Glacier ahead – what is really supporting U.S. equity valuations?

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Much has been written lately about the current state of US Equity markets and how they will perform going forward as we approach the beginning of the end of QE and the start of the so called Fed “tapering”.

As we discussed in our recent post about Hedge Fund under performance, US Equities have enjoyed a stellar run since 2009 that dove tails almost exactly with the start of intervention in the aftermath of the credit crunch by the Federal Reserve and other western central banks. There is difference between causation and correlation of course, but directly or indirectly, the Fed’s actions over the last four years have allowed US companies and the stock indices to prosper largely unhindered. Or so it seems… I say that because everything may not be rosy as the headline performance and quarterly returns suggest…

There is a debate raging right now about just how good the quality of US corporates earnings are likely to be going forward and what this means for the future valuation of the S&P 500 – the broad based index which tracks Americas biggest and best quoted businesses.

To understand what this debate is about, we need to put the performance of the S&P over the last four years into a historical context. World markets and business en bloc ground to halt in the first quarter of 2009 and the S&P500 index reached a low point in the week of the 6/03/09 of the devils number itself – 666.79, and from which point it has rallied extensively with a fee sharp routs along the way.As the chart below shows, that rally led to the index in fact posting a new all time high of 1709.67. That represents a gain of some 256%, trough to peak, in a little over four years, or if you prefer, a gain of 1042.88 index points.  “Classic Bull market stuff” I hear you say as you survey the 45 degree left to right sweep of the S&P chart but not everyone agrees with that line of thinking.

S&P 500 5 year chart

In fact, there are several sets of dissenters and interestingly they both take a longer term view of the index and its performance to make their bearish case. The first camp of nay sayers is made of up of acolytes  of US  economist & academic Robert Shiller  who is perhaps best known for his eponymous  US housing index. However, Professor Shiller’s body of work also includes the calculation of inflation adjusted returns and ratios for the S&P 500. The Cape Shiller PE ratio as it known looks at the real PE ratios prevailing in an index adjusted for 10 year’s worth of inflation data on a rolling basis. Analysis of the S&P 500 using these measures shows things in a completely different light.

Cape Shiller shows overvaluation

If we look at the current PE ratio of the S&P 500, we see that as of the close of business on the 27/0/813 it stood at 18.59 times 12 month trailing earnings versus its historic mean average of 15.50 times (according to data from However, if we apply the Cape Shiller PE, we find that the ratio leaps to 23.34 times earnings against an historic mean value of 16.48 times. That suggests that the S&P is trading at more than 40% above the norm which could be justified if there was an expectation of significantly higher earnings through 2013/2014. That seems unlikely to be the case however as earnings growth rates are actually falling, particularly if we exclude the financial sector as the respected Forbes magazine highlighted just over a week ago.

Forbes suggested that the growth rate for S&P earnings based on 464 companies that had reported earnings for the June quarter was 2.1%. However, if we strip out the impact of the financial sector, that figure becomes a negative 3.1%. Meanwhile, analyst expectations for  coming quarters are being dramatically reduced. For example, in March 2013, analysts expectation for earnings growth amongst S&P constituents was 11.4% and that figure has subsequently fallen dramatically to just 3.9%. Furthermore, with few companies actually adding much in the way of sales to the top line (sales growth rates were averaging just 2.8% across the index as of March this year well below the historical mean of 3.59%) balance sheet adjustments and share buybacks rather than  genuine growth will be the real drivers for any improvement. True, buy backs are positive for share prices but that they also suggest that a business is hitting the buffers in terms of scale, or has run out of ideas or opportunities for growth. 

Secular Bear

The other group that believes that the S&P is overvalued, or over extended if you will, take an even longer term view than the decade’s worth of data employed by the CASE Shiller crowd. This group of long term chartists believe that that rather than being in midst of one of the strongest bull runs in history, the up leg witnessed since March 2009 is nothing more than an uptick in a secular bear market. Pattern recognition to my mind is a function of scale and viewpoint and in this case the viewer is Ron Greiss at the Mr Greiss has plotted the history of secular bear markets back to the early part of the last century using the broader based S&P composite index, once again this adjusted for in inflation. What Mr Greiss found was that these episodes last many hundreds of months. For instance, between 1906 and 1921, and again a between 1929 and 1949 and 1968 and 1982, in each instance he highlights substantial successive falls in the S&P that have been partially offset by counter trend rallies. In the 1968 to 1982 episode the market was down by 66.31% in 165 months according to this research see the chart below .

Mr Greiss contends that were are currently in another secular bear market that began in the year  2000 and that the last four years represent nothing more than an upward leg before a larger sell off. The prior downward moves in this theory were 53.26% and 58.44% respectively in the early part of the millennia. If this pattern is to repeated once more, then we may well see a significant double digit percentage fall in US equity markets. The question is whether the average observer will be able to recognise its occurrence which, like the movements of glaciers, may largely imperceptible to the human eye.

Here at Titan Investment Partners, aside from riding the precious metals rally in recent weeks wel,l and in fact neutralising our geared position here in recent days, we are now positioning our flagship Macro fund for, what we perceive, to be inevitable bumps in the road ahead when QE is withdrawn. We set out some of our thinking in our pieces for the latest edition of this very magazine, but if you would like to join us investing our own capital then click the image below to learn more.

R Jennings, CFA. Titan Investment Partners


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