Comstock Partners, Inc.October 06, 2016
37 Years Later Debt Has Made Jimmy Carter Right And Stocks Are Expensive
Back in 1979 President Jimmy Carter addressed the nation and told his fellow citizens the country suffered from a “crisis of confidence” in what became famously known as the “malaise speech”. Back then the country was suffering from “Stagflation” or inflation with sluggish growth. The former president was on to more than he knew because now, thirty seven years later, the nation suffers from a great “malaise” by virtue of the fact that we are in the weakest recovery ever following the Global Financial Crisis of 2008-2009. While the nation is not suffering from high inflation (tell that to someone cashing a weekly paycheck trying to make ends meet) as measured by the government, the fact is that GDP continues to suffer from a “malaise” as it grows in the sub 2% area.
We have addressed this many times and just to update new readers, we believe that the slow growth has everything to do with the excessive levels of government, corporate, household, and student loan debt. The Federal Reserve, for its part, has mainly addressed this problem by increasing its balance sheet (buying U.S. government and agency debt) and lowering interest rates (such that the price of money is determined by fiat, rather than true price discovery in the marketplace). While these activities were intended to stimulate growth, what they really have done is inflate financial assets to levels, that both on an historical basis and relative to future growth prospects, are among the most inflated in history. For their part, the central banks of Europe and Japan have “upped the ante” and gone to negative interest rates, and are buying government debt, corporate debt (Europe) and also equities (Japan). They too suffer from the “malaise” of slow growth and are having little to no success in stimulating their respective economies. The one area where these policies have been successful is in stimulating the savings rate, which has the exact opposite effect that they intend! This slows economic activity even more.
So given the slow growth and low growth prospects, how has profit growth faired and where are U.S. equities priced? As always, we will be referring to GAAP Earnings, as they are by far the better metric for corporate profitability versus Operating Earnings, which exclude extraordinary items (share repurchases, for example). According to the latest data from Standard and Poors, with 97% of companies having reported for the 2nd quarter, the S&P 500 will just eek out a 2% gain in GAAP Earnings on a quarter versus quarter basis versus a year ago. This is following six straight quarters of sequential declines, with two being defined as an earnings recession. If we give securities analysts the benefit of the doubt on third quarter projections, 12 month trailing GAAP Earnings will be $90.65 and given a 2,168.27 close at quarter end, the trailing P/E will be 23.9. If you, the reader, do not see this as expensive, ask yourself the following question: If you owned a mom and pop business that made $100,000 per year after taxes, that was growing at 2% or less, that could even have negative growth, and if someone offered you $2,390,000 for it, would you sell it? (That is a 23.9 multiple.) We think you should (and go do something else…like start another business)! To not do so means that either you are much more optimistic about the growth prospects or that you believe a “greater fool” will offer you even more later. But, understand that the passive act of not selling puts you in the position of possible greatest fool when the bottom falls out. (If you are a regular reader of ours you likely believe that will happen.)
For historical perspective let’s compare to the two previous bubbles of the modern era, the Dot Com and Housing bubbles. The Dot Com Bubble topped on 3/24/2000 with the S&P 500 closing at 1,527. A few days later the quarter ended with the trailing P/E at 27.8. Keep in mind that tech stocks were on fire (thus the name Dot Com) and the insanity had grown so great that clicks were actually considered a valuation metric. Needless to say, the bubble burst and when the market bottomed at 777 in October of 2002, it had fallen 49%. While true that 27.8 is higher than the current 23.9 trailing P/E, they are both in the stratosphere and to justify valuation on the basis of an even higher degree of insanity is just flat out wrong.
In the Housing Bubble, the top of the market was actually about a year before the bottom fell out. The closing high of 1,565.15 took place on 10/9/07. When quarter end came the trailing P/E was 17.8 and earnings were $69.93. As the third quarter of 2008 ended, and just before the bottom fell out, earnings had fallen to $45.95 and the trailing P/E stood at 25.4 (not far from where we are now). When the decline ended at 666 on 3/9/2009, the market had fallen 57% from its high in October of 2007.
The point we are making, and as our readers know, we are of the strong belief that for the many reasons we’ve espoused over the years, a bear market of giant magnitude is close at hand. The possible (if earnings come in as projected) 23.9 trailing P/E is very, very, rich historically. At the top of other bubbles and with similar rich valuations, the subsequent downside was extremely large. When the bear market begins in earnest and what the catalyst will be is basically a black swan that at this time, no matter what anyone tells you, is a guess. However, given the “Central Bank Bubble” that we are in, as we’ve discussed in these last many months and given the fact that investors all over the world have been forced to chase yield and prices all the way to the insanity of negative territory, it cannot end well. The last many years of zero interest and negative rates have pushed savers into being investors, and investors into being speculators. They are all on the same side of the life boat. And when the seas get rough, as we believe they will, it will be their position in the boat that further exacerbates and accelerates the tipping!