From Nick Colas of Convergex
With the S&P 500 closing just a few days ago above 2400, it is time to once again ask the question: are US stocks still cheap enough to own? The answer based on fundamentals is “Yes”. Earnings growth was strong in Q1 (+13.6%) and Q2’s expectations are low enough to beat (just 5.8%). Interest rates are still low at 2.34% on the US 10 year, partly buttressed by expected Fed rate policy through the balance of 2017. No, at 17.5x forward earnings, equities are certainly not cheap. But you own stocks for the hope of upside revisions to earnings and a temperate environment for rates. Those factors exist right here, right now. What worries us? First, volatility remains low. That’s a sure sign that everyone sees the rosy scenario we’ve just outlined. Second, long run historical measures of valuation show we shouldn’t expect much from US stocks in terms of future returns. The Shiller PE (trailing 10 year) was at 27.2 on January 1, 2007; it is 29.5 now. Compounded 10 year price returns for the S&P 500 since 2007 are just 4.8%. Bottom line: everyone believes the same thing (equities will work), and the crowd will be right (albeit with subdued returns) until it is very, very wrong.
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Since the S&P 500 held 2400 into the close on Monday, I got to wondering what “2400” would turn up on a Google search. Nothing about the S&P’s record close appeared, but I did find out you can get a pretty nice one bedroom in the Gramercy Park neighborhood of NYC for $2,400. And that a perfect score on the SAT is 2400. Or that New York City Tax Commission is in Room 2400 of that huge municipal building downtown.
The closest thing to a “Sign” about the merits of 2400 is that it is military time for midnight (along with 0000), and therefore the classic definition of the “Witching Hour” – when all manner of ghosts and demons come out to play. But just how “Real” is witching hour? Do people see more ghosts at midnight than other times of the day?
Google Trends has the answer: no, people search for “Ghost” on Google most between 2-3am. Moreover, Google users (i.e. everyone) are more likely to search for supernatural information on the weekends and least of all between 7-10am. And lest you think it is an unusual search, consider that queries for “Ghost” outnumber “Insomnia” by roughly 4:1. (Although they do peak slightly after, at about 3-4am).
So, have US stocks hit their “Witching hour” at 2400, or do we have a few more hours before we go online to search for things that go bump in the night?
To answer that question we need to look at equity valuations, a discipline that admittedly feels about as rigorous as the occult sciences. Some numbers serve as warnings, others as welcoming agents, and still others mean nothing. Until they do…
A few points to kick things off:
So, while valuation numbers might be flashing yellow, earnings growth seems ready to speed through the intersection and push markets further down the road.
The second thing to consider is interest rates, which are the foundation for equity market valuations. Remember day 1 of finance class: cost of capital is the risk free rate plus a premium for risk-adjusted expected returns. A few points on interest rates:
So where are the ghosts and goblins in this outlook? Under the bed, in the closet, and behind the curtains, of course. They always hide until you are just about asleep and only then make themselves plain.
And that’s where we are right now in terms of market cycles. Volatility, both expected and actual, is extremely low. The case I have laid out here is extremely well understood and serves as the cornerstone for any positive construct on US equities.
True to the comparisons with the occult, what ails US equities can be summed up with a variety of “Signs” and “Omens”. A few examples:
Where the Shiller PE does have some forecasting ability is in long term (10 year) forward returns, and that makes good sense. After all, buying when stocks are cheap should yield better long term outcomes. Here’s a case study:
Some people use the Shiller PE as sort of a ghost story, meant to scare. And you can certainly read it that way – bad things often happen when it gets this high. And they may do so again.
But when you layer on the current low volatility environment another scenario pops up, one with an equity market that very quietly returns 5-8% with very little price fluctuations. Yes, in the past that scenario would pull investors into the fray and make for an artificially overvalued market, and then a fall. But the current crop of investors has been around for 3 notable bubble bursts: dot com, housing, and Financial Crisis. Will they really get sucked in again?
Or have they had enough scares to know better?