Juggling Dynamite

Tomorrow the S&P 500 will celebrate 3452 days or 115 months since its bear market low of 676 on March 9, 2009–officially now the longest expansion since 1900.  This table from Leuthold Group summarizes all the expansion cycles since 1900 up to January 26 2018. Since then of course, the US stock market expansion has continued a further 7 months to reach tomorrow’s 115 month record.

Pundits are arguing about whether or not market corrections of less than 20% in 2011 and 2016 should be rounded up to count as breaks in this remarkable run (more here).  But in reality, secular bull and bear periods turn not on price but on valuation.  And on the basis of valuation, the recent expansion is one for the ages, as shown below in this chart of the Case Shiller 10-year smoothed price to earnings ratio for US stocks since 1870.  Today’s 32.84 reading remains in rare and infamous company–above the 1929 peak and below the all time tech-mania top of 2000.

While extended Fed largesse, setting aside mark-to-market accounting, cost cutting, under-investment in long-term assets and share buybacks have all enabled S&P 500 earnings (net income per share) to surge 300% since 2009, total revenue growth for the same companies was just 30% over the same time frame.  Hence, on a price to sales basis, S&P 500 stocks are now trading at a manic 2.2x revenue, and even higher than in 2000.

These eye-popping multiples, along with a dividend yield under 2%, all suggest that equity markets are nearing the end of the second cyclical expansion within the secular bear that began from peak valuations in 2000, and are next due for the third cyclical mean reversion within that secular bear.  See more here in Ed Easterling’s work at Crestmont Research.com as well as his chart on left showing the Dow price cycles from January 2000 to the end of June.

While it’s hard for most to imagine, a decline of about 70% from current levels would take this index back to its long-term support in the 7000 range.  This magnitude of retrenchment would be in keeping with the past secular mean reversion periods that brought lower lows with each cyclical downturn and finally ended in below average valuations and above average dividend yields that then launched new 15-20 year secular bull (multiple expansion) periods thereafter.

No profit or economic expansion can continue indefinitely because its life blood–credit growth–is inherently finite in its tie to revenue and wage growth.  With the latest profit and multiple expansion already much longer than most, peak profits and peak equity valuations are a foreboding combination.

Although long-always proponents and products–that were decimated in the 2000-03 and 2007-09 retrenchments–are declaring themselves genius once more, the truth is that the final verdict on who retains lasting financial progress from this record long expansion will not be known until the next bear market ends.  From there we will all take our marks.

Speculative capital allocations move with extreme credit cycles through boom and bust.  But in the end, sustained price appreciation requires new buyers who are able to buy assets from existing owners.  Both groups now share a common problem:  too much debt.

We have been tracking the intersection of these trends for some time now and unsurprisingly, the inevitable is materializing.

One nexus with particularly broad impacts:   the easy credit that enabled home prices and rents to far outpace wage gains in recent years, is the same easy credit that enabled education costs (textbooks, tuition and student housing) to leap more than 3x the cost of inflation as charted below.  In a word:  unsustainable.  Debt cannot grow to the sky, and so neither can asset and education prices.
School budgets have ballooned as students have become debt enslaved.  Once debt can no longer be added, lower prices are necessary for assets and services.

The first will take a chunk out of the net worth of present holders, both will take a chunk out of corporate profits and balance sheets.  Painful for financial markets and the leverage-soaked global economy in the near term, but all needed to reboot the system on a more rational, organic path for future growth. Hark the sound of inevitability, see Student loans are starting to bite the economy: potential homeowners are being thwarted by the costs of paying off bills for higher education.

From 2007 through 2017, the CPI rose by 21 percent. Over that same period, college tuition costs jumped 63 percent, school housing surged 51 percent and the price of textbooks by 88  percent. These troubling growth rates wipe away any mystery  behind today’s staggering levels of student loan debt, which have almost tripled from the 2007 starting point of $545 billion. As of the fourth quarter, student loans represented 10.5 percent of a record $13.1 trillion in U.S. household debt, up from 3.3 percent at the start of 2003.

 

Danielle was a guest today with Jim Goddard on Talk Digital Network talking about recent trends in the world economy and market.  You can listen to an audio clip of the segment here.