Comstock Partners, Inc.June 01, 2017
VALUATION WILL MATTER...IT ALWAYS DOES
As the U.S. stock market continues to make new all-time highs it may appear to many investors that valuations no longer matter. We do not see it that way now, nor have we ever in the past. We maintain our long held belief that the U.S. stock market is extremely overpriced, relative to past earnings and future earnings prospects. This overpricing is the direct result of the largest financial experiment in history, i.e., the growth in the Fed’s balance sheet from $800bn. to $4.5tn. and the setting of the overnight Fed Funds rate to near zero from December of 2008 to December of 2015. Today, eighteen months after the first rate increase in seven years, the daily effective Fed Funds rate typically comes in at a mere 91 bps. We have repeatedly referred to this period as the “Central Bank Bubble”, as asset values have inflated.
By growing its balance sheet and keeping interest rates low, the Fed reasoned asset prices would be backstopped and stimulated. The increase in asset prices would create a “wealth effect” as those in our society, fortunate enough to own these assets, would feel wealthier and spend money. This, in turn, would result in economic growth that would benefit society as a whole, including those at the bottom end of the economic ladder. The result has not been what the Fed intended, and in fact, has caused some unintended consequences. The economy has grown at the most anemic rate ever, around 2% per year, when recovering from any recession. Wealth disparity in our society is at an all-time high. At the same time, by many different valuation metrics, the stock market is near or in excess of the highest valuations in history. As of this writing, the trailing 12 month P/E based on generally accepted accounting principles (GAAP) is approximately 24.2, a historically very high number when the economy is not in a recession and earnings have already dropped more than prices.
We believe that in the long run, corporate earnings should grow about as fast as the economy. The stock market, in our view, is imputing a higher growth rate to future earnings than we think is likely, or even possible, for the following reasons:
Thus, given the level of debt and commensurate interest rate exposure, along with negative population demographics, and the lack of addressing entitlement reform as it relates to long term productivity growth, it is our strong belief that the US economy will not grow at rates that will vindicate current equity market valuations. We remain committed to the thesis that the experimental Fed policies of the past years have inflated and distorted equity and other asset prices tremendously (while generating “unintended consequences”).In our view, this time is NOT different. Ultimately the stock market will reflect an economic reality much different than it does currently. When that happens, as in past times when bull markets ended, stocks will likely fall much faster than they went up.