|
Despite the terrible economic performance of the past ten
years (both in terms of the markets and the general economy), equity valuations
are now approaching the second largest bubble in United States history,
surpassed only by the technology bubble. Both the cause and the potential
ramifications of this development are astounding.
Exhibit
one: The cyclically-adjusted price-to-earnings ratio, or CAPE.
This is not a “fad” valuation metric. CAPE
dates back to 1871, offering 140 years worth of data, during which time the
mean price-to-earnings ratio is 16. According
to Yale University’s Dr. Robert Shiller, the market is now 41%
overvalued according to this valuation metric. The only time the markets have
been more overvalued was a few brief months in 1929 and the tech bubble.
 
Exhibit 2: The Q ratio, which
measures total market value compared to its replacement cost.
The Q-ratio
data in the chart below dates back to 1900. According to the data, the
markets have now surpassed the 1929 peak valuation by over 8%. In United
States History, only the tech bubble was bigger than what we are experiencing
today.
Historically, bubbles turn a believable story and a trend into
an overvaluation. In the 1700s during the South Sea Bubble, the mania driving
the bubble was the seemingly endless wealth and prosperity of the New World.
Railroading prospects induced a bubble in the late 1800s as America became connected
from the east coast to the west coast. In the 1920s, a bubble formed on
belief in the newly formed League of Nations (world peace), and more
importantly, the society-changing impact of the automobile. A similar
life-changing invention – the Internet – swept the attention of
investors in the 1990s as the prospect of a virtual marketplace would forever
globalize commerce. Every bubble has a story, whether it be tulips or
inventions or some other craze.
What is the story today? The prospect of inflation? High
unemployment?
Exhibit 3: The gap between projected
12-month earnings against the 10-year average. (Two notes: a. the chart from Bloomberg
fails to insert the word ‘projected’; Robert Shiller references
this chart in this Bloomberg
article. b. the 10-year average is the cyclically adjusted price to
earnings ratio).
Considering the power of mean reversion, the market is stretching this
reversion greater than 2000 and 2007!
Another question. Could the growth in
earnings have been artificially manufactured?
To quote Elizabeth Barrett Browning: “Let me count the
ways.”
- The change in
accounting rules for the financial sector by FASB has generated massive
“false” account profits beginning in 2009.
- The extended (and then
further extended) unemployment benefits have kept an artificially higher
demand for consumer consumption. As a result, the US government has
artificially subsidized corporate profits.
- The billions saved through
“free loading” by homeowners who have defaulted on their
mortgages yet maintained their residence, thus living without a mortgage
payment.
- The artificially
suppressed interest rates.
So, not only do we have a valuation bubble, but the earnings
on which the projections are based are non-sustaining, and non-market driven.
Brilliant. Again, I am left wondering how it is possible to find ourselves in
the same overvaluation situation as a few years ago especially considering
nothing has been resolved to actually fix the world’s economic system.
A parting thought: according to research
conducted by the Duke University Medical Center, it would seem that even
monkeys are even capable of learning from their mistakes. Why
can’t we?
|
