SPX Topping Valuations
Adam Hamilton | Apr 20, 2014 02:21AM ET
The lofty stock markets are starting to wobble, with selloffs’ frequency and sharpness increasing. The dominant reason the Fed’s stock levitation is running out of steam is severe overvaluation. Stocks are just far too expensive today compared to historic precedent, a dangerous state seen when bull markets are topping. Rampant overvaluation is a glaring warning sign to investors that selling is just beginning.
Investing is all about buying low then selling high. So the price paid for any particular stock is the most-important and often dominating factor in its ultimate price-appreciation success. The surest way to grow rich in the stock markets is to buy good companies at low prices, the prudent contrarian approach. Even buying great companies at high prices leaves little room for those stocks to run higher, so they rarely do.
Low and high stock prices are not defined by absolute share levels, which are irrelevant. A $10 stock can be expensive while a $100 stock is cheap. The key is valuations, or where any stock price is trading relative to its underlying company’s earnings stream. The lower any company’s stock price compared to its profits, the cheaper it is. The more earnings investors can buy per dollar of share price, the better.
This concept is so simple, yet most investors foolishly choose to ignore the valuation price they are paying. Imagine buying a house as a rental property, with expected annual rental income of $30k. If you can get that house for $210k, 7x earnings, it will pay for itself in 7 years. That’s a great deal! But if that same house is priced at $630k, 21x, it’s a terrible deal. It will take far too long to earn back your investment.
Price paid is everything, yet stock investors don’t hesitate to pay 21x earnings and higher for stocks! While not only irrational, a century and a quarter of US stock-market history shows this rarely works out well for investors. And the flagship US broad-stock-market index, the S&P 500, is now priced well above that 21x historical expensive level. Such valuations usually signal a major bull-market topping underway.
The S&P 500 is also known by its symbol SPX, and is widely traded through several massive tracking ETFs. These include the SPDR S&P 500 ETF traded as SPY, the Vanguard S&P 500 ETF traded as VOO, and the iShares Core S&P 500 ETF traded as IVV. Of these, the oldest, most venerable, and most popular by far is SPY. Born way back in early 1993, this ETF has become the SPX’s definitive tracker stock.
Comprised of 500 of the biggest and best American companies, the SPX (or SPY) is the best gauge for the broad US stock markets. Across these elite stocks is where market valuations are best measured. And if you pull up SPY in Yahoo! Finance, it reportedly has a “trailing-twelve-month” P/E of 17x. That remains far from the expensive 21x level, not a cause for concern. The problem is that is totally false!
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Back in early 2000 when I founded my company Zeal, the financial internet was in its infancy and stock-market valuation data was much harder to come by. So in order to capture it, at the end of every month we started feeding all the valuation data for each of the 500 individual SPX component companies into a spreadsheet. Then, and every month since, we averaged them all to get the broad-market valuations.
As of the end of March 2014, the simple average of all 500 SPX companies’ trailing-twelve-month P/E ratios scraped directly from Yahoo! Finance as well was 25.7x earnings! This is vastly higher than the 17x reported for SPY, VOO, and IVV. Why? Maybe Yahoo! Finance is using an index-earnings practice common on Wall Street, aggregation. All 500 companies’ profits are added up, then divided by the SPX level.
Using aggregate rather than individual earnings is very misleading, a flawed methodology. A relatively small number of companies with outlying huge profits, often from one-time events like asset sales, can seriously skew an entire index’s valuation. Wall Street loves aggregation because it masks overvaluation within individual stocks, making the stock markets look cheaper and safer than they actually happen to be.
Another Wall Street trick to hide rampant overvaluations is using forward earnings, or estimates of future earnings. The problem is these guesses are always far too optimistic. They start out at super-profitable a year or so out, and gradually retreat back towards more realistic levels as a quarter nears. Forward P/Es are based on a fantasyland of ideal economic and operational results, something that almost never plays out.
I suspect Yahoo! Finance’s 17x “ttm” P/E for SPY is really a forward one, as that’s about where the SPX’s forward P/E is trading these days. Wall Street loves quoting forward P/Es since they make the stock markets look far more reasonably priced than they really are. The normal P/E slot on Yahoo! Finance’s stock-quote template has a “ttm” label, but there’s no way its index quotes show trailing-twelve-month P/Es.
This first chart shows the real valuation picture, and it is ominous. Once again our methodology at Zeal is simple, we scrape all 500 SPX component companies’ individual trailing-twelve-month P/E ratios (which are hard historical facts) off Yahoo! Finance. Then we average them two ways, simply and by each company’s individual market capitalization. Both are rendered below, but the market-cap weighting is superior.
Larger companies are more important to investors than smaller ones, with more shares held and more capital at risk. Weighting SPX components’ P/Es by their market caps offers a more realistic picture of overall valuations. It better reflects earnings multiples of companies most held by investors, and minimizes any skew from smaller companies with very high valuations. The SPX is now dangerously overvalued
Most stock and options traders view the S&P 500 through the lens of the dominant SPY ETF, so I used its price in this chart. SPY’s extraordinarily massive 5-year bull run is shown in red. The simple average of all 500 SPX components’ trailing-twelve-month P/Es is rendered in light blue, and the market-cap weighted average in dark blue. As of the end of last month, they were at 25.7x and 22.2x respectively!
Just a month earlier as February waned, these clean SPX valuation metrics had hit 26.0x and 22.8x. This is dangerously high relative to historical precedent, even within the short time frame shown above. The last bull market topped in October 2007 at SPX simple and MCWA P/Es of 23.1x and 21.3x, very expensive but still considerably less so than recent valuation multiples. These are truly bull-slaying levels.
This bull market didn’t start out expensive, they never do. The epic once-in-a-lifetime stock panic in late 2008 hammered stocks so far down that the SPX fell to cheap P/E ratios of 12.6x and 11.6x. And the investors like our subscribers who bought low in extreme fear when few others were willing made fortunes as a new SPX bull market was born and powered higher. Earnings were actually rising faster than stock prices.
This is evident in the white line, which shows where SPY would be trading at the US stock markets’ historical 125-year-average trailing-twelve-month P/E ratio of 14x earnings. Between early 2009 and late 2011, the stock markets’ fair value was rising. Profits were growing as the economy recovered out of that crazy stock panic, and stocks were reasonably priced near 16x after the SPX’s last correction in summer 2011.
But starting in 2012 and continuing in 2013, fair value stalled out. Stocks weren’t being bid higher anymore because earnings were healthily growing, but because the Fed was working hard to convince investors that the stock markets were riskless. So as stock prices climbed far faster than earnings, the valuation multiples dramatically expanded. Note the sharp rise in the SPX’s P/E ratios in the last couple years.
This ultimately left stock prices at dangerously-high levels relative to their underlying corporate earnings power, once again between 23x and 26x trailing profits depending on the averaging method. That means without earnings growth, it would take between 23 and 26 years for an investor buying an average elite SPX stock today merely to earn back the price paid! History proves that is far too expensive to sustain.
Once again the century-and-a-quarter average P/E ratio for the broad US stock markets is 14x earnings. That is fair value, and it makes sense. The reciprocal of 14x earnings is 7.1%. That is a fair yield for savers to earn for investing their hard-earned surplus capital in companies, and a fair price for “debtors” to pay to “borrow” money to grow companies. Capital changing hands at around 7% is mutually beneficial for all parties.
But that 14x historical P/E average isn’t smooth, valuations dramatically oscillate from undervalued to overvalued levels and back again in great cycles. I call them Long Valuation Waves, and there is no market force more important for investors to understand. Each LVW takes a third of a century, so they are imperceptible in real-time. But they govern when stock investing will prove wildly profitable or suffer big losses.
Each of these valuation waves consists of a secular bull in its first half and secular bear in its second half. The secular-bull phase sees stocks skyrocket over 17 years or so, with valuations gradually climbing from a deeply-undervalued 7x earnings to a bubbly-overvalued 28x earnings. But at that point, stocks are too expensive to be bid higher so a secular bear sets in. Stocks start grinding sideways on balance.
This secular-bear action continues for 17 years, the same length of time the preceding secular bull ran. It gives earnings time to naturally grow and catch up with stock prices. Valuations start above 28x earnings when secular bears are born, twice fair value. But they ultimately slump to 7x before secular bears end, half fair value. Despite the rampant euphoria on Wall Street, we remain mired in a secular bear today.
The last secular bull topped in early 2000, just 14 years ago. That gives this secular bear a few more years to run yet. And even at the recent euphoric SPX nominal record highs in early April 2014, it was only up 23.8% since its secular-bull topping in March 2000. That is a horrendous compound annual rate of return of just 1.5% over 14 years at very best! If that is not a sideways grind, I sure don’t know what is.
Within these secular-bear second halves of the Long Valuation Waves, stock-market valuations gradually decline from 28x to 7x. But this process isn’t smooth, these sideways grinds occur through an alternating series of shorter cyclical bulls and bears. The cyclical bulls generally double stock prices over a few years, and then the cyclical bears cut them in half again over a couple more. That’s what we’ve seen since 2000.
The toppings of these mid-secular-bear cyclical bulls are determined by valuations, and today’s valuations are at bull-slaying levels. Seeing the elite SPX stocks trade at 23x to 26x trailing earnings 14 years into a secular bear is incredibly dangerous. That means the SPX and SPY are highly likely to see their prices cut in half again in the next couple years! That’s the consequence of stock prices being bid too high.
This last chart zooms out to the entire secular bear since March 2000, replacing the SPY ETF with its underlying SPX stock index. The sideways grind since then is crystal-clear, occurring in a giant trading range defined by a series of massive cyclical bears and cyclical bulls. The combination of how big and old this current bull is coupled with today’s seriously-expensive valuations shows our bull run is over or soon will be.
Stock-market valuations were indeed well above 28x bubble levels in early 2000, and slowly ground lower on balance until late 2011. That’s when the US Federal Reserve really started to aggressively jawbone the stock markets higher, Bernanke trying to use the wealth effect to accelerate the economic recovery. So since then the SPX surged on multiple expansion rather than earnings growth, catapulting valuations higher.
This has left the SPX valuations dangerously high. If you believe the inarguable and incontrovertible evidence that the stock markets have languished in a secular bear since 2000, then the SPX valuations today 14 years into a 17-year bear market should be somewhere near 10x on their way to 7x. So 23x to 26x is scarily expensive, a recipe for a brutal cyclical bear highly likely in the coming years as valuations mean revert.
Now Wall Street never, ever predicts bear markets, as it is bad for business. Wall Street only recognizes bear markets in hindsight, as it wants to keep investors buying stocks no matter how expensive or risky to keep this industry’s profits high. So the popular mainstream view advanced by Wall Street these days is we are in a new secular bull, that the secular bear somehow ended well above 7x near 12x in early 2009.
But even in this Pollyannaish worldview, today’s stock-market valuations are still very dangerous. Anything above 21x is expensive anytime, and usually soon mean reverts back down to 14x fair value or lower. And it’s been 30 months since we’ve even seen a normal healthy stock-market correction, which are necessary to rebalance sentiment. The Fed’s stock-market levitation has short-circuited that essential process.
So even if we are in a new secular bull, which there is no evidence for, SPX valuations need to revert back down near fair value. This would lop more than a third off the SPX and SPY. Of course the popular hot momentum stocks that rallied farther than the SPX in the past year will also fall a lot farther as valuations mean revert. So the SPX trading north of 21x is very risky no matter what your view of bull-bear cycles!
Historically investors foolish enough to buy stocks above 21x earnings might do all right for a little while before euphoria peaks, but they eventually get slaughtered. Buying high means stock prices are far more likely to head lower than higher, not a wise time to invest. Investors are far better off waiting for periods of severe overvaluation to pass. Then they can buy cheap again after valuations inevitably mean revert.
If you are long expensive individual stocks, with P/Es above 21x earnings, you really ought to take profits while this bull is topping and prices remain high. If you can’t sell stocks, you can hedge your long equity positions with sufficient SPY puts. Speculators can buy these very same SPY puts to bet on the stock markets selling off after hitting such dangerously-high valuations. We’ve highly recommended owning SPY puts.
If today’s rampant stock-market overvaluations are a revelation to you, you need better sources of market intelligence. That’s what we do at Zeal. We’ve spent 14 years carefully studying the financial markets from an essential contrarian perspective. We attempt to buy low when things are out of favor and others are scared, which isn’t the stock markets today. We later sell high when they return to favor and others get greedy. Monitoring valuations and sentiment is a major and critical part of contrarian trading.
The bottom line is the US stock markets are dangerously overvalued today. Measured by the elite S&P 500 component stocks, trailing price-to-earnings ratios are well above the 21x historically expensive level. They are up in dangerous bull-slaying territory that has killed past bull markets. So investors need to be exceedingly careful with these lofty stock markets, fighting the euphoric hype pouring out of Wall Street.
Stock prices would need to fall by well over a third simply to return to historical fair value of 14x earnings. And since the stock markets have merely ground sideways on balance since early 2000, we almost certainly remain mired deep in a secular bear. And at this late stage in secular bears, valuations should be near 10x heading down towards 7x. Such a mean reversion would more than cut stocks in half in the coming years.
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