It seems that “crying bubble” will soon replace “crying wolf” in popular sayings. Everybody is bubbling these days, from naysayers warning of bubble dangers to bulls urging to ride the coming bubble to economists saying we actually need bubbles to grow this moribund economy.
Is This a Bubble? As stocks hit new records and small investors—finally—return to the market, some analysts and economists are getting worried. How does the current cycle compare with previous ones:
Sorry, not very useful, is it? The rest is more interesting:
Bubble Trouble? Social media and cloud-related stocks seem stretched to bursting, but big blue chips still look attractive.
The S&P 500 is valued at 16 times projected 2013 operating profits of $109 and at 15 times estimated 2014 earnings of $120. Those price/earnings ratios are about equal to the long-run average. Even if next year’s earnings growth is closer to this year’s projected 5% than to the aggressive current estimate of 10%, the S&P 500 forward P/E is 15.6, which doesn’t look excessive at a time of near-zero short-term rates, a 2.71% yield on the 10-year Treasury note, and sub-6% average yield on junk bonds. The S&P 500 dividend yield is 2%, but the earnings payout ratio is historically low at about 35%, meaning companies have room to further boost dividends.
“The first stage of the bull market was a revaluation to something resembling reasonable levels as it dawned on investors that the world wasn’t going to end,” says Stephen Auth, chief investment officer at Federated Investors. “The second stage began this summer with a transition to the view that the economy is accelerating and that earnings are poised to increase significantly in the coming years.”
Tom Lee, the bullish JPMorgan strategist, says “We’re in a secular bull market that will last at least another three years.” Adds Jim Paulsen of Wells Capital Management, “If inflation stays at 3% or less, the market P/E could get into the 20s.”
Barron’s says that P/Es have averaged 16x “over the long term while Bloomberg claims that they averaged 17.5 since WWII.
The full S&P 500 trades at about 17.5 times trailing 12-month earnings, in line with the average since the end of World War II, according to S&P data.
Everybody and his aunt are now comparing current P/Es to their own historical P/E. The period one chooses is pretty crucial in these comparisons. For the record, again, also using S&P data:
The ultimate P/E idiocy, this time from Factset (Hey! what’s in a name?)
On the other hand, the current forward 12-month P/E ratio is still well below the 15-year average (16.2). During the first two to three years of this time frame (1998 – 2001), the P/E ratio was consistently above 20.0, peaking at around 25.0 at various points in time. With the forward P/E ratio still below the 15-year average and not close to the higher P/E ratios recorded in the early years of this period, one could argue that the index may still be undervalued.
Historical P/Es can easily become hysterical P/Es. The chart below provides a more proper perspective, plotting trailing P/Es back to 1927, the red line being the 13.7 median over that period. No bubble yet but we are definitely not into “buy-low” territory.
This next chart plots the Rule of 20 Barometer since the post war era. The Rule of 20 takes inflation into account. Yes Virginia, inflation matters! The current low inflation is keeping the Rule of 20 below fair value, currently 1870 on the S&P 500 Index. The yellow channel is higher risk area while the red part is bubbly mania. This last word will also become part of the financial press vocabulary pretty soon.
The key question is whether valuations will get over “fair value”, something not seen during this bull market. Sentiment narratives remained generally negative up to recently, preventing overshooting. Are we about to enter the third phase of the bull market as the venerable Richard Russell thinks?
One of the basics of Dow Theory is the thesis of three psychological phases in both bull and bear markets. In a bull market, which we are now in, the first or initial phase is the early accumulation phase. This is the phase where wise and seasoned investors enter the market at or near the bottom, when many stocks are selling at great values after having been battered for months by the preceding bear market. Here many blue-chip stocks are selling “below known value.”
The second phase of a bull market is usually the longest and most deceptive, containing many secondary reactions. During the second phase the retail public shows interest in stocks, and enters the market carefully and sporadically.
The third or speculative phase of a bull market is characterized by a wild and wooly and ever-increasing entrance by the retail public. This phase is characterized by hot tips, hype and pure greed.
My experience with bull markets is that by the time investors have been tricked and fooled by second phase shenanigans, nobody is ready to think about the possibility of a third speculative phase.
This is where I think we are now in this bull market. I believe that during the next 12 months we will experience a surprising and ever-expanding rush by the “mom and pop” public to enter the market. At the same time, veteran investors and institutions will seize the opportunity to distribute stock that they may have held for years.
All primary movements are international in scope, and this bull market will be no exception. In proof I show one of my favorite items, the “International Dow” known as GDOW (consisting of all 30 Dow Industrials plus 220 international major blue-chip stocks.
Note the sharp correction that occurs in mid-2012, and out of that correction the third, speculative phase of this international bull market began. I expect GDOW to go parabolic sometime in the next two years.
In the meantime, I’m reading dozens of advisories and yes, I note the warnings and technical death traps that are offered by other services. No matter, I think the excitement and greed which has enveloped the retail public will trump the adverse technical warning indicators that are now making their appearance.
(…) Messrs. Wurgler and Baker developed five indicators that were well correlated with periods of speculative excess over the past 50 years. None of them currently is detecting the levels of exuberance that prevailed at the top of the Internet bubble. They include the following:
The number of IPOs. (…) Over the first three months of 2000, according to data from University of Florida finance professor Jay Ritter, there were 123 IPOs. By contrast, there were just 73 IPOs in the three months through Nov. 14.
IPO returns. The average first-day IPO pops are also lower now. In the first three months of 2000, the average first-day return was 96%; now, it’s 25%, per Mr. Ritter’s data. (…)
The dividend premium. An even bigger contrast in sentiment between today and early 2000 appears in what Mr. Wurgler refers to as the “dividend premium,” or how much investors are willing to pay for the relative safety of established, as opposed to speculative, stocks. That is a useful indicator, he says, because investors become relatively bored with established companies during periods of speculative excess.
To calculate this dividend premium, he categorizes dividend-paying stocks as “established” and those that don’t pay a dividend as “speculative.” To compare valuations, he focuses on the price/book ratio, which is calculated by dividing a stock’s price by its per-share book value, or net worth. Higher ratios indicate richer valuations.
Of course, not all dividend-paying companies are safe, and not all nonpayers are speculative. Nevertheless, Mr. Wurgler says that, historically, the difference in the two groups’ valuations has been a good barometer of investor sentiment.
At the top of the Internet bubble in early 2000, according to Messrs. Wurgler and Baker’s research, speculative companies had a 43% higher price/book ratio than established firms, on average. Today, it is just the reverse: Among the companies in the S&P 1500 index, according to FactSet, established stocks have a 49% higher price/book ratio than nonpayers, on average.
The researchers would have been well advised to also consider return on equity since Price/Book comparisons are senseless without ROE comparisons (see BLIND THRUST)..
Share of new corporate cash from issuing stocks. The fourth sentiment indicator focuses on the percentage of new corporate cash coming from stock issuance rather than from longer-term debt that matures in more than one year.
Mr. Wurgler says this indicator is a good measure of sentiment because companies increasingly turn to the stock market to raise money as the market becomes more speculative.
Over the first three months of 2000, at the very top of the Internet bubble, this equity percentage stood at 20%. Today, it stands at 11%—or just over half as high. The low percentage of corporate financing coming from stock issuance hardly points to a speculative market. (One might wonder if this overwhelming preference for long-term-debt financing points to a bubble in the debt market, but that possibility isn’t one that Messrs. Wurgler and Baker have studied.)
Share turnover. The last of the five sentiment indicators is based on how often the average share listed on the New York Stock Exchange is sold—the so-called turnover rate—which the professors found increases along with speculation.
Over the first three months of 2000, turnover was running at an annual rate of 89%. Today, according to New York Stock Exchange data, the comparable rate is 60%.
What’s more, Mr. Wurgler says, recent turnover is, if anything, skewed upward by factors that weren’t present in early 2000, such as high-frequency trading. And yet this indicator appears to be showing a lower appetite for speculation than at the top of the Internet bubble.
The investment implication of all five sentiment indicators: If you were thinking of reducing your stock holdings out of a concern that a bubble was forming, you can instead continue to give the bull market the benefit of the doubt. (…)
Perhaps also read BLIND THRUST.
S&P Capital IQ just raised its 12-month price target for the Standard & Poor’s 500 to 1895, about 7% above its Nov. 6 close of 1770. Among the big beneficiaries by early 2014 will be yield-bearing stocks and funds, suggests Sam Stovall, the firm’s chief equity strategist. He doesn’t expect the Federal Reserve to start tapering this year or even possibly early next, ensuring that the markets are plenty liquid.
Stovall says investors should take full electronic advantage in selecting the best stocks to play this rally. “Don’t blindly dive back into higher-yielding issues,” he warns. He recommends careful screening for quality.
His ideal candidates are equities with 3% or better yields, that are rated both high quality and good value by equity analysts. Five years into a bull run, that’s a dwindling crowd.
But there is a little problem with that:
A recent check in the screener for S&P’s MarketScope Advisor (advisor.marketscope.com) found only 18 of the 1,150 U.S. issues and 133 of 1,560 foreign issues meet S&P Capital IQ analysts’ criteria—companies such as ConAgra Foods (ticker: CAG) and Chevron (CVX). Actually, four times that many companies earn high-quality ratings, but the yield hurdle trips up a lot of them. A 3% yield is half again higher than the S&P 500 average. Then, too, it’s tough finding quality at a fair price when so many issues are making new 52-week highs.
Warren Buffett recently said he’s having problems finding good values in this market. If you have not already done so, see BLIND THRUST to understand why.
Bloomberg adds: Buying Low Thwarted by Narrowest Stock Valuation Gap Ever
More than 440 of the S&P 500’s companies have gained in 2013, the most for any year at this point since at least 1990, data compiled by Bloomberg show.
A measure of the dispersion of price-earnings ratios in the S&P 500 compiled by Goldman Sachs Group Inc. narrowed to 41 percent in June, the lowest on record, and held around that level since. (…)
The last time the dispersion of valuations came close to being this narrow was in October 2006, a year before the last bull market ended, Goldman Sachs data show. Before that, multiples were most compressed in September 1997, 10 months before the biggest bull market on record ended.
Goldman Sachs’s price-earnings ratio dispersion is a monthly reading of standard deviation, or the variance from the average, for companies in the S&P 500. Goldman Sachs compiles data for companies whose price-estimated earnings ratios are between zero and 75.
A broad based bull leading to a narrow market. The exit door looks scarier…