A Little Bit of The Bubbly?

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A Little Bit of The Bubbly?

Postby Dacamic » Mon Nov 25, 2013 11:57 am

Dateline: November 15, 2013 -- Janet Yellen says there is no equity bubble.

In front of the Senate Banking Committee, Yellen rejected the notion that stocks are in bubble territory citing the equity risk premium as support for her belief. Is she right? Sort of ...

I've been cringing in dread about the next coming of Armageddon in stocks since May 2011. But, I have lived needlessly in fear: the S&P 500 has risen 33% from that time. Some would argue my forecast was wrong, others might suggest it was early. Either way -- for at least today -- I am rightfully lumped with those economists who correctly predicted seven of the last five recessions. Please read the rest of this note with that in mind.

I look at two metrics when measuring the "bubbliness" of an equity market:

    -- PE Ratio; and,
    -- Equity Risk Premium.
It is worth mentioning my calculation of PE is not typical, specifically the "E" portion is the 10-year average real earnings of the S&P 500. This method for calculating PE -- introduced by Dr. Robert Schiller -- has the advantage of normalizing for business cycles and accounting creativity that occasionally creeps into financial reports (cough ... Enron ... cough).

I have data pertaining to the S&P 500 from 1871 to present. We can see the following using this information:

    -- The S&P 500's PE ratio is 24 today; and,
    -- There have been four times since 1871 the PE ratio has been above 25 --
      -- 1901;
      -- 1928 - 1930;
      -- 1995 - 2002; and,
      -- 2003 - 2007.
For over one hundred years, people rarely paid more than $25 for every $1 of earnings . Beginning in 1995, though, it has happened more often than not. Did we climb to a new plateau in 1995 from which stock prices would never fall? A similar argument was made in the late 1920's ... and we know what happened soon afterward. The S&P 500 has always -- always -- dropped at least 40% from its peak after its PE climbed above 25. Here's the tricky part: the S&P 500 has also usually moved higher after crossing above the "PE = 25" threshold. In fact, it zipped almost 150% higher from December 1995 to August 2000, during which time its PE inflated from 25 to 44. Given those precedents, the caution light now blinking doesn't necessarily mean we should pull the ejection handle. It is blinking nonetheless.

The stock market is a rational beast at its heart, and the PE ratio can be used to help evaluate whether prices have temporarily drifted away from rational levels. But, PEs can be low without stocks being depressed or high without them being manic. Interest rates are key in this regard. It makes sense for stock prices to be low when interest rates are high, and reasonable for prices to be high when rates are low. It is easier to understand the influence interest rates have on prices by flipping the PE ratio upside down and converting the result into a percentage. For example, the interest-rate equivalent of the S&P 500 is 4.2% today (1/PE or 1/24), which compares favorably to the 2.7% equivalent rate of the U.S. 10-Year Treasury bond. Stocks are currently cheaper than bonds from this perspective. By contrast stocks had a rate of 2.2% in March 2000 when the 10-Year Treasury was at 6.1%, thereby reflecting stocks at that time being much more expensive than bonds.

The above comparison of rates is a blunt tool, yet it can be used as a reasonable way for evaluating the "bubbliness" of today's stock prices by looking at its past levels. The equity risk premium mentioned by Yellen is 1.5% today (stock rate of 4.2 % vs. bond rate of 2.7%). Since 1959 the risk premium has rarely been more than that; thus Yellen is right when she says stock prices are not in a bubble. In fact, it's arguable the S&P 500 could climb to almost 3000 -- or 67% higher -- before the premium shrinks to zero and bubbles begin to appear. Here's the rub ...

Janet Yellen is inheriting an economic environment that is enhanced by a high-pressure, oxygen-rich atmosphere created by unusually low interest rates. I think this is where there is danger of someone putting a stick into the spokes of her argument about stocks not being bubbly. Simple arithmetic shows the risk premium benefits from uber-low interest rates. Thus, saying there is no stock bubble is the rough equivalent of saying there is nothing unusual about a runner's record-breaking pace even though they are running downhill and downwind. Both statements are correct, but only within favorable circumstances that will not continue over the long run.

We can only hope Yellen knows her statement needs an asterisk.
Steve
Dacamic
 
Posts: 457
Joined: Wed Nov 30, 2005 12:40 pm

Re: A Little Bit of The Bubbly?

Postby Overload » Tue Nov 26, 2013 10:27 am

I'm curious when the PE crossed above 25, and what are the ranges of time it's taken to fall that 40% afterwards?

Maybe playing devil's advocate here, but it might not be coincidence that 1995 is about the year that Microsoft got in the game. Computers have no doubt supercharged the process of getting new products into the marketplace. This has happened across any number of industries: transportation, finance, entertainment, biotech, etc. And with that rapid development comes smaller time frames for success. Perhaps investors nowadays are willing to pay that higher PE, with the thought that some exponential growth will soon follow. Things change quickly these days. Much more quickly than they did pre-1995.

Pete
Overload
 
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Re: A Little Bit of The Bubbly?

Postby Dacamic » Tue Nov 26, 2013 4:36 pm

Overload wrote:I'm curious when the PE crossed above 25, and what are the ranges of time it's taken to fall that 40% afterwards?

By era, the time between PE crossing above 25 and the corresponding peak is as follows:
    -- 1901 - one month
    -- 1928 - one year
    -- 1995 - five years
    -- 2003 - four years
Maybe playing devil's advocate here, but it might not be coincidence that 1995 is about the year that Microsoft got in the game. Computers have no doubt supercharged the process of getting new products into the marketplace. This has happened across any number of industries: transportation, finance, entertainment, biotech, etc. And with that rapid development comes smaller time frames for success. Perhaps investors nowadays are willing to pay that higher PE, with the thought that some exponential growth will soon follow. Things change quickly these days. Much more quickly than they did pre-1995.

The growth rate of the S&P 500's earnings did not experience a tectonic shift higher in 1995. It did nudge higher at that time, but not enough to explain the current PE level. The more noticeable change was in the 10-Year Treasury rates: 5.6% in 1995 vs. 2.7% today. As a result we have swung from paying a premium for stocks (1995) to paying a premium for bonds (today) even though the S&P 500's PE is essentially unchanged.
Steve
Dacamic
 
Posts: 457
Joined: Wed Nov 30, 2005 12:40 pm


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