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Triggers for a pullback in stock prices remain mostly the same; the worries about when the U.S. Federal Reserve will start raising interest rates and how quick and aggressive that path will be once they begin. The other major risk headline is the financial market contagion that could take place if Greece cannot negotiate revised terms with their lenders and has to leave the EU, or the aptly-named “Grexit.” On that issue we believe it is just time to “rip off the bandage.” The reality is that Greece will never be able to repay its existing debt in its current form and the new government of Greek PM Alexis Tsipras has also made it known that they are unwilling to put the Greek people through the necessary reforms and cutbacks demanded by lenders. Either lenders have to take a substantial cut in their loan amounts or Greece will need to leave the EU and go back to using the Drachma as their currency.
In terms of the outlook for the stock market, there are many ways to look at the overall valuation. One measure that many investors look at is the overall price-earnings (PE) multiple for the stock market. The PE based on forward-year earnings expectations, at just over 17 times, is now pushing levels topped only during the late-1990s. While it is true that PE’s tend to be higher when interest rates are low, we have already seen an adjustment for that as the spread between stock earnings yields and bond yields has been sliced almost in half over the past three years. The ‘cyclically adjust PE Ratio’, also known as the CAPE or the Schiller PE (for 2013 Nobel Economic Prize winner Robert Schiller’s work in this area) is a valuation measure usually applied to the S&P 500 index and is defined as price divided by the average of ten years of earnings, adjusted for inflation. As such, it is principally used to assess likely future returns from stocks over timescales of 10 to 20 years. Higher than average CAPE values implying lower than average long-term annual average returns. While it is not intended as an indicator of impending market crashes, higher CAPE values have been associated with such events. The chart below shows over 100 years of data on the CAPE. While it was higher during the technology bubble of the late 1990s, it is clearly well above the long-term averages and just another indication, in our view, of how extended stock prices are.
On other measures of stock market valuation, the market value of the S&P 500 now exceeds the value of U.S. economic output for the first time since the end of the 1990s. While we definitely take this as a sign that stocks are very expensive, we do recognize that an increasing share of S&P 500 revenues and profits are derived outside the U.S. and, as a result, this ratio has been drifting steadily higher over time. But, even if we take that trend out, stocks still look quite expensive. Another similar measure of stock market valuation compared to economic size is Tobin’s Q Ratio. Here, valuations look quite expensive, and are as rich as they’ve been since—again—the late-1990s. The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Luckily the numbers are supplied by the Federal Reserve. Like the other measure mentioned above, stocks are nowhere near as frothy as they were during the technology bubble, but they look about as expensive as they’ve been outside of that period.
The stock market indicators above all suggest to us that stocks are trading well above normal valuation levels. We could normally accept higher stock valuations early in the economic cycle when growth is just starting to pick up and earnings are coming off low levels. But earnings growth is slowing down as profit margins are at cyclical highs and there are fewer opportunities to grow profits outside of stronger revenues. Labour costs are starting to rise again, interest rates are at unsustainably low levels and stock buybacks have accelerated profit growth over the past few years. So unless economic growth is about to start moving higher, we see profit growth struggling. The chart below shows how the economic data in all of the major global regions (U.S., Europe and Asia) have been missing expectations so far in 2015. The Economic Surprise Index is based on comparing actual economic data to analyst expectations for those same data points. While the U.S. data started missing expectations at the beginning of 2015 due to the negative impact of the strong U.S. dollar on export growth, the European and Asian data has also been coming in below expectations in the second quarter despite the aggressive easing moves by central banks in all of those regions and the ‘tailwind’ impact of lower currency values (i.e. what the U.S. loses due to a stronger dollar should be picked up by Europe due to a weaker Euro).
