Relax (a little) on rising multiples
Stock valuations (simply the question as to whether or not you are getting your money’s worth in stocks at today’s prices) aren’t something I discuss or write a bunch; mostly because of their glacial pace. You can click here for a piece last December that gave a more full view on the topic. A quick summary of that is that valuations are high, are likely behind us in terms of a tailwind for price appreciation, but that does not mean they can’t simply stay put for a while rather than entering in a glide path towards their long term mean.
I want to deliver a couple of thoughts on one of the elephants in this room around this topic. The unknowns outweigh the knowns (or else this business would be easy!)…but here are a couple of clear knowns:
- Clearly …… the expanding multiples movement has continued on to ever higher ground as we’ve moved through 2017. You can make market valuation as difficult as you want, but by just about any method you choose will be at or near all-time highs.
- Clearly…….. these levels represent a headwind for the market, whereby it is quite reasonable to expect we are either at or below these multiple levels in 5 to 10 years’ time. [If you are worried this means stock prices themselves have to be down, please read the beginning of the year post]. But these higher levels also clearly reveal that we are more susceptible to finding an air pocket that resets us to lower levels than we were in the earlier part of the decade.
But here’s the key point for today’s discussion: ….the trend for a long time has been toward higher multiples. One key point to make: earnings plummet during recessions (in the case of deep ones like ‘08/’09 they can outright vanish). This temporarily drops earnings (The “E” part of the equation) unreasonably low and causes spikes in the P to E ratio – which we have to just overlook as anomalies. This can be seen in years like ’22, ’34 and the more recent versions of ’02 and ’09 (though these recent ones are more pronounced for accounting reasons discussed in link above as well as paragraph below). But, you can also see that the trend since the early 1900’s has been for higher valuations as we move through time. Stocks in this light don’t appear quite as excessively valued as compared to their simple long term mean.
A trend is a trend, and sometimes things just are….but I will give a couple of reasons I believe have been behind this trend. Two that I am quite certain of and a third that I will offer up as reckoning at this point
- Over time companies have gradually shifted from shelling out a majority of their profits as dividends to investing a majority of the profits either back into the business or share repurchases. If invested well, those profits can accelerate growth and warrant a higher multiple. Over the past half century the payout ratio for the S & P 500 as a whole has dropped from well over 50 to well below 40; a drop that is not insignificant for a large index.
- Significant accounting changes in 2001 that leads to more losses flowing through to the bottom line. It’s not that the economics of business were any different, but the way we measure them suppresses the “E” over time (raising the P/E ratio…especially during recessions). Again, there is more on that in the post linked above, or better yet …. The best article I have read on the subject here
- The third I would offer up is a reduction in economic volatility. Other things equal, stocks exposed to more risk and volatility trade at a discount to compensate the investor for those risks. One thing I have spent quite a bit of time contemplating lately is the possible impact a reduction in overall economic volatility could have on stocks. If, investors are willing to pay more for less risky investments, it stands to reason that stocks as a whole could be beneficiaries of less volatility.
The chart below depicts an overall drop in the quarterly change in GDP.
A couple of theories (monetary system, etc) are behind this drop, but one that makes a great deal of sense to me is inventory management. Traditionally, inventories are behind a great deal of the “extra” cyclicality in the economy. As businesses become more optimistic, they stock up on inventories to support growth. This is a self – feeding process that causes other businesses to also become optimistic. Eventually, there is a turn in the economy and companies must deal with overstocked inventories. This can become a self – feeding process that feeds negatively back through the system. However, technology has -especially over the past 20 years – continually improved inventory management across many parts of the economy to allow for lower levels in general and less need to over-adjust.
Another factor that could continue to gain steam is increased reliance on entitlement income. The baby boom is speeding towards its day of receiving a significant percentage of its income from social security. This presents a source of income that will generally be the same on a monthly basis. More predictable and steady income could further support more predictable and steady economic readings.
Conclusion
Admittedly, this is the sort of thing that you’d expect to hear late cycle with justification (hope) that the bull will stay alive forever. In no way am I saying that’s the case or that recessions will become a thing of the past. Recessions will hit, corrections will come and go and a bear is absolutely somewhere in our future. I would also doubt that these 3 reasons listed above fully explain the higher valuations. But, I reiterate my point which is the same as last December’s post – it’s certainly possible that we hold these higher valuation levels through the remainder of this cycle. Interest rates have slowly been moving up, but you still only earn a little over 3% for solid corporate paper. This means there can be a high cost to avoid riding stocks (especially globally) on continued earnings growth if this cycle makes up in length what it has missed in strength.