Bubble Worries Inflated

4/17/2017


While calling the stock market somewhat pricey makes you sound like Captain Obvious, calling it ridiculously overvalued can make you sound like a seasoned skeptic. Perhaps that's one reason so many analysts and journalists seem so eager to proclaim we've entered another bubble.

To be sure, stocks are not cheap. The median trailing price/earnings ratio for stocks in the broad S&P 1500 Index is 21, about 17% higher than the norm of 18.1 since 1994. Today's median exceeds 95% of the monthly observations since 1994. Other valuations measures like price/sales and price/cash flow have reached even more extreme levels.

Still, today's valuations remain far below the levels technology stocks reached in 1999 and 2000, shortly before the Nasdaq Composite Index dropped more than 70%. Indeed, the surest way to identify a bubble is by the subsequent crash, and it is far from certain that stocks are headed for such a collapse.

For one thing, stocks remain reasonably priced versus historical norms when compared to bond yields. So, if bond yields are not headed sharply higher, stocks may not be headed sharply lower.

For another thing, corporate profits have begun to grow again, so P/E ratios could come down if stocks move sideways. In rolling 12-month periods since 1992, the median S&P 1500 company averaged 9.1% growth in earnings per share. In more than one-half of periods, growth exceeded 10.6%.

Assuming stock prices go nowhere and the median S&P 1500 company delivers steady 9.1% profit growth, the median P/E would dip below the long-term norm of 18.1 in less than two years. In other words, it won't necessarily take a crash to close the valuation gap.

For a longer-term perspective, consider the data compiled on the S&P 500 Index by Prof. Robert Shiller of Yale. At nearly 24, the trailing P/E for the index is about 17% above the 40-year norm of 20.1. But with two years of 8.8% profit growth — in line with the median growth rate over the past 40 years — the P/E would fall under 20.

The Shiller P/E

Of course, Shiller is best known for his CAPE ratio, widely cited by bubble proclaimers. Because CAPE is based on average inflation-adjusted earnings over the previous 10 years, cyclical swings in the economy don't impact it as much. At 29, CAPE is well above its 40-year norm of 21 — and higher than it has ever been except for the 1929 and 2000 market peaks.

CAPE's methodology has drawn heat in recent years, partly because it labeled stocks as overvalued throughout nearly all the bull market since 2009. CAPE uses profits based on generally accepted accounting principles (GAAP), and changes in those standards have lowered reported earnings. Also, the huge charges taken by banks in the financial crisis are still depressing 10-year average earnings.

In 2016, The Wall Street Journal constructed an alternative CAPE based on the U.S. Commerce Department's estimate of after-tax corporate profits. This estimate of profits, which excludes asset write-downs, has been calculated in a consistent way.  And this alternative CAPE indicates that stocks are about 20% above 50-year norms.

Conclusion

Yes, stocks are expensive, raising the risk of a bear market. But concerns regarding a bubble are overdone. If bond yields remain well below historical norms, above-normal valuations may be sustainable. And if corporate profits show continued growth, today's stretched valuations could be corrected with a couple years of flat stock prices.

For now, with the Dow Theory in the bullish camp and some reasonably valued growers available, we are maintaining a nearly fully invested posture. Our Focus List and Buy List have 100% in stocks, while our Long-Term Buy List has 96.6%.


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