In my previous post, I outlined why I believe the stock market is currently overvalued based on an examination of what I feel the primary drivers of stock prices have been recently. I concluded that stocks (as measured by the S&P 500) are overvalued as earnings are artificially inflated (and therefore not indicative of normal earning power), while separate to fundamental corporate performance, stock prices themselves are elevated due to extraordinary monetary policy (abnormally low interest rates) forcing investors to bid up stock prices in a lower relative return environment. Both of these factors result in a “double lift” to stock prices,driving stocks to a level much higher than where they should probably be, given underlying economic fundamentals and an appreciation of the historical track record of the stock market.
As stocks are just one asset class for investors within the universe of investment, it is appropriate to consider what other sections of the capital and financial markets are telling us. Currently, fixed income yields remain near all-time lows, despite the stock market seemingly telling us that a recovery is at hand. Stocks and corporate earnings have been rising steadily since the March 2009 “bottom,” yet yields on 10 year US government bonds have remained consistently low during the same period (they have in fact fallen over the same time frame). This is attributable to a variety of factors, including central bank purchasing of bonds under quantitative easing programmes and a “safe-haven” preference among some investors, fearful of ongoing uncertainty, helping to keep yields so low. However, I believe financial markets may also be signalling something else to investors about the relative attractiveness or danger of investing in stocks at present.
One would think that with the successive QE programmes enacted by central banks and the unprecedented well of liquidity that they have provided to financial markets, inflation is a likely eventuality. This of course should reduce demand for bonds and lead to investors valuing stocks more for their greater relative appeal. The stock market (using the S&P 500) is valued at a modest 14.4x forward earnings for 2013 (based on S&P estimates as of today’s writing), while 10 Year US treasuries (and indeed Bunds and Gilts) hover around the 2% level, and US investment grade corporate bonds hover below the 4% level currently. Such abnormally low bond yields versus the implied earnings yield on stocks (c. 7% available on the S&P 500, if current year EPS estimates are to believed based on the 14x multiple) creates a relative value environment that increases the appeal of stocks. Yet there remains a very strong demand for bonds, rather than equities, which begs the question: What is the Graham’s “Mr. Market” telling us here?
Taking a step back, it seems that the market is ascribing a modest multiple to stocks, even with peak earnings, the supposed risk of inflation from QE, and the poor relative returns (yields) available from fixed income securities generally. Despite such seemingly clear positives for investing in the stock market currently, market participants clearly prefer bonds still. This seems contrary to what we would expect if stocks really are so appealing in this sustained, relative value world at present. I therefore believe there is an important for investors to heed about investing in stocks in the current environment for investors.
I believe the market may be telling those of us willing to listen that not only is there no immediate fear of inflation eroding investment returns, but that the market in fact does not actually believe the “stocks are attractive versus bonds” story being touted by many commentators recently. With margins and stock prices being where there are, future growth prospects and profitability expectations may not be realistic, and therefore the market is discounting this into stock prices. Another way of viewing this is that it suggests that many investors would rather remain creditors, ranking higher up in the capital structure with a greater chance of safety of principal, rather than accepting equity risk and the prospect of capital loss via stock prices declining upon realisation that current margins and consequent returns on equity capital are unsustainable.
And if inflation risk is low (as bond yields imply) then why go for equities when your investment principal is better protected as a creditor via bond investment? To put it more plainly, the market may well be telling us that the current modest PE multiple of 14.4x expected 2013 earnings is modest for a reason: prospects for further improvements on corporate profitability are limited given the low growth outlook, unsustainably high margins, and the fact that at some point, when economic fundamentals do finally improve as part of a true recovery scenario, there will be a great re-pricing of all risk assets, as interest rates necessarily rise.
It appears then that the stock market is applying a lackluster multiple to current peak earnings, in anticipation of declining corporate profitability as margins revert to mean after such an unsustainable run-up for the reasons previously outlined. So does this mean that stocks are to be avoided altogether? Not necessarily. While the stock market at the general level does not appear to represent “good value” justified by the fundamentals, that is not to stay that careful analysis and selection of certain businesses cannot yield satisfactory investment results – with a sufficient margin of safety, a particular stock can remain a very attractive investment regardless of where the general stock market is priced. The purpose of this and my previous post has been to fully appreciate and understand the current price level of the stock market and the implications of this for returns as I commence my investment programme in such a richly priced environment.