At mid-afternoon on March 31, the S&P was closing the first quarter with a bang, surging to an all-time record of 3994. That peak edged its previous high attained exactly two weeks earlier, and lifted the index to within a fraction of a point of the 4000 milestone. It’s remarkable that the S&P hit its last new millennial mark of 3000 less than eighteen months ago, in September of 2019. Given the shortness of that span, investors’ seeming dismissal of lasting scars from the pandemic or worries over the recent spike in interest rates, and super-high valuations that will only look reasonable if earnings soar, the obvious question arises: Based on fundamentals, is the S&P 500 remotely worth 4000?
Dividend yields are at historic lows
On March 31, the S&P dividend yield stood at 1.46%. It’s only been below that in one period since 1880, from the start of 1999 to mid-2001––the span of the dot com bubble. For the decade starting with the recovery from the Great Financial Crisis to mid-2019, it stayed virtually flat at 2%, and in by the close of that year still exceeded 1.8%.
The dividend yield will have to “normalize” to the 2% range, or maybe higher. It can get there by one of two routes, or the pair in combination: earnings rise sharply, in this case way above their previous highs, or prices plummet. Most likely outcome: Profits don’t wax nearly enough to restore the return investors seek from dividends, so falling valuations will do most of the job. Super-low yields were a harbinger of things to come in the dot com craze. Now, they’re flashing red in the “great reopening” frenzy.
PE ratios are ultra-inflated
Naturally, today’s price-to-earnings multiples don’t show whether stocks are richly or reasonably priced––because the pandemic hammered profits, skewing the denominator, and they’re destined to rebound. It’s important not to be swayed by analysts’ overly optimistic forecasts, or assume that unusually lofty peak reached pre-COVID is simply the starting point for a big jump this year and next.
The best yardstick is the famous cynically-adjusted price-earnings ratio developed by Yale economist Robert Shiller. As of March 31, the CAPE stands at 36.2. That’s the highest reading except for any period since the 1880s, aside from the internet frenzy, and exceeds the average of 25 from 2003 to 2019 by over ten points or 40%+. Another pretty good measure is how pricey the market would be if big caps’ EPS returned to their all-time highs at the close of 2019. In Q4 of that year, the S&P earned $139.47, based on trailing, 12 month GAAP profits. Then, the P/E was 23.2, high by historical standards, but little changed over the previous half-decade.
But as profits dropped in the pandemic, prices partied on, gaining 24% in five quarters. At just under 4000, the S&P multiple would be 28.7 if EPS got back to its pre-COVID record. That number would be four points above any before-the-pandemic figure since the Great Financial Crisis.
A profit explosion is unlikely to bail out the markets
The bulls’ great hope is that earnings leapfrog the 2019 summits. That’s the only way today’s prices would look nearly reasonable. Keep in mind that Goldman Sachs, Credit Suisse and Morgan Stanley all foresees an S&P at year end that’s 7.5% higher than today.
In Q3 and Q4 of 2020, S&P 500 earnings made a strong comeback from the March and June quarters, hitting $32.98 and $31.43 respectively. Analysts are predicting a rise to $35.35 in Q1, which would match the highpoint of Q4, 2019. But EPS had essentially gone flat from early 2018 to the end of 2019. Why? Because the S&P’s profits had soared so far above historic levels, and were so gigantic as a share of national output, sales, and equity that they’d hit a wall.
For the Wall Street enthusiasts to be right, earnings would need to rise to the point where they’d look even more out of whack on all those benchmarks. The CBO projects that GDP will rise just 3.4% this year over 2019. For the S&P’s multiple go return to a still-pricey 25, the big caps would need to earn $160 this year. That’s 15% above the pre-crisis level. Best bet: It won’t happen.
Interest rates are rising, and that’s practically all bad
As the calendar page flipped from 2020 to 2021, the yield on the 10-year Treasury (long bond) was 0.93%. At the end of Q1, it hovered at 1.75%. Wall Street’s market strategists say not to worry. Rates are rising to mirror a greatly strengthening economy. They argue that a increase in the “discount rate” for future earnings, as reflected in the long bond, will be offset by a surge in profits. But once again, earnings were extremely stretched at their 2019 highs, and even if they get back there, the market will look hugely expensive.
In reality, “real” or inflation-adjusted yields are heading back to their norms. Over long periods, the 10-year yield tracks the economy’s inflation-adjusted expansion. Today, real rates are negative or zero, and over the long-term, the U.S. should grow at a real rate of around 2%. Rates may not climb back to that level anytime soon. But they’ll head in that direction, and eventually get there. Even if relatively low yields persist for another year or two or even three, that’s not a justification for super-high stock prices. The stream of corporate earnings stretch over decades, and for tech companies, most of those profits will materialize in the far out-years.
So the view that earnings should be discounted back forever at today’s exceptionally low rates doesn’t make sense. But that’s the view Wall Street is taking. The lion’s share of profit will arrive when rates are much higher, and should be “discounted back” at those more normal rates. When you do that math, today’s prices look outrageous.
The Biden agenda is a big negative for profits and after-tax returns for investors
As part of his new infrastructure plan, President Biden proposes lifting the tax on corporate income from 21% to 28%. That levy is an expense that’s eventually borne by consumers and workers. But if the increase happens, it will cause a big hit to profits for a couple of years. Biden’s also proposed raising the tax on dividends and long-term capital gains from 20%, to the rate on ordinary income, for people earning over $400,000. Since Biden wants to lift the top bracket to 39.6%, taxes on gains garnered from stocks would double for the high-income crowd that purchases such a large proportion of America’s equities.
The markets are cheering $2 trillion proposal, in part because big public works projects promise increased sales for everything from green energy to steel to construction equipment. Blunting those prospects are the enormous risks posed an escalation in debt never equalled in the post-War period. Higher rates are coming anyway. But if investors, notably foreigners, foresee a big fall in the dollar caused by over-borrowing, or fear that inflation is looming, they could dump our Treasurys and send yields jumping. The U.S. is entering uncharted territory on debt. That hazardous journey should send investors running for cover, not toasting great times ahead.
