An ice age or a golden one?

The debate on whether the US stock market is overvalued, as measured by the cyclically adjusted price to earnings ratio (CAPE) as developed by Robert Shiller, or whether CAPE is not relevant due to weaknesses in comparing past cycles with today’s mixed up macro-economic world, continues to rage. I have posted several times on this, most recently here and here. In an article in this week’s Economist, Buttonwood outlines some of the bull and bear arguments on the prospects for US corporate growth and concludes that “America is an exception but not as big an exception as markets suggest”.

Bulls argue that, although the CAPE for the S&P500 is currently historically high at 26.5, earnings growth remains strong as the US economy picks up speed and that at a forward PE around 16 the S&P500 is not at excessive levels indicative of a bubble. The latest statistics compiled by the excellent Yardeni Research from sources such as the Bureau of Economic Analysis show that earnings, whether S&P reported or operating earnings or NIPA after tax profits from current production or based upon tax returns, continue to trend along a 7% growth projection. Jim Paulsen, chief investment strategist at Wells Capital Management, believes that “this recovery will last several more years” and “earnings will grow”. Even the prospect of increased US interest rates does not perturb some bulls who assert that rates will remain low relative to history for some time and that S&P500 firms still have plenty of cash with an aggregate cash-pile of over $1 trillion. The king of the bulls, Jeremy Siegel recently said that “If you look at history, the bull markets do not end when the Fed starts raising interest rates. Bull markets could go on for another 9 months to 2 years“.

Bears point to high corporate profits to GDP and argue that they are as a direct result of low real wages and are therefore unsustainable when normal macro conditions return. Others point to the surge in share buybacks, estimated at nearly $2 trillion by S&P500 firms since 2009, as a significant factor behind EPS growth. Société Générale estimate a 20% fall in Q2 buybacks and (the always to be listened to) Andrew Lapthorne warns that as debt gets dearer firms will find it hard to maintain this key support to stock prices as in the “absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices”. The (current) king of the bears, Albert Edwards, also at SocGen, provided good copy in a recent report “Is that a hissing I can hear?” saying that “companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes“. Edwards believes that an economic Ice Age is possible due to global deflationary pressures. Another contender for king of the bears is fund manager John Hussman and he recently commented: “make no mistake, this is an equity bubble, and a highly advanced one“.

One commentator who I also respect is the author behind the excellent blog Philosophical Economics. A post last month on CAPE highlighted the obvious but often forgotten fact that “the market’s valuation arises as an inadvertent byproduct of the equilibriation of supply and demand: the process through which the quantity of equity being supplied by sellers achieves an equilibrium with the quantity of equity being demanded by buyers”. As such, the current macro-economic situation makes any reference to an average or a “normal period” questionable. The post is well worth a read and concludes that the author expects the market to be volatile but continue its upward trajectory, albeit at a slower pace, until signs that the real economy is in trouble.

For me, the easy position is to remain negative as I see valuations and behaviour that frightens me (hello AAPL?). I see volatility but not necessarily a major correction. Unless political events get messy, I think the conclusion in a previous Buttonwood piece still holds true: “investors are reluctant bulls; there seems no alternative”. Sticking only to high conviction names and careful risk management through buying insurance where possible remain my core principles. That and trying to keep my greed in check…..