Kass: Everybody in the Pool
- The median price-to-revenue ratio of the S&P 500 is now at an historic high, eclipsing even the 2000 level.
- The Shiller P/E is above 25, exceeding all observations prior to the late-1990s' bubble except for three weeks in 1929.
- Market cap-to-GDP is already past its 2007 peak and is approaching the 2000 extreme. (This ratio is stretched at over two standard deviations above its long-term average.)
- The implied profit margin in the Shiller P/E (denominator of Shiller P/E divided by S&P 500 revenue) is 18% above the historical norm. On normal profit margins, the Shiller P/E would already be 30.
- If one examines the data, these raw valuation measures typically have a fraction of the relationship to subsequent S&P 500 total returns as measures that adjust for the cyclicality of profit margins (or are unaffected by those variations), such as Shiller P/E, price-to-revenue, market cap-to-GDP and even price-to-cyclically-adjusted-forward-operating-earnings.
- Because the deficit of one sector must emerge as the surplus of another, one can show that corporate profits (as a share of GDP) move inversely to the sum of government and private savings, particularly with a four- to six-quarter lag. The record profit margins of recent years are the mirror-image of record deficits in combined government and household savings, which began to normalize about a few quarters ago. The impact on profit margins is almost entirely ahead of us.
- The impact of 10-year Treasury yields (duration 8.8 years) on an equity market with a 50-year duration (duration in equities mathematically works out to be close to the price-to-dividend ratio) is far smaller than one would assume. Ten-year bonds are too short to impact the discount rate applied to the long tail of cash flows that equities represent. In fact, prior to 1970, and since the late-1990s, bond yields and stock yields have had a negative correlation. The positive correlation between bond yields and equity yields is entirely a reflection of the strong inflation-disinflation cycle from 1970 to about 1998.
Where Are the Bubbles?There has been a lot of bubble talk of late. That talk (and the very existence of those questioning bubbles) seems to many as a rejection that there is a stock market bubble at all. In "10 Laws of Stock Market Bubbles," I noted that the problem with bubbles is that if you sell stocks before the bubble bursts, you look foolish, but you also look foolish if you sell stocks after the bubble bursts. I also concluded that the market is not yet a bubble; it is simply overvalued (maybe by as much as 10%). If I were pressed, however, to express if and where the bubbles reside today, they likely exist in the extraordinary faith in the Fed and central bankers around the world to shoulder the responsibility of catalyzing economic growth and in the general notion that corporate profit margins (and thus the outlook for future corporate profits) are inflated and in bubble territory at about 80% above the long-term average over the past six decades.
Too HighTo date, the aforementioned headwinds have been seen simply as opportunities for investors to buy more stocks on weakness. Grandma Koufax used to say, "Dougie, investment trees don't grow to the skies." To a rising chorus of self-confident and almost boisterous bulls, fueled by a nearly unprecedented and continuing market rally, the investment trees indeed appear to be rising into the sky. The argument, gaining credence with every 10-handle move in the S&P 500, is that with short-term interest rates anchored at zero, there is no alternative. But as Tennessee Williams wrote, "There is a time for departure even when there's no certain place to go." For, at many points in history, regardless of yield, cash has been king.
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