“I’m not in this world to live up to your expectations and you’re not in this world to live up to mine.” Bruce Lee said that, and it is the closest thing I have to a mantra at the moment.
The sentiment also applies to markets. Asset prices are always and everywhere a function of investor expectations. And, like our friends, families and office mates, they have no responsibility to live up to them.
The tricky bit in investing is actually determining the expectations of other market participants, and in the case of US equities one popular metric is the Shiller PE. It is simplicity itself, and this gives it a lot of weight in many investors’ thinking:
- Take the prior decade of corporate earnings for the S&P 500, and divide by ten. That’s the structural earnings power of the companies in the index.
- Divide that into the current price and you get an earnings multiple.
- Compare that to prior periods and see if US stocks are cheaper or more expensive than average.
With the S&P 500 crossing 2600 today, we thought it was worth a look to see how this level looks against the Shiller PE math. The answer: not good. US large cap stocks trade for 31.5x versus the 1880-to-now average of 16.8x. At present, valuations equal those at the 1929 stock market crash. The only higher historical levels occurred in the lead up to the dot com bust.
Here’s the thing, though: “Math isn’t an edge”. That’s something Stevie Cohen told me years ago. And while not quite as catchy as Bruce Lee’s life lesson, it is equally important for this discussion.
There are many problems with using the Shiller PE as gospel. Here are just a few:
- It ignores interest rates. Stocks discount earnings by a cost of capital, which is anchored to the risk free rate. Global long-term interest rates are lower than most points since 1880, but the Shiller PE does not adjust for that.
- The current reading includes the Financial Crisis, when the S&P 500 reported its first ever loss. Yes, if you wish to incorporate a 100-year flood into your estimates of normal earnings power then the Shiller PE is a great tool. But first look at the current low level of equity market volatility and ask yourself if that is commensurate with general market belief. And why you think you need a raincoat…
- It hasn’t worked very well for a long time in terms of picking entry points. By the Shiller PE, US stocks looked expensive even after the dot com bust. They only got to average levels of valuation after the Financial Crisis. And they certainly looked expensive the last 5 years.
- It treats all corporate earnings as equal. That sounds good in theory, but it implies that the earnings of an energy company are the same as those of Apple, Google or Facebook. The former relies on commodity prices for marginal profitability. Tech companies (ideally) create sticky business models that have less economic sensitivity. Investors do – and should – apply different multiples to those industries. The Shiller PE does not.
Now that we’ve plugged those notable holes, here’s what the Shiller PE can actually tell us:
- US equity markets clearly expect long-term interest rates to remain low for a long time to come. That’s why the Shiller PE is so high relative to historical norms.
- Investors also expect earnings to remain robust. Remember – we are measuring long run earnings power here. Prior economic cycles tended to last 3-5 years. The current one is +7 years and still counting. One potential reason: the belief that Tech-driven earnings are more stable than other industries have shown over time.
- Extend those two observations into the third dimension of volatility, and it is easy enough to see that a high Shiller PE also translates into low expected price movement.
The key point about the Shiller PE is therefore NOT that stocks are expensive. Rather, it is that markets expect inflation/interest rates to remain low and corporate earnings to stay elevated.
- The first point seems fair enough; it is hard to see long-term rates climbing quickly as long and ECB/JGB bond buying continues and developed economy demographics continue to show more gray hairs.
- Corporate earnings are the sticky bit, with sustainably high corporate earnings a function of both no global recession and no geopolitical shock. Higher levels of notionally stable-to-rising Tech earnings are another potential piece of the puzzle as well.
For the moment, this is what markets believe. Just remember: they aren’t here to live up to your expectations.
Data courtesy of Robert Shiller.