratio back into the top quintile, and it has since hovered around that boundary. By this historic measure, the market is expensive, with the ratio approximately 35% above its average (arithmetic mean) of 16.5 (16.47 to two decimal places). Last month it was 33% above.
I’ve also included a regression trendline through the P/E10 ratio for the edification of anyone who believes the price-earnings ratio has naturally tended higher over time as markets evolve. The latest ratio is about 18% above trend, up from 17% last month (18.3% versus 16.5% at one decimal place). Critics of this more optimistic view would point to the unprecedented P/Es of the Tech Bubble as the explanation for this “unnatural” slope to the regression.
We can also use a percentile analysis to put today’s market valuation in the historical context. As the chart below illustrates, latest P/E10 ratio is approximately at the 86th percentile of the 1586 data points in this series.
A more cautionary observation is that when the P/E10 has fallen from the top to the second quintile, it has eventually declined to the first quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 550. Of course, a happier alternative would be for corporate earnings to continue their strong and prolonged surge. If the 2009 trough was not a P/E10 bottom, when might we see it occur? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now approaching its 13th anniversary.
Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations suggests a cautious perspective.
With the S & P 500 trading at close to 23 times trailing earnings and the historical number be 16.5, stocks don’t appear to be cheap.
So who is right? Glassman or the CAPE 10…history has been favorable to the CAPE, but history is just that, history. Is this time different or is this time similar to 1997, where stock valuations doubled before finally coming down to earth again? I don’t know.
What I can say is that there is certainly reason for caution. You should understand your downside and realize that events can happen that have a major impact on the market very quickly.
Scott Dauenhauer CFP, MSFP, AIF