June 10, 2009

Valuation Headwinds for Stocks was featured on Seeking Alpha on June 10, 2009.

Stocks continue to celebrate the survival of the global financial system.  The change in investor sentiment has been dramatic.  As

recently as early March, the market was deeply troubled that the banking system and the worldwide economy may be grinding to a halt.  But in the few months since, this Armageddon view has been swiftly replaced by euphoria that the global financial system will not only survive but may be poised to thrive once again.  This dramatic shift in sentiment along with initial signs of stabilization in the global economy and improvement in the credit markets have helped stocks explode +40% higher from the bottom in early March.  But while the recent rally has been intoxicating, the investment environment is likely to become more sobering from here with a mounting valuation headwind as a major constraint.

The current rally is showing some signs of fatigue.  The stock market as measured by the S&P 500 reached a closing bottom on March 9 at 677 and has rallied nearly +40% through June 9.  Dissecting the path of this rally, a large percentage of the gains were registered in the first stage as would be expected.  From its closing low on March 9 to March 26, stocks gained +23%.  In the weeks since March 26, stocks extended their rally but at a slower pace.  By May 8, stocks tacked on another +12% and were up +37% overall from their March 9 lows.  But in the weeks since May 8, the pace of the rally has diminished considerably.  Despite setting a new high on June 2, stocks have been choppy along the way in gaining just +1% from May 8 to June 9.  This most recent stage of the rally has also included several retests of the previous May 8 peak in recent days.  So although the media conversation about the current rally remains enthusiastic, underlying stock performance is becoming far more measured.  Of course, any such consolidation phase following the dramatic rally in the last few months is certainly expected.  But it is worthwhile to raise a critical question at this time do stocks have the ability to extend the advance meaningfully higher from here, or is the current market rally close to exhaustion?

Stocks face mounting challenges in trying to extend the current rally.  Typical bear market rallies are driven less by fundamentals and more by sentiment.  And while the fundamentals behind the current rally are subject to great debate, it is clear that the global environment remains fraught with considerable risks.  First, economic conditions continue to deteriorate albeit at a slower pace and the subsequent recovery is likely to be subdued at best.  Second, the government faces a high wire act in attempting to finance its massive stimulus efforts while managing inflation expectations and keeping foreign buyers sufficiently interested in our debt.  Third, we continue to navigate unchartered waters with the unprecedented participation of the U.S. government in the private sector and capital markets, which will likely result to unexpected turbulence along the way and conclude with the extremely delicate challenge of successfully withdrawing liquidity without sparking a new crisis.  Lastly, geopolitical and financial conditions remain fragile in many regions of the world and the potential for a crisis erupting that results in larger domino effects is still meaningful.   

Valuations will also be primary headwind for stocks both today and in the years ahead.  Even if one believes that many of the underlying fundamentals behind the current rally are strong and that prevailing risks are manageable, valuations alone are becoming a mounting obstacle that will likely place a heavy restraint on stocks in the months and years ahead.  Even after the recent rally, it is still very common to hear expressions such as "the buying opportunity of a lifetime" when discussing stocks.  But just because stocks are still down 40% from their record highs in October 2007 does not necessarily mean that they represent a good value.  This is due to the fact that stocks valuations are not only based on price but also underlying earnings.  At first glance, stocks are actually in line with their historical average value at present.  When examining the price-to-earnings ratio on stocks based on the 10-year moving average of trailing reported earnings (P/E ratio), we see that stocks are currently trading at a P/E ratio of 16.3 versus the historical average (1900-present) of 16.2 (see chart).  However, when dissecting this data, one might reasonably conclude that stocks may actually be trading at a premium beyond the high end of their valuation range going forward.  If this were the case, it would imply a meaningful headwind and considerable downside pressure for stocks in the years ahead.

The threat to price stability has major implications for stock valuations.  Relative price stability implied by low and stable inflation provides the idea environment for stock investors.  Price stability is positive for stocks because it provides the flexibility for central banks such as the Fed to keep interest rates low.  Such conditions help foster strong and sustainable economic growth, which in turn supports accelerating corporate earnings growth and higher stock prices, as investors are willing to pay more for these earnings.  This leads to higher than average P/E ratios and is essentially the investment environment we have until recently been operating in since the mid 1980s, which helps explain why the U.S. economy experienced its longest expansion in history and the stock market gained +1,000% over this time period.  But since the eruption of the financial crisis in late 2008, price stability is now facing a massive test that is likely to continue in the years ahead.  The threat of deflation, or falling prices, is a worse case scenario for an economy and is the primary battle that the Fed has been currently waging by flooding the financial system with liquidity.  While initial indications suggest the Fed is winning its fight against deflation, lingering risks still remain that could ultimately lead to a Great Depression/Japan style deflationary spiral.  In addition, the cost of aggressively fighting deflation today is that the economy is left exposed to the threat of hyperinflation in the future, as it will be difficult to both properly time and efficiently extract the unprecedented amounts of liquidity currently being injected into the system.  Thus, whether it is deflation today (less probable) or inflation down the road (more probable), we are more than likely to experience relative price instability going forward, which is negative for stocks due to the associated impact on valuations.

Investors require lower than average valuations during periods of deflation and inflation.  We will begin by examining deflation since it remains the current threat.  The last time we experienced extended price deflation in this country was during the Great Depression in the 1930s.  During this time period, the P/E ratio for stocks dropped significantly below their historical average levels to the 5x to 12x range for an extended period due primarily to expectations for declining future earnings growth.  If a similar deflation outcome were to occur today, this would imply a price on the S&P 500 anywhere between 280 and 680, which is 20% to 70% below current levels.  While such a negative outcome now seems extreme given diminishing deflation risks, it was a very real concern as recently as March.  But given that the threat of hyperinflation is now becoming the more pressing concern, we will shift our focus to higher prices.  The most recent period that we experienced a major inflation outbreak was from the mid 1970s to the early 1980s.  During this time period, the P/E ratio for stocks was significantly below historical average levels in the 6x to 11x range due primarily to the fact that investors were willing to pay less for earnings and required a higher rate of return on their investment to maintain purchasing power.  Such an inflation outbreak would imply a price on the S&P 500 of 640 or lower, which is at least 30% below current levels.

Even the best-case pricing scenarios offer limited upside based on valuation.  Suppose all deflationary risks are averted, commodity prices remain reasonable, U.S. Treasury yields remain low and the Fed is able to successfully drain liquidity from the system while returning the economy to relative price stability.  In a financial system that will be far less leveraged going forward, this would imply a P/E ratio for stocks in the 15x to 20x range.  Also suppose that the S&P 500 12-month operating earnings per share estimates provided by Standard & Poors prove correct at $54.09 per share for 2009 and $73.56 per share in 2010. This implies +9% earnings growth for this year and +36% earnings growth next year in an economy that is projected by the Congressional Budget Office to experience a real GDP contraction of 2.2% in 2009 and growth of +1.5% in 2010.  This highly favorable scenario would imply a price on the S&P 500 at the end of next year in the range between 880 and 1170, which is 7% below to +24% above current levels.  While it would certainly be a desirable outcome, it would be considered a low probability outcome at present and still implies that valuations are somewhat rich at current prices.

Conclusion:  Stocks face a valuation headwind going forward at current prices.  Stocks are already at historical average valuations at present.  An outbreak of either deflation or inflation going forward would likely lead to an extended period of below average valuations, which would place meaningful downside pressure on stocks from current price levels.