As I wrote yesterday, stock market price-earnings multiples tend to contract in bad times and expand during good. This is not only due to well-understood macroeconomic causes–the effect of higher/lower interest rates and falling/rising corporate profits–but also from psychological/emotional motivations rooted in fear and greed.
(An aside: Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds (1841) and Charles Kindleberger’s Manias, Panics and Crashes (1978) are only two of the many books chronicling the power of fear and greed in financial markets. In fact, the efficient markets theory taught in business schools, which denies fear and greed have any effect on the price of financial instruments, was formulated while one of the bigger stock market bubbles in US history, the “Nifty Fifty” years, and a subsequent vicious crash in 1973-74, were taking place outside the ivory tower.)
Where are we now?
2008-09 PEs contract severely and remain compressed until 2013
2013 PEs rebound, but only to remove this compression and restore a more typical relationship between the interest yield on bonds and the earnings yield (1/PE) on stocks.
today The situation is a little more nuanced. The bond/stock relationship in general remains much the way it has been for the past several years, with stocks looking, if anything, somewhat undervalued vs. bonds. But it’s also now very clear that, unlike the situation since 2008, that interest rates are on an upward path, implying downward pressure on bond prices.
In past plain-vanilla situations like this, stocks have moved sideways while bonds declined, buoyed by an early business cycle surge in corporate profits.
Since last November’s presidential election, stocks have risen by 10%+. This is unusual, in my view, because we’re not at the dawn of a new business cycle. It comes from anticipation that the Trump administration will introduce profit-boosting fiscal stimulus and reforms. The “Trump trade” has disappeared since the inauguration, however. Our new chief executive has displayed all the reality show craziness of The Apprentice, but little of the business acumen claimed for the character Mr. Trump portrayed in the show–and which he asserts he exhibited in in his long (although bankruptcy-ridden) career in the family real estate business.
Interestingly, the stock market hasn’t weakened so far in response to this development. Instead, two things have happened. Overall market PE multiples have expanded. Interest has also shifted away from business cycle sensitive stocks toward secular growth stocks and early stage “concept” firms like Tesla, where PEs have expanded significantly. TSLA is up by 76% since the election and 57% so far this year–despite the administration’s efforts to promote fossil fuels. So greed still rules fear. But animal spirits are no longer focused on beneficiaries of action from Washington. They’re more amorphous–and speculative, as I see it.
Personally, I don’t think we’re at or near a speculative peak. Of course, as a growth stock investor, and given my own temperament, I’m not going to be the first to know. It does seem to me, however, that the sideways movement we’ve seen in the S&P since March tells us we are at limits of where the market can go without concrete economic positives, whether they be surprising strength from abroad or the hoped-for end to dysfunction in Washington.