"Stocks have only been this expensive during the crash of 1929, the tech bubble, and the financial crisis."
This is an interesting observation from Business Insider but before believing stock market bears and all the wet blankets out there, you should know one thing about this story: It was written on December 8, 2016. Since then, broad U.S. stock market indices are up between +6% and +13.1%. In other words, stocks have gotten a heck of a lot more expensive.
There's a lesson here. As we've said time and time again: Valuation is not a catalyst. Like weather predictions, valuations change.
Sure, Stocks are expensive But...
Knowing that cheap and expensive stocks, however stretched they might seem, can get a lot cheaper or more expensive is an important concept to understand. And luckily, studying market history is deeply instructive on the matter. The thing to note is that it's a catalyst that ultimately tips a stock's valuation in either direction, not valuation itself.
This is what Business Insider fails to articulate. The entire story is based on the cyclically-adjusted price to earnings ratio, developed by famed Yale economist and Nobel Laureate Robert Shiller. The CAPE ratio, as it's called, is a valuation measure defined as the current price of an asset divided by the past ten years of inflation-adjusted earnings. The ratio is designed to put into perspective current equity market prices versus market history.
The current CAPE ratio is 29.3; that's well in excess of the 90th percentile of all stock market readings (i.e. more expensive than 90% of the data) going back to January 1881.
Alarmed? Before you go out and sell stocks, consider that stock market valuations over the last 30 years have gotten a lot more expensive than current levels. As Hedgeye Senior Macro analyst Darius Dale continually reminds us:
"The top 10 one-year-forward returns of CAPE Ratio readings between the ninth and tenth decile carry a whopping average of +34.8%! That figure drops to +30.2% for the top 20 and +21.3% for the top 50. Over the last 30 years, the average of the top 10 one-year-forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%."
Dale asks a simple question: Can you afford to miss a +31% move to the upside in your benchmark?
What's The Catalyst To Send Stocks Higher?
Valuation is not a catalyst but earnings season sure is. Here's analysis from Hedgeye CEO Keith McCullough in today's Early Look.
"Yep, the last two Earnings Seasons (Q4 reported in FEB-MAR and Q1 reported in APR-MAY) have been unadulterated rate of change accelerations in both revenue and earnings growth AFTER 5 straight quarters of a US Earnings #Recession."
So after turning the corner on a protracted earnings recession, it's no surprise stocks have been rising so precipitously. Here's an update on first quarter earnings season to-date in the Chart of the Day below with key callouts. Sales and earnings growth have been growing gangbusters:
- S&P 500: 299 companies have reported aggregate year-over-year sales and earnings growth of +8.0% and +15.7% respectively.
- Technology (36 of 67 reported): Aggregate year-over-year SALES and EPS growth has accelerated to +9.6% and +24.5% respectively
- Financials (53 of 65 reported): Aggregate year-over-year SALES and EPS growth has accelerated to +6.3% and +18.8% respectively
The bottom line: Don't start with valuation. As any good stockpicker would tell you, company fundamentals matter a lot. So why not consider the underlying fundamentals of the U.S. economy and earnings season in your investment process?
Is the U.S. economy heating up? Is growth flowing to the bottom line of corporate America? These are the questions that drive portfolio returns, the answers to which will tell you whether cheap stocks can get cheaper or expensive stocks will get more expensive.
