U.S. stocks are expensive by historical standards, and the bulls try to justify current valuations by pointing to extremely low levels of interest rates. There are a number of reasons why that’s no reason to pay sky-high prices relative to profits.
With companies preparing to start reporting results for the third quarter, the S&P 500 Index is trading at 19.1 times earnings over the last 12 months, compared with the average of 16.9 over the long term. It should be noted that earnings per share in the past year have been supported by unsustainable stock buybacks. Corporate managements, though, generally have a buy high, sell low mentality. They tend to be overly enthusiastic at business cycle peaks when corporate cash is plentiful and purchase their shares at high prices.
Also, the 2017 corporate tax cut that reduced the top tax rate from 35% to 21% boosted cash flows. So has the lack of capital spending. Conversely, in recessions, when stocks are cheap, but earnings and cash flow are weak, buybacks are few and sometimes replaced by emergency stock issuance.
The cyclically-adjusted price-to-earnings, or CAPE, ratio is also high at 30.3, or 44% above its long-term average of 16.9. This P/E is calculated using real corporate earnings over the past 10 years to iron out short-term fluctuations. Except for 2008, that P/E has been above the long-run average since the early 1990s, so if the long-term number is still valid, the CAPE will be below 16.9 for a number of years in the future to return to trend. Some say that long-run average is no longer relevant, but as legendary investor Sir John Templeton said, “The most dangerous words in the English language are, it’s different this time.”
The current argument favoring higher P/E ratios is low interest rates. Low current bond yields mean there’s less competition between interest coupons and appreciating stocks. This assumes, however, that investors buy stocks mainly for price gains but buy bonds for yield. As readers of my columns know, I’ve never bought Treasury securities for their yield, but for appreciation. I couldn’t care less what the yield is as long as it’s going down and, as a result, bond prices are rising.
A comparison of apples-to-apples is sobering. Due to the drop in the 30-year Treasury bond yield from 14.6% in 1981 to 2%, my long-held target (see my Sept. 5 column, “Treasury Bond Yields Have Yet to See A Bottom”), bonds on a total return basis have outperformed the S&P 500 since the early 1980s by 5.5 times.
On a yield basis, that 2% rate on the Treasury bond is identical to the dividend yield on the S&P 500. And the yield on stocks should be higher to account for the higher volatility and risk of equities compared to riskless Treasury bonds.
Of course, if investors neglect the likelihood that low bond yields foretell a recession and possible deflation, both of which are highly detrimental to stocks, they can believe that low rates and high P/Es go hand in hand. But they haven’t. I inverted the S&P 500 P/E to convert it into an earnings yield that many believe should be positively correlated with rates, falling as rates fall - higher P/Es - and rising as rates rise - lower P/Es.
Yet there is a lack of correlation between 3-month Treasury bill rates and the S&P 500 earnings yield since 2000. After the 2008 financial crisis, the earnings yield fell, then rose even though the Treasury bill rates were essentially flat. The correlation coefficient between these two series is low and negative at -37.5, the opposite of what many would expect. Similarly, the correlation between the S&P 500 earnings yield and the 10-year Treasury yield is -46.7, and -38.4 compared with the 30-year Treasury yield.
As I’ve continually observed, inflation is the key determiner of Treasury yields, with a 60% correlation. Inflation can be very detrimental to stocks as it was in the late 1960s and 1970s when double-digit annual price increases disrupted business and transferred profits to the government via taxes on inventory earnings and under-depreciation.
Otherwise, forces apart from inflation and interest rates dominate stock P/Es. Think about the dot-com stock speculation of the late 1990s and the subprime mortgage bubble of the mid-2000s. So don’t rest easy, believing that low interest rates make stocks cheap. Quite the contrary, low yields are probably foretelling economic weakness and possible deflation that will dramatically slash corporate earnings and P/Es.
A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
© Copyright 2023 Bloomberg L.P. All Rights Reserved.