This month marked the fifth anniversary of the “Bull Market” that has characterised the S&P 500 since early spring 2009. During this time the blue chip US equity index the S&P 500 has rallied by over 1200 points, or if you prefer 283 %. Here at Titan we make no secret of the fact that we believe that this “one way market” is now drawing to a close as the “narcotic cocktail” of asset purchases and ultralow interest rates are gradually withdrawn by central bankers and policy makers.
Whilst it’s certainly not impossible that the market will make higher highs in a final hurrah, data that we look at suggests that we are already looking expensive by historical standards. Consider the chart below which plots a rolling 12 month EPS for the S&P 500 index (data courtesy of Multpl.com)
The bold yellow horizontal line represents the prior Earnings Per Share peak for the S&P 500, achieved in 2007 just ahead of the Global Financial Crisis. Earnings peaked then at $94.83.
Note that now, consensus “anal”-ysts estimates for earnings per share in the S&P 500 for calendar year 2014 are at an eye watering $121.86 – a 28% premium to the 2007 number & that seen in 2013. That is hard to square with the numbers we have seen from corporate America so far in 2014.
As the market is priced at a very expensive premium to its “Q” ratio (replacement cost of assets), monetary stimulus is being withdrawn and geo-political risks continue to rise, insiders continue to sell at a frenzied pace and IPO’s are being launched to cash out on the positive sentiment, the only real pillar left to support equity prices is the earnings one. Should the market disappoint here and it seems a near dead cert that we are likely going down. Remember that the “anal”-ysts are always wrong in aggregate and in particular, too optimistic at peaks and the beginning of the year. A warning and historic record that investors would be silly to ignore…
According to Factset data the earnings growth rate amongst S&P 500 companies thus far in Q1 2014 is just 0.5% .That number has been revised down sharply from December’s more positive outlook following negative EPS guidance from 86 of the S&P 500 constituents (we note that just 17 constituents have offered positive EPS guidance in this period). Nine sectors within the index have lower earnings growth forecasts today than they had in December 2013.
Our second chart (see below: source Factset) plots the S&P 500 price against the 12 month forward EPS for the index and as we can clearly see the broken green line which represents that the S&P 500 is running well ahead of the solid turquoise forward EPS line. That suggests that the index is over extended and, given the earnings data above, it’s hard to see how the fundamentals will be able to play “catch up”.
The last time that the index valuation ran significantly ahead of the forward earnings line was in September 2006 – that over extension ran on for twelve months before the price line fell back below forward earnings and which in hindsight was a clear sign of a change in sentiment ahead of the crash of 2008.
We are not alone in thinking that valuations are looking stretched, John Butters, Senior Earnings Analyst at Factset notes that
“The current forward 12-month P/E ratio (for the S&P 500) is above both the 5-year average (13.2) and the 10-year average (13.8). The P/E ratio has been above the 5-year average for more than a year (since January 2013), while it has been above the 10-year average for the past six months. With the forward P/E ratio well above the 5-year and 10-year averages, one could argue that the index may now be overvalued.”
There are some in the market however who contend that in fact far from being expensive and over extended the S&P is actually cheap at current valuations, when compared to historical levels reached in 2000, ahead of the bursting of the internet bubble. This is utter nonsense, like saying that a beer is cheap at £8 per pint because at some point in time people paid £20 per pint for it!
That argument is naïve in the extreme to us and we would be very wary of making comparisons to the current day using the returns generated by a couple of sectors that were detached from historical valuation methodologies. “This time it’s different” was the internet bubble mantra (of course it wasn’t but the “anal”-ysts would have had you believe it was!) and I am sure we all remember internet business that were floated, that had little or no clear business plan or obvious path to profitability. Sound familiar with the social media mania we are seeing today…?
Those that believe that US equity markets look cheap argue that forward PE ratios in the period 1999 to 2001 were often at 20 and touched peaks of 25 times earnings at their highest point, leaving plenty of headroom above the current levels around 15.4 times they say but to use one of the biggest bubbles in history as a valuation benchmark would seem to us to be reckless in the extreme, particularly because when it burst the S&P 500 index effectively halved over the next 20 months or so.
Each bull market is different of course, not least because of the variety of factors that caused it and drove it forward. The highly followed US financial website Marketwatch.com posted a very interesting piece of analysis late last week, which showed that since world war two only six bull markets have lasted for more than five years – two of which fell apart spectacularly as they moved towards a sixth year. These were seen during 1982 – 87 and 2002 – 2007.
With the Small Cap index in the US now trading at an amazing 49x earnings against the internet bubble peak of 39x we argue that it is only a fool that chases stock prices now. Here at Titan we believe that it’s time to prepare for that eventuality rather than believe that US, and by extension global equities, remain a one way bet.