The Equity Drumbeaters Are Out


The Equity Drumbeaters Are Out, Now that equity prices have more than doubled and that it has become fashionable to be bullish, the gurus are out with their often convoluted theories and the media are all too happy to act as megaphones. However, one would expect the more serious media to be a little critical and choosy.

James W. Paulsen, chief investment strategist at Wells Capital Management, was given front page exposure in Monday’s Financial Times to trumpet the arrival of ‘the second
confidence-driven bull market of the postwar era”. Unfortunately, his facts and figures are not what one would expect from the FT. Some excerpts with my comments (my emphasis):

But while many investors have turned cautious, the bull market has probably not ended. This is because the primary force driving the stock market is not earnings performance, low yields or quantitative easing; rather, it is a slow but steady revival in confidence, a trend that is just beginning.

In this scenario, investors need not be overly concerned about slower earnings growth. While earnings are obviously important, stock prices have frequently diverged from earnings trends. In fact, for the third time in the postwar era, stock prices and earnings are repeating a remarkably similar three-stage cycle.

Here’s Paulsen’s recipe:

First, earnings surge while the stock market remains essentially flat (the earnings production cycle). Second, earnings performance flattens while the stock market surges (the valuation cycle). Finally, both stock prices and earnings move in tandem (the traditional cycle). It appears the contemporary bull market has just entered the second phase, making earnings growth less important.

So, for the third time in the postwar era, we would be in a “remarkably similar” three-stage cycle which apparently begins with an earnings surge accompanied by a flat market. Mr. Paulsen does not divulge when exactly his first stage began, but the fact is that the stock market has doubled along with surging earnings between March 2009 and May 2012.

Nonetheless, “it appears the contemporary bull market has just entered the second phase”, when “earnings performance flattens while the stock market surges”. If there is such a “second phase”, it began in the spring of 2012 when equity prices rose 30% on flat earnings.

So much for the “remarkably similar” three-stage cycle. But there’s more:

In both the 1950s and the 1980s, the earnings cycle was followed by an explosive stock market run despite almost flat earnings performance. Between 1952 and 1962 the market rose about 3.5 times, while from 1982 to about 1994 it surged almost fourfold.

Here’s the chart for the 1952-62 period during which we can see five periods when earnings and equity prices moved pretty much in tandem. Based on monthly closes, the S&P 500 Index actually tripled between January 1952 and the December 1961 peak.

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There were actually two broad stages between 1952 and 1962:

between 1952 and September 1958, earnings grew only 18% while the S&P 500 Index doubled from extremely undervalued levels after going through highly volatile times following the end of WWII. Inflation went from 2% in 1945 to 20% in 1947 to -3% in 1949, to 9% in mid-1951, to -0.7% in mid-1955 and to 3% at the end of 1957. Understandably, investors were totally uncomfortable with this extreme volatility. As a result, P/Es on trailing earnings plummeted from 22 times in June 1946 to a deeply undervalued 6 times in June 1949. By January 1952, P/Es had recovered to 10x but were still very undervalued based on the Rule of 20 formula which then called for P/Es around 17-18x.
Multiples reached 19 in December 1958 as inflation decelerated from 3.6% in the spring of 1958 to less than 1% 12 months later. Between September 1958 and the end of 1962, equities rose 26% while earnings rose 20%, not a meaningful discrepancy.
The same can be said of the 1982-1994 period which is Paulsen’s second “remarkably similar period”.

Inflation reached 14.8% in March 1980 when the U.S. economy was in recession. Inflation receded to 8% in early 1982 but a second recession had begun in July 1981. Equity prices troughed in July 1982 at 7.7x earnings as 10Y Treasury yields reached 14%. Earnings bottomed in December 1982 and doubled by June 1989. Meanwhile, the S&P 500 Index more than tripled as P/E ratios reached 14.5 in June 1989 right where the Rule of 20 stated since inflation was then 5%.

The U.S. entered a mild recession in July 1990 but the sudden 170% jump in oil prices between July and October 1990 created a severe margins squeeze which brought earnings down 25% by the end of 1991. The successful Operation Desert Storm and the subsequent rapid decline in oil prices led investors to expect a rapid restoration of profit margins which brought P/E ratios to 21x by the spring of 1992.

In brief, Paulsen’s characterisations of the 1952-1962 and the 1982-1994 periods to fit his theory are far fetched and certainly not even close to the present circumstances.


But on with more recent data:

In the contemporary era, since autumn 2012, despite earnings growth slowing to low single-digit rates, the price-earnings multiple has risen from about 13 times to about 16 times. If this means the stock market just entered its third “valuation cycle” of the postwar era, is slower earnings growth really that worrying?

We are obviously nowhere near the extreme undervaluation levels of the so-called “remarkably similar periods”. Actually, using trailing earnings rather than Paulsen’s forecast, the S&P 500 Index is currently selling at 17x earnings. With inflation at 1.8%, the Rule of 20 P/E is 18.8x, a mere 6% below the “20” fair value level. If there was a “third valuation cycle”, we’ve just had it.

As to the question whether “slower earnings growth is really that worrying?”, the chart below, covering 1946 to the present, is a clear reminder of the importance of profits in equity valuation.

Yes, equity markets can, and sometimes do, for brief periods, rise in spite of slow or even negative earnings growth. When it is not to correct extremely low valuation levels, such advances inevitably bring markets to overvalued levels which significantly raises investors risk.

Mr. Paulsen does address some of the risks:

One concern is that the recent rise in US bond yields will abort the stock market bull run. But rising bond yields reflect improving economic confidence, rather than increasing inflation expectations or concerns about the creditworthiness of the US government. A rise in bond yields predicated on a growing belief the “world will not soon end” hardly seems bad for the stock market. Indeed, since 1967, when bond yields have risen in tandem with consumer confidence, the stock market has advanced at almost 12 per cent a year. (…)

Hmmm! Never heard that one. It would have been nice to get the details, especially given that, during the 45 years since 1967, only the first 14 years have seen a marked rise in long term interest rates.

Just for fun, however, I checked Paulsen’s assertion since 1977, the last year I have data on the Conference Board Consumer Sentiment Index. I only found 3 periods when interest rates rose in tandem with consumer confidence:

  • April 1983 to July 1984. S&P 500 down 7.9%.
  • January 1987 to October 1987: down 8%.
  • September 1998 to February 2000: +34%. The bubble years!
  • You might want to scratch that last one. But there is more:

Since 1900, there have been three major bull markets, in the 1920s, 1950s-60s and the 1980s-90s. Both the first and the third of these were driven by a persistent decline in interest rates, an option not feasible today. However, the 1950s-60s bull market was characterised by a simultaneous rise in both stock prices and bond yields, driven by rising confidence. (…)

May I just mention that earnings have grown at a 5.0% compound annual rate of growth between 1950 and 1969. As to rising confidence, read the above comments on the 1952-62 period once again.

Mr. Paulsen’s conclusion:

Certainly earnings, bond yields and Fed actions will create some turbulence along the way. But beware of becoming too myopically focused on these mainstream issues lest you miss what could be the second confidence-driven bull market of the postwar era.

Now, how confident are you?

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