It’s Expensive So Let’s Buy More!

by Robert Katch

Can a stock market rally built more on Price Earnings (PE) ratio expansion and low bond yields, rather than on earnings growth, be sustained?

This question highlights a precarious state of affairs and helps to explain the market’s recent ups and downs. While the major indexes like the Dow, S&P & NASDAQ have hit new highs, most stocks are struggling. It hasn’t bothered investors much that earnings for the S&P 500 peaked in 2014 and have stagnated since. Nor that American consumers are barely propping up our economy’s sluggish growth (struggling to stay over 1%), while European growth stalls and China’s economic spending continues to slow.

A recent study showed that 92% of the stock market’s returns over the past four years can be tied to the drop in the equity risk premium, which causes higher PE ratios. Thus, we have a stock market straining to trade at 19 times corporate earnings. This means that for every $19 you invest, the S&P 500 is only earning $1 – therefore creating a longer time horizon to earn back your investment. Contrast this with a few years ago when investors were only willing to pay $17 for every $1 of earnings. So while earnings growth has been tepid, investors have been willing to pay more for that same $1 of earnings. A PE moving from 17 to 19 drives the stock market up 12% (2 divided by 17 equals 12%). When was the last time you rushed out to buy something simply because it was going up in price?

Given these facts, why has our market stayed up for so long? Thank you TINA!  Investors feel “There Is No Alternative” and, in desperation, they are buying stocks.  This continues to push and hold the market up.

Central banks around the globe are running out of road to ease and stimulate the economy and will soon find themselves on an exit ramp leading to a place they’ve never been. The Fed’s balance sheet has quintupled in size since 2008 due to the creation of digital dollars.  Global bond markets support $12.3 trillion of bonds with interest rates below zero.  A Sub-Zero used to just be a refrigerator, but now it is a bond, too!

The condition of the labor market is also a concern and the monthly employment data is one of the most highly-anticipated sets of numbers. The Fed has hinted that further strong jobs growth would allow them to increase their artificially-low interest rates, but we all know that many great jobs have been lost over the past decade.

Where have all the good jobs gone? Many have been lost to productivity. Google is a very important company in our economy and its stock has a major impact on our markets. While it has twice the market value of the former giant, General Electric, it has only 57,000 employees versus the 330,000 at GE. With 4,000 employees, Netflix has superseded Blockbuster, which had 60,000 employees at one point. Amazon is a global powerhouse but has only 270,000 employees, which is about half that of the retailer Kroger. It’s awesome if you work for one of these companies. But real economic growth requires jobs growth, and better yet, the growth of good jobs! While technology improves our lives in many ways, it eliminates jobs and creates deflation.

This market has done well over the past few years for all of us, but almost entirely on the back of PE expansion – which is only great while it lasts. It can work the other way, too, if investors lose confidence or find an alternative to equities and subsequently drive stock prices down. For real stock market progress to take hold, our economy needs to create traction leading to higher sales. This will then increase profits and fuel the growth of more good jobs.

Robert J. Katch is the founder of Manchester Financial, an Investment Counsel/Wealth Management firm located in Westlake Village. For more information call 800-492-1107.

This material is provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.

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