At the end of 2019, the Standard and Poor’s 500 index of U.S. share prices stood at 3221.29. Since then, the United States has been subjected to a devastating epidemic, has wasted trillions of dollars in response to that epidemic, driving its debt to GDP ratio up to 108%, has suffered debilitating inflation that has caused interest rates to be raised sharply, and has replaced competent economic policies with ones that seem especially designed for economic destruction. Yet the S&P 500 Index is today up a full 40% from its December 2019 level. When examined carefully, the market is not only overvalued, it stands at three times its fair level.
There are three fundamental factors that should determine the overall level of stock prices. First, there is the level of interest rates in relation to inflation – if interest rates are far below inflation, as in the 2010s, stock prices will be driven up to absurd, unsustainable levels. Second, there is the level of corporate earnings; if those are especially high in relation to GDP, stocks will again be driven up, but in this case, if we think earnings levels will be maintained, the rise is sustainable as (theoretically) stocks could rise while maintaining the same price/earnings ratio. Third, there is the level of productivity growth in the economy; if that is rapid, stock prices should rise because the underlying growth in corporate earnings and potentially dividends will be faster, making stocks genuinely more valuable.
It must surely be clear at this point that we are no longer in the era of zero interest rates. Short-term U.S. interest rates at 5.5% are modestly above the level of inflation, almost for the first time this century, except for a brief 3-month period in 2008. This is likely to persist, since inflation is unlikely to subside quietly, with the immense Federal budget deficits tending to push it up. Thus, in terms of short-term rates, we are in a position scarcely seen this century and judging from Fed commentary, we are likely to remain in it for at least the next year or so.
Long-term rates are still artificially low, more than 1% below short-time rates, as the dozy bond traders are convinced rates will drop back to 2010-21 levels, at which time their holdings of long-term bonds will yield them a magnificent profit. (I have often thought the market could do with some 80-year-old bond traders, with experience of the last half century’s business cycles – as it is they tend to age out at 40.) With the new supply of long-term U.S. government debt exceeding $1 trillion in the current quarter alone, this is not going to happen. Absent a recession to match the 1929-33 abyss, long-term rates will soon rise to match short-term rates, possibly plus a premium to reflect the difficulty of absorbing so much debt of an entity which, as I remarked a few weeks ago, should rightly be rated BBB minus.
In 2019, after a decade of near-zero interest rates, the market was surely priced to reflect that interest rate structure, and a belief that it would continue for the long-term future. Since the market is up 40% since then, far more than growth in nominal GDP, it follows that the over-exuberant stock traders, especially in the tech sector, have continued to assume that real rates over the next decade will be negative, as they were through most of the 2010s. The valuation correction once they realize this is unlikely is theoretically infinite, since discounting a stream of earnings at a negative real interest rate produces an infinite result. In practice a halving would seem the minimum downdraft to be expected.
Corporate earnings in the 2010s soared far above their historical average since 1950 of 6.9% of GDP, peaking at 12.3% of GDP in the second quarter of 2022. To a large extent, this was due to the artificially low level of interest rates; corporations were able to borrow for a decade at near-zero real interest rates and use the proceeds to buy back shares or acquire other companies. With higher earnings producing higher stock prices and top management heavily, indeed excessively incentivized by luscious grants of stock options, the result was soaring corporate earnings and a grievous slackening in accounting and auditing quality.
Since early 2022, when interest rates began to rise, the surge in corporate earnings has gone into reverse, falling to 10.3% of GDP in the second quarter of 2023, although inflation has disguised the extent of the decline. Going forward, since interest rates are now likely to be positive in real terms and much higher in nominal terms than in the 2010s, a further decline towards the long-term average of 6.9% is likely, a 34% decline from current levels.
The excesses of 2010s corporate finance are at that point likely to catch up with the market. Almost all companies have leveraged themselves and engaged in massive stock buybacks, whose amount has generally exceeded even the bloated level of earnings. Inevitably some companies that have engaged in these practices will find themselves undertaking “emergency” share issues at prices far below those at which they bought back stock. This happened to some extent in the recession of 2008-09, but the number of cases this time round will be far greater, as the tsunami of buybacks has been far larger and much longer in duration than in the 2000s.
The gross rip-off of shareholders through selling stock at levels far below those at which it had previously been bought back will seriously damage confidence in the company concerned and indeed lead many such issues to be spectacular failures. The overall effect on confidence in corporate America will be dire, and rightly so – the lawsuits that are bound to follow will themselves sap the health of the companies concerned. Thus, even though the decline in earnings will be moderate (although recession may worsen it) the damage to the stock market’s health is likely to be considerably greater.
Finally, we come to productivity growth. From 1948-73, U.S. productivity growth averaged 2.8% per annum. That allowed the U.S. economy to grow at a rapid rate, and U.S. corporations, innovating rapidly, to dominate world markets. In that environment, stellar P/E ratios would have been justified. Yet the reality was that P/E ratios, while rising from an abnormally low level in 1949, remained moderate throughout that period, certainly nothing like their recent level.
From 1973 to 2010, productivity growth averaged 1.8% per annum. The slowdown from the 1948-73 level was almost certainly due to damaging regulation; the transition coincided with the institution of the Environmental Protection Agency, the Office of Safety and Health Administration and other unaccountable agencies that have devoted themselves to clogging up the U.S. economy with their regulations. The desire to regulate, combined with increasing frivolous litigation, was mitigated only under President Trump from 2017-19; under Presidents Obama and Biden it has intensified, with the damaging economic results that would be expected. In this period, you would expect lower stock prices; in fact, after a depressed period in the high-inflation 1970s, they began after 1995 to rise far beyond their historical levels, despite the economy’s inferior performance.
Since 2011, productivity growth has declined further, albeit with a modest recovery under Trump, to a mere 1.0% per annum, with zero growth in the latest ten quarters of Biden’s presidency. This is most likely due to artificially low interest rates, which divert investment into unproductive areas such as real estate and mindless tech, although the regulatory enthusiasm under Presidents Obama and Biden clearly exacerbated the problem. With such low productivity growth, there are no prospects for overall economic growth beyond a sluggish level, and stock prices deserve to be accordingly depressed. Of course, this is not the course we have seen; stock prices have been buoyant during the period, even in the last ten quarters of zero productivity growth. This downtrend in productivity growth, whether due to the “end of innovation” or not, deserves to produce a further decline in the appropriate level of stock prices.
Add the three tendencies together, you get a rule of thumb that stock prices are somewhere around three or four times their proper level. To calibrate this in an alternative manner, we can look at stock prices on December 31, 1994, immediately before Fed Chairman Alan Greenspan made the ill-fated revolution towards ever-easing monetary policy at the meeting of February 23, 1995. At the close of that day, the S&P 500 index stood at 459.27. It was above the peak of September 1987, before the infamous “Black Monday” when the market fell 20%, and over four times its 1982 low — in other words, at somewhere close to a fair level.
To get an equivalent today, you should inflate by the growth in nominal GDP between the fourth quarter of 1994 and the second quarter of 2023, a factor of 3.599. That takes in both economic growth and inflation between the two dates; it assumes the S&P Index is the same percentage of GDP at both dates. Multiplying by that factor gives a “fair” value for the S&P 500 Index today of 1653.18 – just 36.6% of the current value. Given that productivity growth and the prospects therefor have deteriorated substantially since 1994, and that the West, far from recently having achieved victory over its main geopolitical rival, is assailed on all sides, I stand by my statement that the market is today at three times the fair level.
Eventually, this market will crack, and prices will head towards their fair level. Given the gnashing of teeth, tearing of hair and lunatic policy prescriptions this decline will cause, I expect the market to overshoot on the downside!
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)