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The stock market dodged a bullet when the Blue Wave––a Biden victory and a Democratic takeover in the Senate––didn’t materialize. But ducking the specter of more taxes-and-regulation didn’t erase the fundamental problems weighing on equities before the election. Indeed, investors face two threats, that taken together, pose risks as grave as at any time in the past century. First, shares overall are so hugely expensive that history tells us they’re far more likely to fall than to soar. Second, an unusually large number of lurking spoilers (potentially devastating shocks from more lockdowns to soaring federal debt) could sap the strength that must return for stocks to prosper: Businesses’ capacity to generate strong growth in earnings.
To be sure, Wall Street’s pundits and market strategists, along with plenty of journalists and even some top academics, are touting divided government gridlock as great news for the markets. My friend Jim Cramer of CNBC praised gridlock as “nirvana for growth stocks,” while revered economist Jeremy Siegel of the Wharton School pronounce the election split “excellent for the economy and excellent for the markets,” predicting big stimulus and infrastructure packages that will buoy stocks.
The markets were clearly nervous about the prospects big tax increases if Biden took the presidency and the Democrats gained control in the Senate to match their majority in the House. (One caveat however: There are still five Senate races that have yet to be called, making it not impossible that the Democrats could reach a tie in the Senate.) Biden had pledged to raise the corporate income tax from 21% to 28%, and impose a 39.5% levy on capital gains over $1 million, both big negatives for the markets. From October 11 to 30, the S&P dropped 7% as Biden and blue Senate candidates expanded their leads in the polls. But then, a tightening race lifted the S&P by 3.1% through Election Day, followed by more gains on November 4 and 5 that swelled the relief rally to 7.5%, capping the best 4-day performance since the snapback from the mid-March lows. At mid-afternoon on November 6, the S&P stood within 2% of its all-time high posted on September 2.
That jump looks great for people who own stocks. But it darkens the cloud over the market’s future by making the already super-expensive S&P 500 even pricier. Once again, those towering valuations are the first of our two classes of danger. At the close of 2019, S&P profits hit a record of $39.43 based on the trailing four quarters of GAAP earnings. Because that number was so elevated as a share of revenues and shareholders equity, it looked like profits would “revert to the mean” by falling, or at least going flat.
The best measure of “sustainable” earnings-per-share is the number used in the Cyclically-adjusted price-earnings ratio created by Yale economist Robert Shiller. The CAPE calculates an adjusted P/E that’s a great guide to whether shares are over or underpriced. Since a profits bubble like the one experienced last year makes stocks look like a bargain, and a temporary collapse creates the illusion they’re exorbitantly priced, Shiller uses a 10-year, inflation-adjusted average to get a normalized number. Today, Shiller’s adjusted figure for S&P 500 earnings-per-share is just under $110. With the S&P at 3518, the Shiller P/E is 32. That reading matches the peak just before the crash of 1929, and was only significantly exceeded once in the past 90 years, during the tech bubble of 2000.
By the Shiller measure, stocks look really, really rich, signaling that future returns will be either negative or near-zero, adjusted for inflation. Of course, the Wall Street bulls want you to believe that a surge in earnings that not just regains the heights of 2019, but keeps waxing in double-digit from there, fully justify what they acknowledge to look like challenging valuations.
It’s true that S&P profits staged a comeback in the third quarter to $35. But that’s still 11% below Q4 of 2019, and analysts are predicting much lower readings of around $28.50 over the next two quarters. Even their forecasts, which are generally overly optimistic, don’t see earnings getting back to last year’s levels until the middle of next year. It won’t happen. Why? Because the economy won’t match the 2019 output in goods and services, according to projections from the Congressional Budget Office, until the final quarter of 2022.
Since the economy will just regain lost grounds, profits can only beat the 2019 all-time record by taking a much bigger share of national income. At the close of last year, corporate earnings were absorbing 7% of GDP, well above their below-6% mark over the past half-century. They’d have to break that mark and go higher for the bulls to be right.
The more expensive equities get, the more prices teeter on a knife edge because they’re increasingly vulnerable to economic shocks that can send them crashing––the second big threat to equities. The number and ferocity of storms that could hit the U.S. is dangerously high. Here’s what I call the Perilous Three. The first is the most obvious: Another sweeping lockdown if the pandemic doesn’t retreat soon, especially since Biden has promised to take much stronger action than Trump. We’re already seeing severe restrictions re-imposed in Europe that’s hitting our exporters. With the U.S. witnessing a record 100,000 new cases a day, our tourism, hospitality, restaurant, and airline industries could be facing many more months of pain, spotlighted by giant losses.
Second, interest rates have been ticking up of late. From early August, the 10-year treasury yield rose from .5% to .86% before retreating when uncertainty over the election’s outcome caused a flight to quality. The CBO is predicting rates to rise only to around 1% next year. But that forecast could easily be wrong. “Real” interest rates typically track GDP, and if economic growth returns to 2% in late 2021 and 2022, it’s highly possible the 10-year yield (which includes a premium for inflation), could rise well above 2%. It was paying 3% as recently as the end of 2018. The markets tend to freak out when real rates rise. It may not happen, but if we get renewed prosperity, it isn’t unreasonable to forecast that we’ll get much higher yields as well.
Third, the markets have been spiking and retreating of late on the careening prospects for billions more in stimulus. Enhanced unemployment insurance, aid to small businesses designed to help them keep employees, and cash payments to families are an important buffer to preventing bankruptcies and foreclosures, and easing pressure on lenders. But the trillions lavished on assistance to counter the pandemic also comes at a high cost few are addressing: An explosion in federal debt. The CBO projects that by the close of 2021, federal debt will jump by $5.1 trillion from $16.8 to almost $22 trillion, or 104% of GDP. To finance those shortfalls, the Treasury is issuing bond with maturities of just a few weeks. If rates suddenly spike, interest expense will soar, potentially causing a debt crisis and mandating big tax increases. Or, the buildup in debt will cause foreigners crucial to funding our deficits in demand higher rates, mainly on the risk that the dollar will keep falling and cutting interest payments translated into their own currencies.
Of course, America may be able to put off the reckoning for years to come, if those overseas borrowers keep loading up on Treasuries. But the risk is still there, and the trillions spent to blunt COVID-19, with more to come, keeps sharpening that risk.
Stock prices are ignoring the Perilous Three, and the Perilous Fourth, those gigantic valuations. Taken together, this mix may not be nirvana at all.
