What happens when equity valuations do not support equity prices?

After 5 years of “highly accommodative” monetary policy, which has seen the Federal Reserve’s balance sheet grow by several trillion dollars and interest rates kept at record low levels, financial assets have recovered from their post crisis lows and have even gone on to break all time nominal highs. As far as markets are concerned, the job is done. The recovery is well underway and all that nastiness of the last few years can be put behind us. Except…

Except as anyone, who lives in the real world, will tell you, the story isn’t quite as simple or as rosy as some would have us believe. Now, more than ever, it is time to examine the correlation between financial assets and the real economy.

A simple way of doing this is to look at S&P earnings and ask the question: are earnings justifying stock prices?

If you take a look at P/E ratios you should get an idea of how undervalued or overvalued a stock is. In simple terms, if P/E ratios are above their historical averages then it is a fair bet that stocks are overvalued. Equally if P/E ratios are below the historical averages then this is probably a good time to buy.

Barry Knapp has recently conducted a short study to investigate whether the current market is overvalued or not. He used several measurements, taken from balance sheets and income statements, and collated historical data from 1973 to draw his conclusions. The following table summarizes his results. We have added an extra column to demonstrate the difference between current and mean values (“Difference”). To help guide you, when the “Difference” percentage is positive, this means the current valuation measure is above average, suggesting the stock is expensive on the basis of each measurement.  This is applicable to all the lines apart from the “Dividend Yield” asof course a better than average dividend would be a positive thing in most people’s eyes!

As is clear, all the numbers above in the “Difference” column are positive, apart from “Dividend Yield”. These results suggest that stocks are overvalued, compared to their long term averages, on each valuation measure. In addition to this, the dividend yield is below its long term mean, which further reduces what little value there might currently be in the market.

The top line of the table looks particularly significant. According to this, current valuations appear especially expensive when using sales as a calculation variable. This suggests that companies could be struggling to sell enough of their products and services to justify their price (87.5% above the mean). In a world suffering from depressed demand, this is further confirmation of the tough business environment out there.

The second line of the table is also interesting. This shows valuation according to Price/Free Cash Flow and could be interpreted that stocks are trading only marginally above fair value (2.4% above the mean). Scratch away at the surface of this and another version of reality is revealed. In this age of unlimited liquidity, one thing markets are not short of is cash. However, what the Fed hasn’t been able to drive higher, is demand for goods and services. This explanation of the apparent discrepancy between lines 1 and 2, hints at possible further trouble to come, once the free money spigot is turned off.

To complement Knapp’s study, we decided to delve a little deeper into the current valuation story, using the Shiller’s P/E ratio. This too confirms that markets look overvalued.  The Shiller P/E for the S&P 500 stands at 23.8, against its long term average of 16.50.

While valuations look increasingly expensive, conversely, measurements of market risk are near their lows. Take a look at this next table that we have borrowed from Knapp’s study. Again we have added an extra column (“Percentile”) to make it easier to understand where volatility is in comparison to the long term averages;

The higher the “Percentile”, the nearer volatility is to its high. As you can see, most numbers are in fact much nearer to their lows instead. In particular, 1-month and 3-month volatility are just 5% – 6% above their means, suggesting markets have been pretty relaxed this summer!

As contrarians, we find this all quite troubling. With the Fed’s tapering decision approaching, it is hard to understand why so many in the market are apparently so complacent to the obvious pending dangers. After all, look at any chart, since the advent of QE, and it is abundantly clear just how addicted to easy money markets are. The withdrawal of this is bound to have an unsettling effect, at the very least. Perhaps investors and traders have decided that, based on the Fed’s actions in the last few years, if things do get too choppy, they’ll simply step in again. As abhorrent as this idea might be to true believers in the free market, this is also a consequence of attempts at centrally managing economies.

This cannot last forever though. Once the Fed starts to taper its bond purchasing program, which it is going to have to do at some point, then stock fundamentals are rapidly going to become important again. With the S&P 500 currently up 20% YTD and earnings expected “only” to rise 7%, at most, over the rest of the year, it looks like something will have to give. It doesn’t take a genius to figure out what that will be.

In our Global Macro account we have been positioned net short and have enjoyed the downdraft in the last 2 days and as we alerted readers to in this blog here – http://www.spreadbetmagazine.com/blog/just-how-much-more-gas-is-left-in-the-tank-of-the-equity-mar.html

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R Jennings, CFA. Titan Investment Partners