The S&P 500 has reached five year highs and is closing in on the all-time high set in 2007. New highs are not, in and of themselves, cause for concern. Some participants act as if they are, as if there were some rule to follow, that new highs always lead to bear markets. If that were the case, stock markets wouldn’t have been able to return an average of 5% to 6% per year (excluding dividends) since the 1920s. Markets make new highs–and under the right circumstances–that is a good thing. The pertinent question then, is whether or not we are under the “right” circumstances today.
From what you may have read or heard, stock markets are “cheap” and we are on the cusp of another multi-year bull market. Analysts expect the S&P 500 to earn over $111 per share in 2013, placing the forward P/E multiple at a modest 13.7x compared to the historical average of 15x.
As you can see from the table above, valuations today are better than they were the last two times we approached these levels. Though, in our opinion, valuation is by no means cheap–the index trades at a 15% premium to the long-term average P/E if we utilize the actual earnings from the trailing twelve months and not the hoped-for future earnings. We would argue that valuation is actually worse than meets the eye. As Sherlock Holmes said, “there is nothing more deceptive than an obvious fact”.
For one, net margins are near peak. The S&P 500 has historically delivered profit margins ranging from 3.5% to 8.5%. Today, profit margins are over 8.0%, near the top of the range. Record low interest rates have helped.
S&P 500 companies used to pay significantly more interest. The Fed, benign inflation, and mediocre economic growth have driven 10-year Treasury rates down from over 5% in 2007 to approximately 2% today. As such, interest costs of the S&P 500 have fallen from almost $15 per share to less than $5 per share. If we adjust for the difference in interest costs, valuations are actually a bit more expensive today than they were in 2007.
Why would we bother to think along these lines? Because interest rates are at historical lows and aren’t likely to stay there. Most economists and market participants expect economic growth to accelerate over the next several years. If that is the case, we might logically assume inflation would normalize from current low levels and interest rates rise.
Inflation expectations (as measured by the TIPs spread) are at multi-year highs. Generally, the 10-year Treasury would trade at the nominal rate of GDP growth, give or take. If Real GDP can be sustained at 2% per year and inflation reaches 2.6% (the current TIPs spread), 10-Year Treasuries should yield 4.6%, not 2%. Over time, higher yields will translate into higher interest costs that will be a drag on future earnings per share growth.
This isn’t to say markets will decline once we hit a new high. Markets reached new peaks with trailing P/Es of over 17x and continued higher on nine occasions: 1928 – 18 months, 1958 – 9 months, 1961- 10 months, 1963 – 19 months, 1967 – 18 months, 1972 – 10 months, 1987 – 7 months, 1991 – 113 months, and 2007 – 5 months. Excluding the 1990s–the grandest bubble period in modern history–markets continued to make new highs for an average of one additional year from the point a new high was made with a trailing P/E over 17. Put another way, the durability of a market advance is much improved if starting valuations are low. Today, they are not.
When you put all this together (peak margins, unsustainably low interest costs, and above average multiples), you are left with a somewhat gloomier-than-consensus vision for future earnings growth and equity return expectations. Though, inflation is tempered by subpar economic growth and companies have cut costs and held wages as a percentage of GDP to all-time lows, both of which have and should continue to buoy profit margins.
These tailwinds are not likely to persist indefinitely and nor is the Fed’s seemingly unending support. As such, we would suggest investors expect normalization and an average of no more than a low to mid-single digit nominal total return in equities over the next decade. Of course, we are certain to have a recession or two over the same period and should have plenty of opportunities to take advantage of better valuations in the future.
Black Cypress returned 5.4% during the month of January. We have compounded capital at nearly 18.0% per year, net of fees, since inception.