My expectation, moving into September, was that all the economic issues that had been pretty much left alone during the summer would resurface. The debt ceiling, the situation in Europe, China—all would move back to the front pages.
Boy, was I wrong. Looking at today’s papers, I find no stories about economic problems on the front pages—none. The lead story is Syria, which makes sense. There’s also a story, in both the New York Times and the Wall Street Journal, with a retrospective of the financial crisis. Old news.
You can look at this in two ways. The first is that the economic problems have, in fact, normalized. The case for this is that the deficit is down; U.S. economic growth, though slow, continues; Europe and China are improving, as shown by recent data; and the pending political issues, though real, are nothing we haven’t successfully weathered before.
This is actually a pretty powerful case. Despite all of the hand-wringing over various risks during the past couple of years (including quite a bit by yours truly), the fact is, for both the real economy and the markets, things have gone pretty well. Europe and China did not collapse, the housing market continues to do well, and employment is still growing. If you look at what has actually happened, compared with what might have happened—or, according to some commentators, should have happened—you have to say things are pretty good. Maybe it’s time to stop worrying.
I acknowledge all of that. By temperament, though, I’m a worrier, and the second way to look at this is to wonder whether the problems remain but just aren’t showing up in the headlines. Often, by the time a problem has hit the front pages, it is well along—and my job here is to consider a full range of possibilities and to look at what might happen, as well as what’s most likely to happen.
Looking at what might happen, you have to wonder what’s out there but not showing up in the headlines. Based on that, I’m still concerned about the stock market.
Here, again, you can make a good argument that everything is fine. Last week, all eight major world indices finished with gains, for the first time since the week ending July 12, per Doug Short, an analyst I follow. The price-to-earnings ratio, based on the past 12 months, is around 17–18—not cheap, but not exorbitantly expensive either. Stocks are priced even more reasonably based on forward earnings, which are expected to grow over the next 12 months. At the aggregate level, the St. Louis Fed’s Financial Stress Index says markets are not stressed at all.
All well and good. I certainly hope this is correct, but I think investors should also be aware of the reasons to pay attention, starting with longer-term market valuations. Using 12-month periods as the basis for valuation sometimes leads to nonsensical results, as in the last quarter of 2008, when earnings were negative. More often, using 12-month figures gives too much weight to periods that may be atypical, as when, during the financial crisis, the trailing 12-month P/E ratio went to 123.7. Even more important, using 12-month figures implicitly assumes that a shorter time period is a better indicator of the market’s status and future performance. This is not the case.
My own research and that of others has shown that using a longer-term earnings denominator provides better predictive power for future returns. Using a 10-year P/E ratio, often referred to as the Shiller P/E, suggests that the market is much more overvalued than the 12-month figure does. Other longer-term metrics provide similar results. The short conclusion is that, if you think today’s financial and corporate environment is normal and the past or next 12 months are good guides to the future, then there’s no problem.
Maybe so. But with interest rates still at very low levels historically, forced down by Fed policy that’s on the cusp of changing, I think the past 12 months, and even the next 12, should be considered abnormal. With corporate profit margins close to all-time highs, I would again suggest that those time periods are not very typical.
The other key assumption embedded in current stock prices is that future growth will resemble historical growth. Stock prices are based, at least in part, on expected growth. For valuations to be normal, in a historical sense, growth also has to be normal in a historical sense. Growth appears to have downshifted for the past couple of recoveries and, as I’ve written in the past, is expected to be slower in the future for many fundamental reasons. Again, if you think we’re going back to the average growth rates since World War II, there is no problem. But I have my doubts.
Even with all of the reasons to be cheerful, therefore, I remain concerned that the fundamental assumptions on which the current stock market rally has been based may not be well founded. As we have seen many times in the past, just because something isn’t showing up in the headlines doesn’t mean we shouldn’t be paying attention.