It has been a while since we did a deep dive into US equity valuations. It isn’t just that the S&P 500 is up 17.5% in 2019 and +12.0% over the last year that gets our attention or that the index trades for 17x forward earnings, a lofty level versus historical norms. US equity market volatility – both actual and forecast – is exceptionally low at the moment. This implies a high degree of investor confidence that every valuation input, macro and micro, is stable and predictable at present.
To assess that sanguine judgment, we will outline bullish and bearish scenarios that both key off the same factors:
- The level and volatility of risk free interest rates
- Corporate earnings leverage and future margin growth
- Earnings quality and capital efficiency
First, here is the upside case using that framework:
#1: Risk free interest rates: central banks and bond markets will discover that the neutral rate of interest is far lower than both recent cycles and their own prior estimates. This is why, for example, US inflation is still below the Federal Reserve’s 2% target despite strong labor markets.
Why is this happening? Higher levels of corporate and private sector indebtedness than historical norms make the US/global economy more levered to the cost of debt. That is why equity markets rolled over so hard at the end of last year, fearing a Fed policy mistake driven by this new dynamic.
As central banks and future economic reports condition fixed income markets to this reality, long-term rates will drop further, boosting equity valuations.
#2: Corporate earnings leverage and future margin growth: S&P 500 net margins have been rising since the 1990s and will either remain stable or continue to improve in the future. The data here:
- Peak net operating margins in the 1990s cycle: 7.5% (2000)
- Peak in the early 2000s cycle: 9.0% (2007)
- Peak in the current cycle: 12.0% (2018)
#3: Earnings quality and capital efficiency: record stock repurchases and rising dividend payments show that the companies of the S&P 500 are able to pay out 100% of accounting earnings, highlighting both high levels of capital efficiency and exceptional free cash flow generation even at mid-cycle levels of economic activity. The data:
- From 2014 to 2018, the companies of the S&P 500 reported net income on an operating basis of $4.2 trillion.
- 40% of that has gone to dividend payments ($1.7 billion)
- 59% has gone to stock repurchases ($2.4 billion)
Pull these points together and the bull case looks like this:
- Long-term interest rates have further to fall even as economic growth continues. The 10-year Treasury should yield something more like 2.0% if the neutral rate of interest is 1.0% to 1.5%, for example.
- Corporate margins are rising and asset efficiency remains high, which means returns on capital/equity have further to climb. Even before the 2017 tax bill passed, for example, the companies of the S&P 500 generated $181 billion in incremental net operating profits (20% growth) over the prior 3 years while spending 98% of their earnings on dividends and buybacks.
- The upshot: lower interest rates and higher returns on capital is a powerful combination to drive valuations higher.
And here is the downside case:
#1: Even if neutral interest rates are lower than expected because the world is over-levered that is still a problem because:
- Even in good times, overly indebted countries with aging demographics will find it difficult to grow their way out of high debt burdens. In the next recession this will also limit their ability to provide fiscal stimulus, making future downturns more severe.
- Cheap capital leads to malinvestment, which unwinds in downturns making them more severe than if interest rates were properly set through the cycle.
#2: Corporate profit margins are unsustainably high because capital has been increasingly over-rewarded since the 1990s at the expense of labor.Globalization of both supply chains and high-growth technological product lines (i.e. personal electronics) has also played a role here. The political process in democratic countries will correct this imbalance through wage regulations/taxation/tariffs and/or by changing trade agreements.
#3: That means corporate returns on capital/equity are at similarly unsustainable levels. Companies will have to reinvest to remake/localize supply chains/reallocate profits to labor and away from their sources of capital, both of which will have the effect of lowering shareholder returns.
Our takeaway from this bull-bear debate: the S&P 500 trades for 17x earnings just now and whether valuations go to 18x (bullish) or 15x (bearish) in the next 12-24 months depends on:
- To what degree bond markets and the Federal Reserve come to the view that neutral interest rates are substantially lower than current market prices. That process has to happen before too-high central bank policy or an exogenous shock causes a recession, however.
- Not so much the level of current corporate earnings or profit margins, but how sustainable those are over the next 3-5 years, especially if in the case of recession.
- What, if any, impact the political process will have on capital allocation and structural returns on corporate investment.
The bottom line is that equity valuations are always a function of investor confidence in the predictability of interest rates and corporate earnings/return on capital. Thirty years of lower rates and higher earnings/margins/capital efficiency make it tempting to extrapolate those trends will continue. And perhaps they will, but it is also important to understand where they could stall or even reverse. Our position is that rates will trend lower, supporting higher valuations. We’re much less convinced that corporate returns on capital have much more room to grow.
* * *
Continuing on the topic of US equity valuations, two datasets are worth specific mention:
#1: The Shiller Cyclically Adjusted Price-Earnings (CAPE, for short) Ratio.
What it does: instead of using one-year forward earnings expectations, the Shiller CAPE averages and inflation-adjusts the last decade of reported earnings for the S&P 500. The idea is to use a simple and entirely fact-based measure of cross-cycle earnings power rather than rely on just single-point analyst projections.
Here is the current math for one-year forward earnings as compared to Shiller CAPE valuations:
- FactSet shows that consensus earnings expectations for the S&P over the next 12 months are $175/share so the index trades for 16.8x forward earnings. That’s higher than the 5-year (16.4x) and 10-year averages (14.7x) but not what most investors would call outlandishly expensive.
- At current prices, however, the S&P 500 trades for 31.1x its last 10 years of reported earnings adjusted for inflation (CAPE earnings, in other words).
- That compares to a very long run (1870 – present) average of 16.6, pointing to the possibility that US stocks are dramatically overvalued.
- Furthermore, at current levels US stocks are as expensive as they were just ahead of the 1929 crash (30x), although not quite as high as the late 1990s dot com bubble (44x).
Why this matters: more than any other long run valuation analysis, the Shiller CAPE’s current message of a profoundly overvalued US equity market resonates with market watchers who feel domestic stocks are in a bubble. We routinely field questions about this measure.
What it misses: to our thinking the Shiller PE has 2 existential flaws:
- It assumes interest rates revert to some long run average with the same regularity as corporate earnings, namely around a 10-year cycle. In practice, this has not happened for decades. Interest rates have fallen over the last 10, 20 and 30 years. Of course US equity valuations are high. That’s just the math behind discounting cash flows.
- Even today CAPE earnings hold the lingering after effects of the Financial Crisis in their “normalized” cyclical average earnings of 2009 – 2018. We won’t be through those until 2020/2021, which will finally give us more normal cross-cycle earning power averages.
The bottom line on the Shiller CAPE ratio: US stocks are expensive on this measure mostly because it ignores structurally low interest rates.
#2: Current sector-level S&P 500 valuations.
The numbers here: The S&P 500 trades for 16.8x forward earnings but within the index there is a broad dispersion of sector-level valuations. Here is a breakdown:
- Sectors that trade cheap to the S&P: Financials (12.1x), Health Care (15.1x), Materials (16.0x), Industrials (16.2x) and Energy (16.3x).In aggregate these represent 44% of the index by weight, and on average they trade for 15.1x forward earnings.
- Sectors that trade at a premium to the S&P: Consumer Discretionary (21.4x), Technology (19.3x), Consumer Staples (19.1x), Utilities (18.3x) and Communication Services (18.0x).The groups here represent 53% of the index by weight, and on average they trade for 19.2x forward earnings.
- Not directly comparable to these due to tax treatment, but presented for completeness: Real Estate (19.1x), at a 3% weight in the S&P 500.
Why this matters: US equity sectors broadly fall into two categories, and these drive their valuations:
- High growth or rate sensitive groups get above-average valuations. The former includes Tech, Communication Services and Consumer Discretionary (where Amazon has a 25% weight). Consumer Staples and Utilities make up the latter.
- Low growth/cyclical and politically exposed groups get low valuations. Financials, Industrials, Materials and Energy make up the first group. Health Care is a class of one in the second.
The bottom line here: US equity valuations are a mathematical tug of war between these 2 camps. As long as rates stay low and Tech/Comm Services companies can continue to grow, aggregate valuations will remain high.
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