If Commander Chris Hadfield were still in space today, he might be surprised to see the U.S. stock market rocketing by.
It’s been a record breaking year for the S&P 500. The market is up more than 25 per cent since the start of January and has been hitting one record high after another. As you might expect, the gains have buoyed the spirits of investors who are showing signs that they are no longer feeling bound by the normal forces of market gravity that tie a stock’s price to its earnings.
The recent initial public offering of Twitter Inc. is a case in point. It was a huge success for the company and the underwriters. For investors, though, it is a mission into the unknown.
After all, what could possibly go wrong with a stock trading at 45 times revenue and 2,500 times cash flow? Just think about the heights it could achieve when it actually manages to turn a profit.
To my mind, the launch of Twitter is all too reminiscent of the bullish times in the late 1990s. Of course, if you listen to the market’s cheerleaders, there is no need for worry. The Greenspan put has morphed into the Bernanke bounce. The U.S. Federal Reserve stands ready to inject liquidity into the system at the slightest hit of economic – or market – weakness. Should a bank CEO suffer even a touch of indigestion after a three martini lunch, the Fed will be there with antacids in hand.
To which I respond: Bah! Humbug!
The market might be throwing a party but, just as in times past, it’s starting to get carried away with itself. For proof I turn to data from Robert Shiller, the Yale professor who recently won the Sveriges Riksbank prize in economic sciences in memory of Alfred Nobel.
Prof. Shiller tracks a variant of the U.S. market’s price-to-earnings ratio. The standard P/E formula divides the market’s price by its earnings over the last year, but Prof. Shiller’s method divides the market’s price by its average earnings, adjusted for inflation, over the last 10 years. He calls the result the cyclically adjusted P/E ratio, or CAPE, because the procedure smooths out temporary earnings fluctuations that tend to occur from year to year.
According to Prof. Shiller’s data, the S&P 500’s CAPE has averaged 16.5 since 1880. It hit a low of 4.8 way back in 1920 and a high of 44.2 in late 1999.
The S&P500’s CAPE recently touched 24.8, which puts it into rarefied territory. Until recently, past periods when CAPEs exceeded 24 were few and far between.
The first instance occurred in 1901 and another happened just before the crash of 1929. The end of 1965 briefly marked the third. In recent times, though, the market has routinely traded at lofty levels, most notably during the dotcom frenzy of the 1990s.
The returns generated after such periods have often been dismal. The crash of 1929 is still seared into our memory; so is the collapse of the dotcom bubble.
To be sure, a high CAPE ratio doesn’t mean a crash is right around the corner. As we saw in the late 1990s, the market could continue a multi-year trip to the moon even if the odds favour a retrenchment over the long term.
Some will also point to the possibility of a middle path. Should earnings remain at similar levels for a long time, or grow significantly, then investors stand to do reasonably well. However, such an outcome is essentially equivalent to betting that the business cycle has been repealed.
As a buyer of stocks, my preference is clear. I would like to buy stocks at more reasonable valuation, which should enable them to achieve good returns in the years ahead.
That means I would prefer to see the market come crashing back down to earth sooner rather than later – provided it doesn’t cause too much collateral damage along the way.
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