Most Overvalued US Stock Market in History & Catalysts for a Bear Market


Proof of the Most Overvalued US Stock Market in History

  • Median price-to-sales ratio for the S&P 500 today is the highest ever by a wide margin, more than 60% greater than the tech bubble peak
  • Median price-to-book value is also at the highest valuation ever
  • Adding to the risk in the markets today, S&P 500 companies are more leveraged than ever before
  • Corporate leverage for the whole US economy, not just the S&P 500, is at all-time highs relative to GDP
  • Median EV/Sales multiples for the S&P 500 is at record valuation levels; EV/EBITDA at its highest ever valuation
  • Using Shiller’s cyclically-adjusted P/E (using a 10-year moving average of real earnings in the denominator of the P/E), or CAPE, current markets trade at 31x which is in the vicinity as it was at its peak in 1929
  • Today’s profit margins are at all-time unsustainable highs; profit margins surge at the end of business cycles before bear markets
  • Margin-adjusted CAPE shows that today’s P/E ratio for comparative historical purposes is 43, the highest ever (41x in 1999 and 40x in 1929)
  • Margin-adjusted CAPE has a correlation of -0.89 with future returns; market is so overvalued today that margin-adjusted CAPE is predicting negative average returns for the next 12 years!
    • This should prove terrible new for buy-and-hold index fund investors
  • After using 3-year smoothing for real FCF and margins, we compared historical EV/FCF multiples: median cyclically-adjusted EV/FCF for non-banks in the S&P today is at an insanely high 41x

Macro Factors

  • Undeterred bulls will say, aren’t record valuations justified due to low interest rates, low inflation, low unemployment, and recently improving earnings growth?
    • No, they are not. Our empirical analysis of stock market and economic history strongly proves otherwise
  • We plotted 10-year yields with Shiller CAPE ratios going back to 1900 along with today’s margin adjusted CAPE. Regression line shows that there is indeed a relationship between higher multiples and lower interest rates, but with a huge deviation
    • Problem is that we are already at the extreme end of the deviation for the current level of interest rates
    • Both today’s CAPE and margin-adjusted CAPE are at the highest multiples ever for the current level of interest rates
    • In other words, a more than 50% stock market correction would be justified to get today’s margin-adjusted-CAPE back to its average multiple for the 2% interest rate zone on the 10-Year Treasury note
  • What about inflation?
    • With data going back to 1914, P/E multiples do indeed tend to be higher under low positive inflation, but today’s multiples are again among the highest P/Es ever for the current 2% headline CPI level
    • There is a huge variation, suggesting that we could see a 50% decline in stock prices just to get back to mean historical P/E multiples for this level of inflation (and that is just the mean)
    • P/E multiples mean revert over time; inflation and deflation shrink P/Es; P/Es too high today even for low inflation with average growth
  • What about earnings growth?
    • It is true that earnings growth has been picking up recently, but it is very typical for earnings growth to pick up when it is late in the business cycle before topping out and falling off a cliff
    • It did that in 1928-1929, in 1999-2000, and in 2006-2007
    • Recent S&P 500 EPS growth resembles 1929 pattern – growth is not sustainable late in a business cycle and does not justify record P/E multiples
  • What about Goldilocks zone that we are in now for simultaneous low inflation and low unemployment? It’s an ideal spot on the Phillips Curve, isn’t it? Doesn’t that justify extended valuation multiples today?
    • Based on history, no
    • The problem is that there is a natural boom-and-bust business cycle; our long-term Phillips Curve analysis going back to 1990 shows that inflation and unemployment tends to stray wildly with the business cycle
    • Downturns in the business cycle are often deflationary and lead to high unemployment, but there can be inflationary routs too
  • Imagine the perfect economy: full employment, low interest rates, low inflation, strong corporate earnings growth; perhaps that could be the market that could legitimately sustain a high valuation multiple
    • Irving Fisher, the most well-known economist of his time, thought so
    • He declared just 9 days before the stock market crash of 1929 that stock prices had “reached what looks like a permanently high plateau”
    • There are remarkable similarities between 1929 and today: unemployment rate below 5%, CPI YoY rate higher than 0% but lower than 4%; S&P 500 CAPE ratio 50% higher than long term average; Real GDP growth; S&P 500 EPS YoY growth greater than 10%; US 10-year rates below 4% (only happened twice in history: 1929 and today)

Inflation vs. Deflation

  • Given the record debt-GDP levels, aging population, China credit bubble, housing bubbles in Australia and Canada, and the Fed tightening, the biggest risk in the short-term is deflation, which is typical when asset bubbles burst
  • We started to see deflation emerge in the GFC until central banks came to the rescue with massive QE, but not before a market crash
  • Similarly, we started to see deflation in China in 2015 before policy makers there ramped up money and credit growth even further to make global asset bubbles in stocks, real estate, and credit even bigger today relative to underlying world GDP
  • Paradox is that once a true deflationary spiral gets going, central banks are forced to resort to extraordinary inflationary money printing or QE to counter it. In the face of truly massive QE, at a certain tipping point, the mindset of the world should ultimately shift to a lack of confidence in central bankers’ ability to contain inflation
    • Only then does inflation become a self-fulfilling prophesy as investors start ratcheting up their inflation expectations
    • Rising inflation expectations never happened in the wake of the last crisis – indeed, the response to QE was to build bigger asset bubbles
  • What will change the mindset? Probably a bigger crisis and certainly a bigger central bank response. At that point, it is not only inflation but very possibly hyperinflation that becomes the end game. We see hyperinflation as a likely outcome to emerge first in China but not before a deflationary crisis emerges first

The Catalysts

  • Tightening of credit by the Fed in our view is the main catalyst that will burst global asset bubbles including the credit bubble in China
  • Whenever the Fed starts a campaign of tightening credit conditions in earnest, late in the business cycle, to temper an overheating stock market, economy, and/or inflation by raising interests, it is soon the kiss of death for the stock market and ultimately the economy
  • Today, it is also the kiss of death for China that has been pegging its currency to the USD
  • Recently, Fed has been raising rates at the highest rate of change ever very late in the business cycle. It is also beginning a long-term campaign to reduce its balance sheet, a quantitative tightening
    • We are in the 9th year of an expansion – longest economic expansion ever in the US lasted only into its 10th year, but the stock market topped out in the ninth year (March 2000, the peak of the tech bubble)
    • Asset bubbles tend to top out first then business fundamentals turn down, then the recession is declared, at which point past GDP reports get revised downward
  • Gold has been true money that has stored value in all countries for thousands of years. However, gold and silver are significantly undervalued compared to fiat money today
    • Gold will almost certainly prove its mettle over both fiat money and Bitcoin in the coming Bitcoin bust that should go hand in hand with the coming global asset bubble meltdown

Crescat Capital 3Q17 Letter, November 18, 2017

Image Source: Crescat Capital, Rober Shiller/Yale