Investors have truly witnessed something special. The past decade was the first to begin and end without a single recession. In fact, the U.S. economy is still riding the longest economic expansion in its history, dating back to the early 1860s.
We also saw all three major market indexes climb to record highs, with the benchmark S&P 500 (^GSPC 1.22%) bouncing nearly 380% from its Great Recession closing low in March 2009 to its close on Dec. 31, 2019. Investors who had the wherewithal to stick with their holdings probably fared very well and handily outperformed the historic return of 7% for the S&P 500, which includes dividend reinvestment and is adjusted for inflation.
But after nearly 11 years of being in a bull market, the valuation caution bells are ringing. The big question is, should they be?
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Compared to historical measures, the stock market looks expensive
On the surface, there are a number of reasons to for value investors to be concerned with stock market's monumental run. For example, the Shiller price-to-earnings ratio -- a P/E ratio based on average inflation-adjusted earnings from the previous 10 years – has been vacillating between 31 and 32 for the past couple of weeks. Since the early 1870s, the average Shiller P/E is 16.7.
What's more, the Shiller P/E ratio has only exceeded 30 on four occasions in 150 years. The first was in 1929, just before the stock market fell off a cliff during the Great Depression. The second time was during the dot-com bubble, when the Shiller P/E peaked at 44.2 before the stock market crashed. The third time was in the third quarter of 2018, just prior to the stock market's precipitous fourth-quarter tumble. And the fourth is right now. Historically, when the Shiller P/E crosses above 30, bad things happen.
To make matters worse, the broad-based S&P 500 is in the midst of an earnings recession. While most folks are focused on whether or not the U.S. economy will enter a recession, they've overlooked that the fourth quarter of 2019 is likely to be the fourth consecutive quarter of year-over-year earnings declines for S&P 500 companies. This earnings recession is only exacerbating already perceived-to-be high current and forward P/E ratios.
This would seem to be a pretty cut-and-dried case that equities are expensive, right? Well, not so fast.
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Higher price-to-earnings ratios could become the new norm for equities
Despite being in the midst of a long uptrend, three factors suggest that, instead of the stock market being pricey, higher P/E ratios are actually a new norm for the market.
To begin with, at no point throughout history have businesses had the ability to so easily access cheap capital. Between December 2008 and December 2015, the Federal Reserve kept its federal funds rate, which impacts consumer and corporate borrowing rates, at an all-time low of 0% to 0.25%. Even after nine quarter-point (25 basis point) rate increases between December 2015 and December 2018, and three subsequent quarter-point reductions in 2019, corporations have been able to continue borrowing at rates that are well below the historic norm. This access to cheap capital encourages high-growth businesses to innovate, hire, and acquire, and we're unlikely to see considerably higher interest rates anytime soon.
In 2017, for instance, Amazon.com (AMZN 1.47%) chose to raise $16 billion in cash by issuing debt to acquire Whole Foods Market, rather than utilizing the $21 billion in cash the company had on its balance sheet. The simple reason Amazon did this is that access to financing has been cheaper over the past decade than at pretty much anytime in the recorded history of the United States. Sure, Amazon is valued at what looks to be an eye-popping 70 times next year's per-share profit forecast, but it also looks to be inexpensive when its growth rate is taken into account via the price-earnings-to-growth ratio (PEG ratio).
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Another consideration that needs to be made here is that corporate buybacks have hit all-time record highs for two consecutive years, and there's nothing to suggest that this won't continue to have a positive impact on earnings per share.
The passage of the Tax Cuts and Jobs Act in December 2017 paved the way for a number of major tax reforms, including capping the peak marginal corporate income-tax rate to 21%, down from 35%. This overhaul is expected to save corporations $1.35 trillion over a 10-year period, according to the Joint Committee on Taxation, and we've already seen some of these savings deployed on beefed up capital-return programs. These capital-return initiatives, including buybacks, can provide more than enough incentive for shareholders to overlook valuation metrics that might traditionally look pricey.
Finally, don't overlook the role that computers and the internet have played in disseminating information over the past 25 years. Before gaining access to information at the click of a mouse or a swipe of a smartphone, it often took quite a bit of time for Wall Street or retail investors to learn of macroeconomic news or major corporate events. I'd propose that this uncertainty is a key reason valuations remained so comparatively low between the 1870s and mid-1990s.
However, that's not an issue in today's environment. The playing field has been considerably leveled thanks to internet and computer access. With information streamlined from businesses to Wall Street and Main Street, there's less uncertainty being priced into equities, which in turn allows for perceived-to-be pricier valuations.
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Valuation metrics aren't everything
However -- and this an important "however" -- keep in mind that traditional valuation metrics are just one part of the puzzle that helps investors evaluate the current and future state of the stock market and equities. Even if the thesis that equities are pricey turns out to no longer hold water because we've entered a new norm, there are plenty of other cautionary tales to be issued.
As an example, while low lending rates have allowed businesses to borrow cheaply and continue this robust rally, it could be argued that corporate debt levels are now worrisome. In July 2019, Forbes reported that nonfinancial corporate debt had nearly hit $10 trillion, which was more than 50% higher than $6.6 trillion peak hit during the third quarter of 2008, in the height of the Great Recession. As a percentage of U.S. GDP, nonfinancial corporate debt has risen from 44% of GDP in Q3 2008 to 48% of GDP 11 years later.
We also can't overlook the brief yield-curve inversion that occurred with the two-year and 10-year Treasury notes in late August 2019. Although not all yield-curve inversions lead to a recession, each of the past five recessions have been preceded by a yield-curve inversion. It's typically a warning that a recession is, on average, less than two years away.
The point is that equities could still be on the verge of what some would consider a long overdue correction. But stocks simply being "pricey," at least in the historical sense, no longer seems to be enough justification for equities to sell-off.
