By: David N. Hale, From the Ground Up
“In the business world, the rearview mirror is always clearer than the windshield.”
— Warren Buffet
Pardon the “shock headline.” You may be thinking that I’m shamelessly trying to garner more readership. And you might be right. However, I also believe that this question of current stock market valuations is a more serious one than many believe. Today, it seems most analysts would scoff at anyone who suggests the market is cheap. And on an absolute basis, they would be right1.
By most measures (Price to earnings, Price to book, Enterprise Value to EBITDA, and Price to sales) the S&P 500’s valuation hasn’t been this expensive since 2001, according to FactSet. The numbers of researchers, and individuals, who believe the market is expensive and overbought are legion2. 11 of 16 Wall Street Strategist forecasts, classic contrarian indicators3, believe the market will end 2017 lower than where it is at this writing4.
However, in a recent TV interview5, none other than Warren Buffett said this about stock valuations:
“We are not in a bubble territory or anything of the sort…you measure everything against interest rates basically…and measured against interest rates stocks actually are on the cheap side compared to historic valuations. But, the risk always is interest rates go up a lot and that brings stocks down.”
Indeed, it appears the Oracle is correct. When you compare the S&P 500’s valuation to the 10 Year Treasury Yield, you see a different picture. Dividing today’s 10 Year yield of 2.38% by any of the valuation metrics mentioned above puts the S&P’s current value near the low-end of the past 17 years and certainly nowhere near bubble territory6.
Why is this important?
It could be suggesting the market has stronger legs than many believe. However, the more important takeaway, in my view, is that it confirms just how much interest rate and inflation risk is embedded into current stock prices. Why? Consider the following:
We know that the Fed’s primary mandates are to promote low and stable inflation and maximum employment7. Their long-run inflation target is 2%8. They recently told us that they expect to raise rates gradually because inflation is still lower than their 2% objective and the labor market is improving gradually9. Moreover, long-run inflation expectations are somewhat low relative to the past 30 years10.
It appears as though inflation will not be breaking out anytime soon. Knock wood. If so, the question becomes: What will break this cycle? What will cause either an unexpected increase in interest rates or in inflation and inflation expectations?
Enter the 45th President of the United States. He appears to want aggressive fiscal stimulus11. Specifically:
- $1 Trillion in infrastructure spending
- Large corporate and individual tax rate reductions
- Deregulation, and
- Repatriation of profits that US companies have earned abroad
All of this could boost the economy, perhaps significantly. However, many believe these policies will also increase the national debt and budget deficit substantially. He may also create lasting frictions with our global trading partners. His propensity to micromanage domestic companies could reduce business confidence. In effect, he could produce short to medium-term gain but create problems in the long run12.
There is also the valid question of whether or not we need stimulus at all right now. Since the 3rd quarter of 2016, GDP, corporate profits, the composite index of leading economic indicators, and retail sales have all jumped significantly13. Yet, Trump’s combined proposals may well be larger than the American Recovery and Reinvestment Act of 200914.
In my view, this could boost stock prices for another few years, provided corporate revenues, profit margins, and earnings re-accelerate along with it. My question is: what happens when it is all over? Once the fiscal stimulus has largely subsided, inflation will probably be higher than it is today and the bond market will have to price that in. In this case, what happens to the already high absolute valuations if you begin to remove their embedded interest-rate support? As always, it is anyone’s guess, and at this writing we are pretty far from interest rates being at a level where treasuries could be viewed as competitive with stocks. Still, Warren Buffet’s answer to that question should be understood seriously. Here is a link to the interview.
As always, if you agree, disagree or have any questions, please call or email directly or start a conversation thread over on LinkedIn. Thank you for reading.
- Jill Mislinski, Is the Stock Market Cheap? Advisor Perspectives; 3/2/2017
- Jeff Cox, A Record Number of Investors Think This Market is Overvalued; CNBC, 3/21/2017
- Richard Bernstein – CEO, CIO Richard Bernstein Advisors; It’s Checkers Not Chess; Insights, January 2017
- Sam Ro – Managing Editor, Yahoo! Finance; What 16 Strategists Forecast for the S&P 500 for 2017; 12/30/2016
- Warren Buffett, Interview with Rebecca Quick of CNBC for Warren Buffett Watch series; 2/27/2017
- US Federal Reserve Board of Governors; Conducting Monetary Policy; Education Series; Page 25
- US Federal Reserve Board of Governors; Conducting Monetary Policy; Education Series; Page 26
- Federal Reserve Press Release; Monetary Policy Statement; 2/1/2017
- University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; 3/29/2017
- Fact Sheet: Donald J. Trump’s Pro-Growth Economic Policy Will Create 25 Million Jobs; www.donaldjtrump.com 9/25/2016
- Philip Marey et al.; Trump’s Impact on the Economy; RaboResearch – Economic Research; 1/20/2017
- Wikipedia – American Recovery and Reinvestment Act of 2009