Today more than any time since the GFC, droves of market commentators, sell-side strategists and well-respect fund managers are jumping on the bearish bandwagon warning of financial apocalypse, yet equity markets continue to reach new highs. One favored measure of relative valuation by which the US stock market is judged to be in a bubble is the Shiller Cyclically Adjusted PE ratio (“CAPE”). For those not familiar with the metric, the Shiller CAPE is a valuation multiple that makes two adjustments to the traditional trailing P/E: i) instead of using last 12 months’ earnings, CAPE uses the average earnings over the last 10 years; and ii) these historical earnings are adjusted for inflation so as to be comparable with today’s earnings.
The US market currently has a CAPE of 27.3x, which, if one believes in reversion to the mean, is indisputably high relative to the historical average of 16.7x (since 1881 when data is first available). However, investors need to ask two questions before they jump to a conclusion that the stock market is in a bubble that is soon to burst. Firstly, the current CAPE is high relative to what? So much has changed about the fundamentals of financial markets and the pricing of risk that if an investor accepts that interest rates will be lower for longer, then surely a 135-year average is going to be the wrong benchmark against which to judge the current CAPE. On 20-year (capturing the GFC and dot com bubble/crash) and 30-year views (also capturing Black Monday), the CAPE has averaged 27.0x and 24.0x respectively – hardly a discount to the current CAPE of 27.3x. Consider that the Bond P/E for 10Y UST is currently 64x (and infinite for those global bonds with zero or negative yields), and a 27x CAPE becomes even more attractive to long-only money managers that need to stay fully invested.
To pre-empt any accusations of bias for not including the high interest, high inflation period during the early 1980’s, your author readily admits that the multi-decade secular decline in interest rates have helped drive up stock market valuations. However, if the Fed funds rate was to return to 20 per cent in the near future, the details of CAPE averages will be the least of investors’ worries.
The second question has two parts: i) what is the predictive power of CAPE; and ii) more broadly, do earnings still drive stock prices? On the predictive power of CAPE, NYU professor Aswath Damodaran has found that not only is the CAPE not much more informative than normalized P/E (10-year average without inflation adjustment, 0.97 correlation) and trailing P/E (0.86 correlation), its predictive power is also low, showing only -0.59 correlation with stock returns over the next 5 years, and a paltry -0.27 correlation with stock returns over the next twelve months. In this job, being 5 years early is indistinguishable from being wrong.
Turning now to the second part of the question, the prevailing heuristic these days (with quarterly reporting and Wall Street’s myopic lens) is that earnings drive stock prices through the P/E multiple. Adherents of value investing will immediately see that this ignores the fundamental premise of valuation – that in the long-term, assets are only worth the present value of all future cash flows they generate. More interestingly, earnings growth for the S&P 500 was negative in 2015 and is expected to be negative for 2016 as well, yet all three major US equity indices are still pushing to record highs through multiple expansion. With forward P/E at 18.6x and CAPE at 27.3x, it is all well and good to say that by these metrics, the stock market is overvalued relative to historical averages and an imminent crash is coming (without having to stick one’s neck out and actually identify a catalyst). However, this ignores the elephant in the room – clearly, earnings declines are being offset by multiple expansion, so the overvalued market will likely only correct when multiples begin to contract.
In order to understand what may cause earnings multiples to contract, we need to ask what is driving multiple expansion in the first place. The obvious answer here is cash flow. With bond yields at 5,000-year lows and $15 trillion of sovereign bonds in negative yielding territory, investors chasing income have been forced into equities, where low-to-mid single digit dividend yields are substantially (or infinitely) more attractive than sub-1 per cent, zero, or negative bond yields. Since the S&P 500 dividend yield of 2 per cent is still higher than the yields on the majority of global sovereign bonds, a yield demand-driven bull market rally can still run for some time.
However, big caveat – it takes two to tango, and investors will only bid up stock prices to the extent companies can keep returning capital to shareholders. Damodaran conducted another interesting analysis looking at the S&P 500 as a multiple of total capital returned (dividends plus stock buybacks).
What the above graph reveals is worrying. Since 2012, the index as a multiple of capital returned has hovered around 20x, while the CAPE has expanded from 21x to 27x. This would suggest that the growth in dividends and buybacks has far outpaced the growth in not just earnings but also free cash flow (bearing in mind that buybacks reduce the number of shares outstanding, which helps inflate EPS without improving the company’s cash generation, and also provides downside support to the company’s share price). To highlight this concern further, consider the table below.
The rightmost column shows that the cash payout ratio for S&P 500 companies has been increasing every year since 2009, and since 2015, has actually exceeded free cash flow. Unless earnings were to grow materially over the next few years (and nothing currently suggests this will happen), this trend is clearly unsustainable. The only way a company can continue to pay back to shareholders more cash than it generates is by drawing down debt, or foregoing growth capital expenditure. Neither practice bodes well for the company’s long term prospects, and both practices have been prevalent since 2011.
Your author does not profess to have a crystal ball to scry when this practice of debt-funded capital returns will become unsustainable and when the markets will experience a correction. Given the low/zero/negative rate environment and no clear line of sight to sustained rate rises, companies could potentially continue to draw debt and dole out unsustainable capital returns to yield-starved shareholders, and the market could continue to enjoy multiple expansion in spite of declining corporate profitability. Nonetheless, we at Montaka believe there is value in thinking about what drives the markets at current levels, even if we cannot forecast when that might turn (nor do we try to engage in market timing). This macro overlay helps inform which rocks we need to be turning over, and companies tend to show symptoms of ailment long before the overall market catches on.