Corporate profits are up. One by one, throughout the month of July, corporations announced earnings for the quarter which ended June 30th and the vast majority declared they are making money. Some, like General Electric, have raised their dividend….dividends which were drastically cut two years ago.
Corporate balance sheets are flush with cash and, on a relative basis, a case could be made that stocks are not that expensive. Below is a 30-year chart of the Price to Earnings ratio of the S&P 500 Index (the higher the P/E ratio, the more expensive are the stocks in that index).
click image for a larger view
In 1981, as we were enduring a significant recession, the S&P 500 Index was trading at about 8 times earnings. By historical measures, this is very cheap. In 1999, everyone seemed convinced that technology and the internet were going to permanently change valuations….that “this time it is different”. The S&P 500 Index climbed throughout the late nineties until it was trading at about 30 times earnings….also known as the “internet bubble”. Speculative bubbles are not different from prior speculative bubbles. They seem different at the time but they all end in heartache.
Today, the S&P 500 Index is trading somewhere between 14 and 15 times earnings which is about the average. Not extremely cheap but not horribly expensive either.
Here’s an interesting note about the “average” P/E ratio. The “average” includes periods where you could earn an interest rate of over 16%….risk-free! The 3-month T-Bill in 1981 reached an interest rate of 16.3%. If you can earn 16% risk-free, you are not going to be very likely to take risk. A high interest rate environment will inevitably lead to lower stock prices. And that is exactly what happened. With a risk-free rate of 16% in 1981, the S&P 500 Index was trading around 8 times earnings.
Logically, that would lead you to believe a lower risk-free rate of return would result in higher stock prices. In 1999, the risk-free rate had declined to 4.29%. Not surprisingly stock prices were trading at 30 times earnings. Makes perfect sense, doesn’t it? If I can only earn 4% risk-free, I am more likely to take risk than when I can earn 16% risk-free. So if we eliminate the periods of unusually high interest rates, the “average” P/E ratio is much higher than 15 times earnings. It’s probably closer to 20 times earnings.
Today, the risk-free rate of return is virtually 0% and stocks are not trading at 15 or 20 times earnings. If investors can earn NOTHING risk-free, it seems they should be all over the stock market. With corporate earnings increasing, healthy balance sheets and a risk-free rate of return of 0%, why aren’t investors buying stocks and paying 30 times earnings….or 40 times earnings? So what went wrong? Why are investors content to hold bonds with low interest rates when they could own stocks, many of which pay dividends in excess of 4%?
Obviously the correlation between interest rates and stock prices broke down somewhere. It broke down because, even though interest rates are very low, investors are reluctant to take another investment beating similar to the two they endured in the past 10 years. Stocks fell over 44% from the top in 2000 to the bottom in 2002. Then they plunged another 51% from October, 2007 to March, 2009.
Baby boomers, who contributed to retirement savings plans from 1975 through 2010 started turning 65 this year. Those that lost 50% probably can’t retire yet. Those that still have enough money to retire are well aware they cannot lose 50% of their investment funds….again.
It also broke down because the stock market, as inefficient as it can be at times, is forward-looking. And as the market looks forward, it doesn’t like what it sees.
Here are some of the things that it sees that it doesn’t like:
Last week the Commerce Department reported that, in the 2nd quarter of 2010, the U.S. economy grew at an annual rate of 2.4%, down from 3.7% in the 1st quarter and 5% in the 4th quarter of last year. This is disappointing but shouldn’t be a huge surprise. It wasn’t that hard to see. “Cash for Clunkers” was finished a long time ago. Car sales declined almost immediately. The home buyer’s tax credit expired and sales of new homes and existing homes dried up almost immediately. The Obama Administration’s $787 billion stimulus package has not been very effective at jump-starting the U.S. economy. Apparently, the market is concluding that, without additional government stimulus, future economic growth may be very slow.
The official unemployment rate is still almost 10% and the Senate just voted for the seventh time to extend unemployment benefits. The SEVENTH time! And there is no reason to believe they won’t have to extend it for an eighth time after this extension runs its course. Over 8 million people have lost their jobs since this recession officially began in December, 2007 and it will take many more years to get 8 million jobs back. That doesn’t include the additional jobs necessary to absorb new younger workers entering the work force….or should I say entering the “unemployed force”? Apparently, the market is concluding that, without any significant growth, unemployment will remain high and consumer demand will remain lethargic.
There were over 313,000 new foreclosure filings in June, the 16th consecutive month in excess of 300,000. Home ownership in the U.S. peaked in 2004 at almost 70%. It is now closer to 66% but will likely decline much further as millions of homeowners are behind on their mortgages and many more of them will lose those homes to lenders. Apparently, the market is concluding that, if four million homeowners are going to be evicted, there are probably several million more who are barely making their house payment, leaving little extra discretionary income for purchasing consumer goods.
Twenty-one. That is how many For-Sale signs I counted on my bicycle ride at the end of July. I’ve been counting since the summer of 2007 at which time there were seven homes for sale. The peak was last summer when I counted 26 For-Sale signs. When it declined to fourteen just three months ago, I was dubious. Was it improving because the recession was over or was it improving because of the tax credit for home buyers? As soon as the tax credit for homebuyers ended…..a 50% increase in three months.
At Boyer & Corporon Wealth Management, we increased our equity exposure as the markets were declining in May and June. However, we are still below our targets for equity allocation. As the markets increased 7% in July, opportunities for purchasing equities cheaply dried up. We continue to view the equity markets as “range-bound” and will look to decrease our equity allocation should we continue to see significant appreciation on top of July’s increase.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.