Update: The charts below are based on reported earnings, which I converted to constant 2013 dollars using the CPI.
Back in May, I suggested the stock market was showing some signs of froth, although “maybe in the same way that froth was apparent in 1997 or 2006, several years before the respective peaks.”
Before making that statement, I checked a few valuation indicators that I use to gauge such things. I was especially interested in a comparison of three types of price-to-earnings (P/E) multiples, which I’ll share here.
The idea isn’t to forecast a market top, since P/E multiples are useless for predicting turning points. But they can tell us something about the risks we may face when the bull market finally runs out of steam (whether that’s what we’re witnessing this month or not).
I’ll start with the not-too-bad news.
The first chart shows a traditional P/E multiple (based on trailing four quarters earnings) and compares today’s valuation to the last eight bull market peaks:
You may be concerned by the proximity of today’s P/E to the peaks in 1966, 1968 and 1973. But the market pushed much higher before correcting in 1961, 1987 and 2000, and there’s still more than a full P/E unit separating today from the 2007 peak. Optimists can take some comfort from these results, and especially if they expect earnings to climb higher.
Which brings us to, well, earnings.
It’s important to keep three things in mind when we talk about earnings:
- In economic expansions, the consensus always calls for increasing earnings. Forecasters may expect a short-term dip if company guidance has been weak, but the consensus projection invariably reverses the dip a quarter or two out.
- Based on (1), the consensus never anticipates a prolonged drop in earnings.
- History shows that earnings often defy the consensus and fall further and longer than expected, reverting to a rising trendline.
Here’s a chart that demonstrates (3):
Especially in recent economic cycles, it’s clear that changing perceptions about earnings explain a substantial portion of the market’s volatility. Just as investors can easily forget that P/E doesn’t rise forever, they sometimes forget that earnings don’t climb forever. And when earnings are unusually high, traditional P/E multiples fail to capture the full risk of a correction.
Yale economist Robert Shiller had these challenges in mind when he suggested a different P/E measure over 15 years ago. Instead of using four quarters of data, he averages earnings over the last ten years to smooth the ups and downs and plugs the result into the denominator of the P/E multiple.
Here’s a different version of the first chart above, this one using Shiller’s P/Es:
The market looks more expensive today with Shiller’s approach than it does with traditional P/Es. But I’m not finished just yet. A third way to capture earnings risk is to divide price by a “normalized” earnings estimate that’s plucked from a trendline, such as the trendline in the second chart above. Although trendlines are notoriously unstable, I like this approach because it accounts for long-term earnings growth (and also because it’s visual).
To compare today’s P/E to past bull market peaks using this third method, I calculated a separate trendline for each peak. In each case, I used only information that was available prior to the peak. (For further details, see the “technical notes” link at the bottom of the article.)
Here are the results (please have a look, Jeremy Stein, and give us your thoughts on stock market froth as you did for the bond market in February):
The chart shows that today’s valuation may be comparable to what we were seeing a few years before the 2000 and 2007 bull market peaks. This is the conclusion I flagged in the May article, when I suggested investors may be experiencing another 1997 or 2006.
More ominously, we’ve blown past all of the other six bull markets in the 50+ year data set. In my opinion, this isn’t a welcome result. It marks valuation risk as unusually high, exceeded only by the truly extreme levels reached in the last two market cycles.
What Does Price-to-Trend-Earnings Tell Us About the Fed’s Policy Mix?
The price-to-trend-earnings multiples also raise questions about the Federal Reserve’s long campaign to prop up asset prices through unconventional policies. I’ve argued in other articles that the “wealth effects” sought by the Fed are mostly bringing forward gains that would have otherwise occurred in the future. They’re weakening tomorrow’s growth in return for a shot in the arm today.
Of course, policymakers would like you to believe their actions are stabilizing. But the last two decades suggest otherwise. And the chart above reinforces the risk that we’re stuck in a Groundhog Day-like loop of living through the same boom-bust cycle over and over. It shows that the next policy-induced bust may be gradually coming into view.
(Click here for technical notes about this article and a few more charts.)
Update 2: If anyone read the Horan Capital Advisors response to this post and wondered if their conclusions are accurate (as of right now, they’re not), please see the comment below from reader Lance Paddock and my reply.