My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

How did we get here: US equities are expensive

By almost any metric you use, the US equity market looks very expensive compared to the past. According to multpl.com, the current P/E (ttm) of the S&P 500 is 34.1x, versus an average of 19.8x over the last 50 years (since Jan 1970), and an average of 26.1x over the last 20 years (since Jan 2000). The price-to-forward earnings of the S&P 500, perhaps more relevant since global economies are still recovering from the pandemic, is 21.6x according to Yardeni Research, Inc, a graph of which is below so you can see the migration over the last 15 or so years.


As this graph illustrates, the market is dancing with historical highs as far as price-to-forward earnings, too. Looking at one more metric, the dividend yield of the S&P 500 is currently 1.31%, its lowest yield level since June 2001. The monthly dividend yield of the S&P 500 since 2000 has ranged from a low of 1.11% (Sept 2000) to a high of 3.60% (Mar 2009), averaging 1.87% over this 20-year period. Equity yields are trending down, not far off of near-record lows, as stock prices appreciate. As a final anecdote, both the S&P 500 and the Eur STOXX 600 closed at record highs just last Friday. I could go on and on with valuation metrics, but any way you slice it, equities are expensive based on historical averages, even when considering things like earnings growth, technological advancements, improvements in productivity, etc.


How did we arrive here less than 1.5 years after the worst pandemic the world has seen in 100 years, one that shuttered most major economies for much of 2Q20? Even today, we continue to live in a world in which – although the worst might be behind us – the ongoing effects of COVID-19 and associated economic uncertainty are far from over.


In this article I will present the five reasons that I think US equities have gotten so expensive. The rapid recovery and then the further ascent to record highs is not unjustified, although my personal view is that we are severely stretched at the moment and the bias is to the downside. There are probably plenty of other reasons aside from the five I will mention below, so please feel free to include your thoughts in the “comments” section below this article. In a follow-up article, I will discuss the alternatives that investors might consider if they are concerned about today’s very rich equity prices.


I believe that the current euphoria is being caused by some combination of the following:


1. Excess savings from fiscal stimulus – As the graph below from FRED illustrates (here), there is currently a savings glut in the US following three rounds of direct stimulus cheques to people plus huge amounts of fiscal stimulus through other channels. The personal savings rate since March 1, 2020 (beginning of brunt of pandemic) has averaged 17.9%/month according to FRED, with peaks most visible following each stimulus cheque: April, 2020, 33.7%; Jan 2021, 20.7%, and March 2021, 27.6%. This compares to the average savings rate/month over the last 20 years for the US of 6.9%/month, and the average during the GFC (1/1/08 to 6/30/09) of only 5.5%.



According to data from the FDIC (here), bank deposits increased $5.3 trillion during the 10-year period from 2010 to 2019 but have increased a further $3.9 trillion in just the last five quarters (since the beginning of 2020). Clearly, much of the excess liquidity from fiscal support is being channelled into bank deposits, but perhaps more concerning, it is also being channelled into riskier financial assets, as I discuss further below.


2. Unprecedented monetary stimulus, with no end in sight – Unprecedented and ongoing monetary stimulus from central banks in the world’s largest countries – including the US, Japan, the Eurozone and the UK – is also promoting risk taking. Lowering overnight borrowing rates to zero (or even negative levels) and purchasing government, mortgage-backed and in some cases corporate bonds with impunity through quantitative easing programmes has anchored interest rates at artificially low levels across the yield curve. This provides pandemic relief to businesses and is intended to spur investment in order to jumpstart beleaguered economies and lower unemployment by creating jobs. However, excess liquidity and historically low financing costs mean that margin finance is also readily available to institutional and retail investors which can be used to purchase higher return, higher risk financial assets with almost nil cost of carry. The graph below shows the growth in margin financing since 1997 (source: FINRA).


The next graph, also from FINRA for the period starting 1997, illustrates changes in the sum of excess cash and additional margin capacity at US brokerage accounts over the same period (source: FINRA).

As both graphs illustrate, investors have certainly not been shy about taking advantage of cheap financing to purchase equities (and perhaps other risk assets). However, the graphs also depict the hangover that occurred following both the bursting of the tech bubble in 2001 and the excess mortgage fuelled GFC in 2007-09. The current period of artificially low interest rates will not last forever, but the end of this unprecedented period of monetary stimulus is so far back in most investors’ minds that it seems like nothing more than an afterthought at the moment.


3. Near-nil cost of “playing the game” – Zero commission trading, fractional share trading and boredom during the pandemic all helped develop a new cadre of stock investors, mainly thought to be younger people trading though app-based platforms like Robinhood. This phenomenon is often referred to as the “gamification of the stock market.” I do not mean to pick on Robinhood per se, but as the posterchild for the gamification phenomenon, one of the most interesting statistics involving the platform is the average size of its accounts versus its peers, which I have extracted from businessofapps.com in the table below:

According to their S-1 (here), Robinhood added six million new accounts in 1Q21 alone, increasing their customer base to around 18 million. More than 50% of these customers were setting up their first brokerage account. The average age of a Robinhood brokerage customer is 31 years old. These new retail investors might be small individually, but are influential collectively, using social media to share ideas and ­ – from time to time – to steal the spotlight by (successfully) focusing on meme stocks.


4. Few attractive alternatives to equities – Complicating matters further is the reality that investors have had very few other places to invest since the early stages of the pandemic that offer returns that are as attractive as returns in the equity market. Even “safe havens” like banks only offer zero to marginally positive rates on savings or CDs. The corporate bond market offers interesting yields only by moving down the credit curve into the lowest rated corporate high yield bonds. And if you wish to be really cynical, with the most recent CPI data in the US coming in at 5.1% for June 2021, the nominal average yield on USD-denominated high yield bonds of 4.04% (source: FRED) means that the real return on risky high yield bonds is negative! Granted, this is an apples-and-oranges comparison given I am comparing monthly CPI to long-term yields, but still, the revelation clearly demonstrates that real returns are only available in the riskiest corners of the market, like B- and CCC-rated high yield bonds. It’s increasingly hard to understand why an investor would not invest in equities when even the quickly falling dividend yield on the S&P 500 provides a higher return that the 10-year US Treasury. As equities become more and more expensive, the lack of other investments to generate returns that even match inflation is causing investors to consider alternative assets like private equity, cryptocurrencies, NFTs and the like.


5. Earnings and analysts’ consensus expectations – The sell-off during the early stages of the pandemic saw share prices collapse at an unprecedented pace because the future was so uncertain with respect to earnings. The S&P 500 fell from a pre-pandemic high of 3,386.15 on Feb 19th 2020 to a low of 2,237.4 on March 23rd 2020, a decline of 51% in just over four weeks. Investors knew what to expect from normal recessions, but the fact was that the global economy was heading into a manufactured recession related to a pandemic, the likes of which modern investors had never experienced. Once the government stepped in with fiscal support and the Fed turned on the monetary stimulus, the effects of the pandemic on various sectors and companies became better understood. In other words, whilst the trajectory of the pandemic and its economic damage was hard to predict (and remains so), the confluence of better understanding COVID-19 and proactive monetary and fiscal stimulus measures enabled astute investors to better choose the winners and the losers. Many of these bets have paid off handsomely, as investors initially and correctly favoured companies that benefited from the pandemic. For example, investors bought stocks of work-from-home (“WFH”) companies, and sold stocks of cyclical companies and companies involved in leisure (restaurants, cruise ship companies, gyms, hotels, cinemas, theatres, sports) and travel (airlines, hotels). Later as vaccines became available, many of the formerly out-of-favour companies returned to favour as they were expected to be beneficiaries of a strong post-pandemic economic recovery. Value also came into focus because many small and medium sized companies had been left behind whilst the initial WFH companies saw their shares advance rapidly, in some cases well ahead of what their earnings could justify based on almost any growth trajectory. According to Yardeni Research (here), earnings of the S&P 500 companies decreased 14.2% in 2020 as the pandemic-effects were brutally felt by companies, but earnings are expected to increase 39.5% this year as company earnings bounce back with record economic growth. However, Yardini is expecting earnings growth to slow in the last two quarters of 2021, and to then experience “more normal” (albeit still robust) growth of 5.1% in 2022. Sales/share data from S&P Global shows a similar pattern, although it is interesting to note that S&P 500 companies still have not returned to their quarterly pre-pandemic (Dec 2019) sales of $369.23/share. This being said, research analysts have done a poor job of providing accurate sales and earnings forecasts, perhaps because they have erred too much on the side of caution. This has resulted in several consecutive quarters, including the reporting quarter we are seeing unfold now, in which actual reported earnings have largely exceeded consensus expectations. According to Refinitiv (latest report here), around 65% of companies normally beat analysts’ consensus expectations. However, in the last four quarters, 83.4% of companies have beat analysts’ consensus expectations. In the current reporting quarter (2Q21) with 120 of the S&P 500 companies having reported, 88.3% have exceeded expectations! This ongoing pattern of above-average earnings (and sales) beats has undoubtedly thrown even more fuel on the existing valuation fire.


If you’re the nervous type – like me – you might be starting to feel uncomfortable with the indices reaching record high after record high. As I pointed out at the beginning of this article, valuations are at never-seen-levels no matter how you slice it. Fortunately, investors have not had to be choosy since the pandemic to have made money in equities – they have just had to be long. Had an investor been more proactive (and correct) as far as recognising early the in-vouge sectors and / or shifting investment strategies (e.g. momentum vs cyclicals, value vs momentum, reflation vs non-cyclicals, etc) along the way, he or she would have probably had amazing returns compared to those that could have been earned by just investing in the indices. Of course, this one-directional market can’t go on forever, so what should an investor do? It is not an easy question to answer, but I will discuss some strategies in the next article I write. Let’s face it – it is very difficult to reconcile the desire to achieve what looks to be easy returns in equities against lightening up or dumping equities completely. The opportunity cost of doing so, should equities continue to run, would be huge. If you should decide to take some money off the table, then there is the question of what to do with it. Remember – cash earns nil at the moment, bonds are at risk of rising rates, and alternatives take a different level of analysis and are illiquid.


 

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