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#148 Stock Market Assessment - May 2019


The current unprecedented wealth of stock market earnings is only of recent origin since 1980:


The growth of earnings since 1980 has quadrupled. There were 25 recessions prior to 1980 that have held back the growth of earnings for 40 years. However earnings subsequent to Ronald Reagan's presidency exploded (with the exception of the 2008 recession) from $0.20 per share to current levels of $1.25. A new era arrived.  It conveyed a steadily increased wealth for shareholders except for a suggestion of greater volatility. Shareholders who held their wealth since 2008 have now shown more than fivefold gains in wealth. 

The question before us at this time concerns whether in the future the gains in earning will continue to grow as before, whether the number of S+P shares will increase and whether the price/earnings ratio per share will continue to gain.  To evaluate such projections we need to consider that the earnings per share depend on three variables. Each of these is dependent on effects that are independent of cash earnings for the S+P companies. First, US companies can reduce the number of shares, thus increasing the earnings per share. Second, cash earnings can diminish as business profitability declines. Third, the earnings value of each share is greatly influenced by the the multiple of the valuation that is attributed to cash earnings. When shareholder costs (as measured by the cost of debt) are low the valuation multiple will be high. At present the shareholder implied costs of capital are at a historical low level whereas the multiplier of the value of shares is at an all time high. 

What are then the indicators that will suggest the future of the worth of the shareholder's wealth as indicated by the worth of its SandP shares?

The total stock market capitalization, as defined by the stock market worth of Wilshire 5000 shares, is now 1.5 times greater than the total earning capacity of the US, as measured by the current value of the US GNP. This ratio has risen three-fold since 1980 and has shown an increased volatility over the last two recessions. This ratio is now at an all time high:



There is no question that the underlying earning capacity of the US, as measured by the GNP, is currently overstated and is vulnerable to precipitous declines when the next recession strikes. If the US is restored to its 1980 equivalent GNP levels, the multiple used to calculate SandP earnings would be reduced from 125 to 25.  That would be a five fold reduction which would suggest that a share of SandP would decline by as much as 80%. One could also ask whether there is an upside of the ratio of Wilshire over GNP.  Could it rise from the current 1.5 to a much greater in the next 20 years? That is highly unlikely as the projected GNP growth would have to rise than the current rate of 2%/year. The total market capitalization of Wilshire 5000 would also have to rise well over 200%. These are highly unlikely prospects.

When future prospects are considered, the current Wilshire 5000 market valuations at a multiple of 120 or greater will give the following projections:


Despite a recent  upward spike in annualized returns (e.g. reduced corporate taxes by Trump) the annualized shareholder returns, using a high stock market multiplier of 120%, have steadily declined from 12% in 1980 to the current 2.2%. That represents a most favorable view except that it currently offers to shareholders only below current money-market returns. That is an optimistic outlook.

A more realistic outlook is a reversion to Total Market Capitalization (TMC) to GDP ratio that prevailed in the 1980's:



This graph shows a decline in annualized returns in more realistic terms of a total market valuation of 40%. The projected returns then decline from 17% in 1980 to the present -9.9% which suggests that the market is grossly overvalued if examined from a historical perspective.

As of today, the Total Market Index is at $ 30,344 billion, which is about 144.1% of the last reported GDP. The US stock market is positioned for an average annualized return of -2.1%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 1.76%. As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”:


According to Buffet the current $30 Trillion stock market is worth only $22 Trillion, which is a discount of 27%. During a recession the decline in the market could exceed its stated valuation by at least 50%. That suggests that the current TMC downside could be as high as $15 trillion. What could deliver such a large shock is not clear but it come from a recognition that the current premier position of the US dollar could be permanently threatened.

Prof. Robert Shiller of Yale University invented the Schiller P/E to measure the market's valuation. The Schiller P/E is a more reasonable market valuation indicator as compared with the P/E ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. This is similar to market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.

The current Shiller P/E stands at 30 at levels that is comparable to the 1929 depression. This ratio has been recently highly unstable rising from below its historical mean of 15 in the 2008 recession. Such fluctuations in the P/E ratio confirm the inherent instability of the current markets.

Another way of assessing the current conditions of the US stock market is through international comparisons (see https://www.gurufocus.com/global-market-valuation.php):


At present the investment returns of the US are negative, which are the lowest among major economies. Such low returns are the results of excessive market valuations as well as profit returns that are below the average global cost of capital.

SUMMARY

There is no question that prices of shares on the US stock market are excessive as well volatile. All of the trusted indicators show that.  The current stock market is extremely vulnerable to a recession that  may see as much as 50% declines in the valuation of the S+P shares. However, the prices of some of the shares will continue to rise even during a recession. Individual investors may be able to overcome, or preserve their assets waiting for the next recovery. Whether that is feasible warrants a consideration of the global standing the US stock market as compared with other large national holdings. The huge accumulation of cash that is represented in the current valuations is most likely to be sustainable in the near future. 

What will be the effects of the next recession on the prevailing dominance of the US stock market is not clear. In the long run (10+) years there are strong chances are that a conglomeration of markets that include all emerging economies will displace the current overwhelming domination of Wall Street in market trading.

















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