Last week, yours truly here cautioned investors not to trust the bullish thrust from the Dow Jones Industrial Average and the S&P 500 Index, and/or corresponding exchange-traded funds like the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).
Although, in many regards it was a classic breakout move for both indices, between the market’s valuation and the fact that stocks were so technically overbought, it just wasn’t worth the risk.
Not everyone agreed, which is fine. Differences in opinion are what make the world go ’round; and if opposing viewpoints help an investor make a well-informed decision about the future of the market, that’s a good thing.
And yet, when one of those opposing opinions glosses over or outright overlooks key details en route to a conclusion, I have to rebut.
Bernstein: Missing Some Key Points
For the record, it was Yahoo Finance’s Sam Ro (who I enjoy reading) that made the opposing argument, but he was basing it on some optimistic assessments from Richard Bernstein Advisors, which said earlier this month:
“There is an old investment rule-of-thumb called the Rule of 20 that uses combinations of headline inflation and the S&P 500 P/E to determine fair value. Our valuation models are, of course, more elaborate than the simple Rule of 20, but based on a more rigorous analysis of inflation and P/E ratios, the current equity market appears, at worse, to be fairly valued. Investors forget that inflation was increasing leading up to the 2008 bear market. In fact, the CPI, which is a lagging indicator, peaked at 5.6% in July 2008. Today’s headline inflation is 1.0%.”
That thesis flew right in the face of mine, as I suggested the then-trailing price-earnings ratio of 21.4 for the S&P 500 (it’s now somewhere around 21.5) simply didn’t leave room to rack on any more gains. Bernstein thinks it does, as inflation is uber-weak.
I get the premise of the “low inflation is bullish” argument. It’s not really an argument, however, that’s as sound as it may seem on the surface.
The Deal With Inflation
Click to Enlarge Yes, “headline” inflation is muted right now, but that’s only thanks to low oil and (some) food prices. When taking food and energy costs out of the mix, the annualized inflation rate stands at 2.3%.
It as well as the non-core inflation rates are on the rise right now. If this is a trend — and it sure looks like it is — then the Bernstein thesis may need to be reworked soon to acknowledge the rising inflation … especially if oil prices continue to swell.
With that being said, even if the current rise in inflation is a short-lived fluke, from a historical point of view the market’s current valuation still isn’t justified relative to inflation.
It’s not been without its critics (and I’ve been one of them), but the Case-Shiller CAPE ratio (the cyclically adjusted price-earnings ratio for the S&P 500) has merit in that it weeds out a lot of the inflation and valuation noise and paints a more meaningful picture … a picture that most inflation-aware investors have to respect, even if they disagree with what it says.
Click to Enlarge And what does it say right now? It also says stocks are well overvalued, even when factoring in the current inflation data. As the S&P 500 CAPE chart below readily illustrates, the current CAPE score of 26.2 — an inflation-adjusted reading — is also an alarmingly high level.
It often causes investors to speak these famous last words: “But this time is different.”
With all of that being said, it was something else Bernstein said and Ro reiterated that may have me the most worried about Richard Bernstein Advisors’ optimism:
“Some market observers have cautioned that overvaluation always leads to poor returns because multiples contract. There is indeed history to support such concerns. However, the key word is ‘always’. As we have shown, there have been many periods in stock market history during which earnings growth improves, interest rates increase, PE multiples contract, and a bull market continues. They are called earnings-driven bull markets.”
Fair enough. There’s just one problem … well, two problems actually.
The first one is, we haven’t seen that combination of items (at least not significantly) since before 1990. The only time since 1990 that the 10-year Treasury yield has ended a bull market higher than it started is the 2002-2007 bull market.
Click to Enlarge It started it around 4% and ended it around 5%. During the other two bull markets, rates fell from beginning to end. Point being, we don’t really know how stocks are going to behave if rates start to rise in earnest, as we’ve not seen them rise much in the modern era of market-supporting policy.
The other hang-up? Yes, earnings growth can override the ill-effects of rising inflation, and compress P/E ratios as a result. Earnings aren’t growing right now, though.
The second-quarter bottom line for the S&P 500 should be up about 7% on a year-over-year basis, but the only reason we’re seeing meaningful growth from the market is the modest rebound in oil prices and subsequent rebound in the energy sector’s earnings.
Taking the energy and closely related materials sectors’ earnings out of the mix, the S&P 500 is only expected to post about a 5% increase in earnings. That’s not much.
Click to Enlarge For Q3 and beyond the outlook is a little brighter, but caution is advised. As the table of historical earnings outlooks for the S&P 500 goes, analysts habitually overestimate how well the market will do.
In other words, earnings may not be growing enough this time around to justify P/E levels above 21.5 in the face of rising inflation, as muted as that inflation may currently be.
Even without knowing earnings estimates are usually hyper-inflated though, it’s not difficult to see on the earnings history/outlook chart that the pros currently expect income growth to do something well out of character of its normal growth trend.
Bottom Line for S&P 500, Dow Jones
The market very well could be higher a month from now, and a year from now. Nobody has a crystal ball. Just make sure you’re coming to a conclusion based on all the facts and an outlook doesn’t require something rarely seen to pan out.
I stand by my pessimistic view. That is, while I don’t believe we’re at the beginning of a bear market, I do believe the market as a whole has pretty much reached its maximum value for a while.
The rest of 2016 and the first half of 2017 could be frustrating ones. Choose your stocks carefully, sticking with ones that don’t need help from the market’s tide.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.