Rational Exuberance?

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“The mob will now and then see things in a right light” — Horace

If one dares make mention of overvaluation in the U.S. equity market, the derision incited takes one back in time to angry Roman mobs. Is it not plain, the masses shriek, based on a traditional price-to-earnings (P/E) ratio, that stocks are valued just a hair above their long-term average? Indeed, if you look back over the last 12 months of reported earnings, the current P/E of 20 is not alarmingly above its long-term average of 15. And that’s that.

But is that, that simple? At nearly 76 months, the current rally in stocks is surpassed in length by only two other stretches since 1932 – the 86-month run that ended in 1956 and the extraordinary 113-month era that culminated with the bursting of the Nasdaq bubble. Shouldn’t the current stock market rally prompt a rational investor to at least ask what underlying factors are driving the persistent trend? There’s no post-war economic surge that promises to produce the next Baby Boomer generation. Nor has a technology emerged that begins to compete with the advent of the world wide web? The shale revolution aside, the current rally has not been catalyzed by anything that appears set to alter the course of history.

Of course, stocks could have been so undervalued in March 2009 that they were simply poised to rise after a brutal and prolonged slump. The problem with this line of thinking is that history suggests otherwise. Stan Nabi, now the Chief Strategist “Emeritus” at Silvercrest once told a group of wet-behind-the-ears MBAs in training that there was one rule that never failed to deliver when it came to valuing stocks. Way back in 1996, when Greenspan was angsting about “irrational exuberance” and Nabi was still at Donaldson, Lufkin & Jenrette, Nabi said, “Stocks never emerge from a bear market until the Standard & Poor’s 500 is trading at a single-digit P/E multiple.”

There was little doubt in our minds as to Nabi’s credentials. He’d had the good fortune to study at Columbia University under the tutelage of Benjamin Graham, the father of value investing. It didn’t hurt that he’d attended Graham’s class with a young student named Warren Buffet. Suffice it to say, a long vigil began that day for one very impressionable market watcher for whom the wait has yet to end. The closest the market got to a single-digit P/E breach occurred in March 2009 when the S&P 500 troughed at the ominous level of 666, taking the P/E down to its most recent low of 13.3.

As for the true secular bottoms, ones that laid the groundwork for secular bull markets? The years 1921, 1931, 1942 and 1982 featured bear market troughs, when the P/E ratio did skid to a single digit. In some of these cases, P/E’s languished below 10 for prolonged periods prompting investors to cry “Uncle!” and abandon the despised asset class once and for all.

While there’s no doubt stocks had put deep fears into investors’ hearts by early 2009, they were nevertheless not the screaming bargain history suggested they could be. Maybe it was good enough that there was a gaping distance between 13.3 and 1929’s 32.6 to say nothing of December’s record high of 44. Maybe, but that reasoning just didn’t sit right with this market historian, especially from my perch within the halls of the Federal Reserve.

It’s undisputed that the financial crisis sparked by the subprime mortgage conflagration was the worst since the Great Depression. Why then, did stocks not react in kind, bleeding out until they too were trading at a single-digit P/E as they were in 1931? Could it be that interest rates, which had been slammed down to the zero bound three months prior, had a hand in halting history in its steps?

Few Fed insiders would deny that extraordinary measures undertaken in the heat of the financial crisis put a floor under asset prices of all kinds, including stocks, though such aims could never be uttered publicly by policymakers. Except for the fact that they were, on October 20, 1987 in a statement released by Alan Greenspan’s tightly-run Fed: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

The Fed intervened in the markets that very day bringing the fed funds rate down by a half-percentage point to just under seven percent. The stock market responded in kind, rallying as if on cue. Throughout the course of the next few months, The Fed repeatedly took overnight interest rates lower. Sometimes, as an added bonus the central bank would go so far as to give trading desks advance notice. How awesome was that, traders must have thought, the ability to position to profit before the fact.

Nobel Prize winner Robert Shiller has devised a twist of sorts on the traditional P/E ratio by comparing stock prices to the average inflation-adjusted earnings from the previous 10 years. The thinking behind this construct is corporate earnings can be affected by the bumps in the business cycle, which can render the traditional P/E ratio highly volatile. Smoothing out volatility to make any indicator less noisy and therefore more efficacious is intuitive enough. And yet, the Shiller ratio has become a target of stock market cheerleaders, many of whom have made a professional sport out of debunking his methodology. (Shiller’s measure suggests a higher current level of overvaluation than the more malleable, shorter-term P/E does, so what’s to like?)

To his credit, legendary investor Jeremy Grantham has not succumbed to attacking Shiller. Rather, he recently made an elegant observation with regard to the good professor’s full historic data set: The Shiller P/E averaged 14.0 times earnings from 1900 to July 1987; in the period that’s followed Greenspan’s taking the helm to present day, the Shiller P/E has averaged 24.4.

In other words, some element appears to have entered investors’ calculus that justifies paying prices that are markedly higher than they were before Black Monday, before Greenspan committed to provide liquidity to support the financial system. Years ago, investors even came up with a nickname to describe the effective floor placed under all risky asset prices since the Fed began making policy with an aim to mitigate losses: the “Greenspan Put.”

A put is a contract that allows the owner to profit if the price of an underlying security declines. If you own a put contract on the broad stock market, you make money as the stock market declines. To be sure, investors have changed with the times when it comes to the identity of the put’s benefactor. The current put is ever so originally called the “Yellen Put,” which replaced, of course, the “Bernanke Put.”

So which history should investors reference to judge the current value of the stock market — the pre-Greenspan era or that which followed? The former casts the current Shiller P/E of 27 as frothy, if not rich; the latter suggests investors are perfectly rational in their exuberance. After all, stocks are not nearly as overvalued today as they were in 1999. And more to the point, policymakers remain loathe to end an era, regardless of the damage it has wrought on the notion of price discovery.

The catch is that a put, as is the case with any contract, is not designed to be in effect in perpetuity. Then the question becomes, what happens if history eventually catches up with stocks, ultimately pushing valuations into single-digit P/E territory?  In that event, investors would rightly conclude that interventionist policymaking, while well-intentioned in name, was nevertheless destructive in the end.