Based on forward earnings estimates, many claim the market is “cheap”.
Bloomberg cites one of the best rounds of corporate earnings upgrades ever seen in the S&P 500. Combined estimates for 2018 profits among companies in the index have gone from $145.90 a share on Dec. 15 to $156.20 on Friday, a rate of increase that is four times faster than any stretch since at least 2012, data compiled by Bloomberg show.
Things Always Rosy at Tops
Forward earnings are extremely difficult to predict, and estimates are amazingly wrong at market peaks. CAPE ratios tell a better story.
CAPE stands for Cyclically-Adjusted-Price-Earnings (cyclically-adjusted P/Es). CAPE ratios are at rarified-levels seen in 2000, 2007, and 1929.
CAPE Analysis
Research Affiliates provides a stellar case Why CAPE Naysayers Are Wrong.
By dwelling on the potential flaws of a metric such as CAPE, it’s easy to become disillusioned and want to disregard it completely. Before we do that, let’s review what CAPE brings to the table. CAPE shows remarkable efficacy in forecasting long-term equity returns, not just in the United States but across the world,15 providing investors a consistent tool for comparing potential equity market investments. The fit is imperfect, but impressive.
Every time the CAPE ratio suggests caution, CAPE skeptics suggest we should ignore it. We are highly confident those offering eulogies today for the CAPE ratio are premature—as has been the case repeatedly in the past. We readily acknowledge that the historical average CAPE of 16.6 is a poor guess for today’s equilibrium valuation level, as both Jeremy Siegel and we at Research Affiliates have written about in the past. But even after dickering over accounting rules and growth rates, the fact remains the US equity market looks expensive. If we take out the extremes of 2009, perhaps the current multiple is closer to 29 than 32. If we adjust for accounting rules, perhaps the equilibrium is 20. When the US CAPE hits 20, then we can have a spirited debate about whether we’ve reached fair value or are still a little richly priced.
Read the Article
That’s an excellent article well worth closer scrutiny, but few will listen. More accurately, few can listen.
Mathematically, it is impossible for the masses to heed the warning because someone has to hold every security in existence, 100% of the time.
I suspect even bears will get sucked into this bubble on the belief a 10% or 15% decline makes things cheap. A 15% decline would barely represent a down payment on what’s likely to come.
Mike “Mish” Shedlock
http://vimaxmedan.xyz
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QTPie, I made the same point in a later post. I guestimated that the average would be 20%, but you might be right at 10-15%. Some businesses are not profitable, or have sufficient loss carryforwards that they don’t pay tax anyway, and got no benefit from the tax cut. Others paid a lot more tax, and will see more benefit. Certainly my point wasn’t that the market is “cheap”, but rather more that we really don’t know what the real PE ratios are post-tax cut.
I’m not sure a 30% rise in earnings is the magic number that will transpire becuase many corporations’ effective tax rates are much lower than the headline corp. tax rate. Only time will tell but my gut feel says that the actual benefit to earnings would probably be more in the range of 10-15%.
If we assume the S&P 500 would be fairly valued at a CAPE ratio of 20 that would require a 1,000 point drop in the index from today’s close. Not sure if the wizards at the Fed would allow that.
Taking into account estimated 2017 and 2018 earnings the “forward” CAPE drops to 26.
The real problem is that the system is absolutely corrupt. When the market was tanking in August 2014, Bullard came out and lied that QE shouldn’t end, causing the market to rocket to a new all time high. We are in the midst of the greatest financial fraud of all time. All that is needed is another FED lie to goose the DOW to 27,000 and beyond. There is no trusting a fraudulent market. At some point, where ever that will be, a parabolic move fails, as it did with the Nikkei and NASDAQ. Then the truth comes out.
“A “one-time event” that got priced into equities about 30 times.” Based on rates alone, the tax cut should raise EPS by 30%. Note that not all companies are profitable, and that many/most don’t pay the full tax, so let’s guess that EPS will actually go up, on average 20% or so. In that case, the SPX at the peak of the current price of 2709 is equal on an EPS basis to about 2250 before the tax cut, about where it was a year ago.
When markets become frothy earning estimates soar because the large corporations are pocketing fictitious profits through their treasury department. Should the stock markets fall by 20% in the next few weeks which they will, we will see an avalanche of downgrades for profit projections. Here is the conundrum that is going to sink the economy: the economy cannot withstand interest rates of 2.7% or higher at current inflation rates, but rates cannot fall even as the economy weakens because the recent tax cuts have just added an extra $455 billion in borrowing this year already. While Trump took undeserved credit for the stock market rise, he is not taking credit for its collapse which is deserved. This is not 1982, the US economy is boxed in, and the Chinese economy is not more sound either.
“Carl-R … wouldn’t this be a perfect opportunity for more buybacks to get the earnings up even higher still, pushing the stock up increasing the value of their stock options?”
Corporations have a duty to do whatever maximizes shareholder value, not that they always do. They have several alternatives they can do with the extra earnings. First, they could invest it to grow. They already invested in anything that made a high enough rate of return, but with less taxes, a project that wasn’t quite good enough before might now look better, so they will certainly invest some money into growth. If they don’t have good investments to grow, they can give some of the money back to shareholders, which in turn will generate tax liabilities at the individual level, partially offsetting the taxes they didn’t collect at the corporate level. One way to pass the money to shareholders is to pay dividends, which is taxed to the shareholders at the ordinary income rate. Another option is to do share buybacks, which in theory pushes the share price higher, resulting in capital gains to shareholders (and holders of stock options). I expect to see some of both. I also expect corporations to pass some of the extra profits to employees, either through raises, bonuses, or more stock options, all of which also generate additional tax liability at the individual level.
I have no idea how much “revenue” the government will lose from the tax cut, by the way, but it won’t be nearly what doomsayers expect. The corporate tax decrease will be at least partially offset by increased taxes from increased dividends, capital gains, and employee bonuses.
A “one-time event” that got priced into equities about 30 times.
are these inflated earnings OPERATING or PRO FORMA earnings?
“Since 1996, the US CAPE ratio has been above its long-term simple average (16.6) 96% of the time,”
Let us look at what came after 1996:
1. LTCM
2. Full-time meddling from the Fed by the Mastreo
3. Dot com Bubble
4. Dot com burst
5. Lowering of interest rate to 1%
6. Housing Bubble
7. GFC – everything would have gone under but for the money spigot from all the central banksters led ably by the “got everything wrong” Bernanke, TARP and FASB accounting rule change.
8. ZIRP and NIRP across the world
9. Central banksters in command
Given above, could one say that CAPE of 16.6 pre-1996 would probably be a more appropriate measure?
Is it conceivable that any theory based on history will not do full justice to the situation today, given the unprecedented central banksters’ intervention since 2008, not to mention the never before seen level of coordination among the central banksters and the unprecedented levels of debt. Is this a pivotal point in history or do we have a blip and then go on like the last decade?
First, yes, we can be sure that forward earnings will be significantly higher than trailing earnings. The tax rate change is a one-time event that will raise corporate earnings by about 30%, and that has nothing to do with projections of growth. If the companies simply do as well as before, their EPS will be 30% higher. Now, it’s possible, even likely, that the excess earning will cause them to over-invest, and over-expand, in time driving the earnings back where they were, but that will probably take a few years.
Second, I have a major problem with this chart for a core fundamental reason: it tells nothing about the interest rate at the time. The EPS should equal 1/interest rate. Without the concurrent interest rate it’s impossible to say that the market was “overvalued” or “undervalued” on a PE basis. For example, in the late 70’s and early 80’s, interest rates spiked to high numbers. Therefore, the market PE was correspondingly low. Currently the market interest rates are much lower, so the corresponding PE ratio is significantly higher. At the very least, Mish, why not add to the chart above another line, that being 1/corporate bond rate, or say, 1/ten year bond rate. I think you will find that it correlates nicely, and additionally, that times where the two curves deviate signal significant buying or selling opportunities.
Note that the one thing we know for sure is that, if and when the market interest rates rise, the market PEs will fall. There is an old saying on Wall Street: Don’t fight the Fed. When they decide to raise rates, it takes awhile to have an effect, but the market always responds.
What has a higher probability – govt bond bubble popping or stocks tanking? When was the last time both crashed at the same time? When was the last time stocks were the safe-haven? Did CAPE or other valuation models used today exist during these times (if they ever existed)?
I don’t think the market is cheap. In fact, I expect a 20 to 30% decline in the next year or two. However, the CAPE – i think – is misleadingly high, due to not only 2008-2009 earning, but the very slow growth that followed.
We had a big jump in forward earnings estimates because of the tax law change. A one time event that may be whole or partially reversed at some point. We’re clearly in a bubble. Don’t know when it will end, but bubbles always pop. They never stay inflated for extended periods of time.
And is there ever a recession factored into those forward earnings “estimates”?