The S&P 500 equity index, at a level of 2,100, trades at 17.4-times forward four-quarter aggregated consensus earnings expectations of $121.03 per-share, near the upper end of the historically normal range for stock market valuation.
Since 1936, there have been five instances of sustained P/E ratios in excess of 18x:
- Third-quarter 1945 and fourth-quarter 1945, because of an economic recession occurring between February 1945 and October 1945.
- Fourth-quarter 1960 to first-quarter 1962, partly because of a recession occurring between April 1960 and February 1961.
- Fourth-quarter 1990 to third-quarter 1993, because of a recession between third-quarter 1990 and first-quarter 1991 and then the “jobless recovery” that ensued through late 1993. Although the U.S. economy actually exited the recession in April 1991 when unemployment stood at 6.7%, the unemployment rate did not peak until June 1992 at 7.8%, and didn’t fall below 6.7% until September 1993.
- Fourth-quarter 1996 to second-quarter 2002, in response to the Greenspan Fed-era “Goldilocks” economy and ultimately the technology-driven stock market bubble of 1998-2000, and then the recession between first-quarter 2001 and fourth-quarter 2001.
- Second-quarter 2007 to third-quarter 2008, after the global financial crisis of 2008-2009 and the recession between fourth-quarter 2007 and second-quarter 2009.
The first three of these occurrences were the result of misplaced optimism, manifest in high stock market prices, when investors were caught off guard by the looming recessions of 1945, 1960-1961, and 1990-1991. These recessions had substantial negative effects on actual reported corporate earnings relative to the lofty pre-recession equity market prices and valuations.
The two most recent episodes of extreme stock market valuation are much more complex because they can’t be explained by a simple interruption and departure from sustained U.S. GDP and earnings growth. The period of heightened valuation between 1996 and 2002 was actually the result of multiple influences.
The “Goldilocks” period of strong non-inflationary economic activity, when U.S. GDP growth averaged 4.3% between 1996 and 2000 and core Consumer Price Index (CPI) averaged just 2.4%, resulted in average S&P 500 earnings growth of just above 8.5%. What began as a fundamentally justified macroeconomic earnings-driven bull market became the tech-stock market bubble. This series of events proved to be a precursor to the 2001 recession that dropped S&P 500 earnings growth into negative territory by the final quarter of 2000 from the 19-20% growth heading into that year.
In the fifth instance, forward P/E ratios moved above the 18x level in the second quarter of 2007 as U.S. financial conditions tightened in advance of the bursting of the U.S./global real estate bubble, the subsequent worldwide financial crisis, the U.S. recession occurring between December 2007 and June 2009, and collapseof S&P 500 earnings growth deep into negative territory for two years spanning the third quarter of 2007 and the third quarter of 2009. The S&P 500 has not traded at a forward multiple in excess of 18 times since the third quarter of 2008.
Existing stock market valuations, though fully valued from a historical perspective, are not so egregiously rich that the current 17.4x P/E ratio mandates a long overdue correction in market prices. However, history does suggest that the market is vulnerable to an unexpected exogenous shock. These might include a traditional GDP/earnings recession, a major geopolitical event (such as a Greek exit from the eurozone), or a largely unexpected surge in core U.S. inflation that would require a Fed response to defend its credibility. This could lead to significantly higher market-based interest rates that would be a drag on consumer activity and future corporate earnings.
In conclusion, a 17.5x market multiple doesn’t necessarily cause problems for investors, barring any shocks from a sudden increase in investor risk-aversion. Heightened economic uncertainty combined with elevated equity market valuations suggest that the margin for monetary policy and investor judgement error are potentially as thin as what occurred during the five episodes of 18.0x-plus multiples mentioned above. GMI believes that divergences among high profile economic data will be resolved in coming months, including the opposing rates of change in home prices and headline CPI, setting the stage for additional clarity on the appropriate level of equity market valuation and performance over the balance of what has proven to be an extremely elongated recovery cycle.