If you are of a certain age, or like listening to the moldy oldie channel, you might recall a song by Herman’s Hermits called “I’m Henery the Eighth, I am.” If so, you know it is a very silly song. You will also likely remember the lyrics to the start of the second verse: ‘second verse same as the first.’ This is because they simply repeat until the very end of the song. As an aside, the song amazingly dethroned “(I Can’t Get No) Satisfaction” by the Stones to top the Billboard charts here in the US.
I bring this up because this week’s pertinent news seems eerily similar to last week’s: 1) the potential tapering of the Fed’s monthly asset purchases, and; 2) the ongoing debacle at the Kabul airport. Although the stock markets have performed a little better this week, you could probably simply re-read last week’s Common Cents, and get a pretty good idea about what is happening. Throw in the issue from the previous week, and you would have an excellent idea.
Essentially, second verse same as the first.
It is one of those rare times when the fascinating becomes, well, boring due to repetition. However, something that WAS different about this week was I got the following question, or some variant thereof, on no fewer than a half-dozen times: “how much higher can the stock market go? It seems very overvalued.” Fair enough.
Here is my answer: “there is nothing in my crystal ball which suggests the stock market will be able to generate the same results it has over the last 12 months over the next 12 months. Conversely, there is nothing to suggest stock prices are going to fall precipitously either.” How is that for being non-committal and necessarily vague?
Although my answer mighty seem nebulous, I mean it wholeheartedly. I would be extremely shocked to report the same YTD and 12-month results this time next year. However, what is going to be the impetus for a sharp market correction? Especially one of the 2008 variety? Please understand it is impossible to adequately, and accurately, predict so-called “black swan events.”
With that said, as defined by the price/earnings ratio (P/E), the US stock market is expensive by historical standards in absolute terms. There, I have said, and I won’t deny it if you say I said it. There is no reason to dispute the obvious.
Currently, the trailing P/E on the S&P 500 Index is roughly 27x stated earnings. The forward P/E is around 25x expected future earnings. By comparison, the average and median of quarterly observations going all the way back to 1954 is closer to 17x. Further, remember the stock market bubble back in the late 1990s? Well, back then, the P/E was about 29x stated earnings. So, we are closer to the valuations of the stock market bubble of the late 1990s than we are the median for the last 60+ years.
It is only a matter of time before things go ‘poof,’ am I right? Probably not.
The problem with comparing today’s valuations with the past is market conditions aren’t the same. For instance, the average height of an American male is currently around 5’ 9.” However, a century ago, it was closer to 5’ 6” or 7”. Due to a variety of factors, namely an increase in nutrition and healthcare, Americans are taller now than they were in the past. The subject is the same, the average American male, but the time period has changed.
Consider today’s investment markets. The yield (interest rate) on cash/money markets, as defined by the 3-month Treasury Bill, is less than 5 basis points. For its part, the yield on the 10-Year US Treasury Note, a common proxy for the bond market as a whole, is around 1.30-35%. Finally, the dividend yield on the S&P 500 Index is 1.31%. As such, the stock market is ‘yielding’ way more than cash and about the same as the bond market. By comparison, these yields were 5.33%, 6.44%, and 1.11%, respectively, on 12/31/1999.
In other words, immediately prior to the tech bubble crash, investors had other options to generate both an absolute and a relative rate of return. These days, where does one turn to generate anything? The low hanging fruit for the average investor, if we are keeping things liquid and reasonably safe, is the stock market, despite the historically high valuations, in absolute terms.
However, at this point in time, a P/E of 25x is not as expensive as it would have been back in 1999 because the markets were fundamental different. Why? Because bonds and cash were much cheaper back then, which gave investors legitimate options/alternatives. Shoot, the Consumer Price Index (CPI), a common proxy for inflation, was 2.7% at the end of 1999. This means investors could significantly ‘beat inflation’ with either bonds or cash! That is nowhere near the case today.
As such, and as I have written here recently: stocks continue to be the most reasonably valued of all overvalued asset classes. If my back of the envelope calculations are anywhere close accurate, this will be the case until: 1) the market P/E spikes to 75x; 2) the yield on the 10-Year climbs 2.70% to 4%, or; 3) they meet in the middle at some point, which is the most probable case scenario.
If it helps, think of it this way. How much ground sirloin will you eat if it is $10/lb. when chicken is $5/lb.? Assuming you have to choose one or the other, probably not a lot. Now, how much ground sirloin will you eat at $10/lb. if chicken is selling for $15/lb.? Your answer is undoubtedly different, even though the price of sirloin is still a somewhat elevated $10/lb.
I hope this makes sense.
In the end, I freely admit I have written on this topic in the not so distant past. However, people understandably get worried when stocks seem to get overheated. After all, bear markets and financial system crises aren’t a lot of fun, are they? No, but trust us: when things start to look ugly in both absolute and relative terms, we will let you know.
Until then, let me just say: “second verse same as the first.”
Take care, have a great weekend, and be sure to listen to our Trading Perspectives podcast.
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself. Finally, we do NOT make a market in any of the companies listed in this newsletter, and I do not own them personally.