Weekend Reading: A Permanent Shift To Valuations?

Authored by Lance Roberts via RealInvestmentAdvice.com,

One of the ongoing thesis behind a continuation of a bull market from current valuation levels is that there has been a permanent shift higher in valuations due to changes in accounting rules, propensity for share buybacks, and a greater adoption by the public of investing (aka ETF’s).

This apparent shift to valuations is shown in the chart below.

There are two important things to consider with respect to the chart above.

  1. The shift higher in MEDIAN valuations was a function of falling economic growth and inflationary pressures.

  2. Higher prices were facilitated by increasing levels of leverage and debt, which eroded economic growth. 

The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising. It is also the point that valuations shifted higher.

Given that economic leverage (corporate, consumer, financial, and Government debt) is at all-time records, and rising, the ability to create stronger, sustainable, economic growth (which would lead to higher rates of inflation) remains little more than a hopeful goal.

The issue with the idea that valuations have had a permanent shift upward is that the assumption is based on a market anomaly form 1990-2000 which temporarily skewed valuations above the long-term medians. However, economic growth set to remain near 2% over the long-term, the average valuation ranges will most likely trend lower in the future.

Ed Easterling at Crestmont Research made a great point recently in this regard:

“However, as real economic growth significantly declined over the past two decades, it triggered a series of adjustments that represent the forces behind The Big Shift. Most importantly, the downshift in real economic growth disrupted the financial relationship of profits, future growth, and market value.

Slower growth drives P/E downward for similar reasons that it drives EPS upward.”

Of course, much of the shift upward to EPS has been a function of wage suppression, buybacks and tax cuts more than actual top-line revenue growth as I discussed just recently. Ed continues.

“Therefore, since future economic growth is expected to be slower, it is only consistent that the future average for the market P/E will be lower. The new normal growth rate (i.e., slower) for the economy will drive slower overall earnings growth. Such slower growth will drive market P/E lower, just as previously higher growth supported the market’s P/E at a higher level.

The inflation rate also drives the level of market P/E, but it occurs within the range driven by the growth-rate environment. Higher inflation drives P/E lower; deflation drives P/E lower. The level of P/E peaks when the inflation rate is low and stable. Thus, while the growth rate drives the level of the P/E range, the inflation rate drives the relative position of P/E within the range. 

Figure 6 illustrates these effects. The bar on the left illustrates the range for P/E under a historically average level of growth. The bar to its right illustrates the range for P/E under slower growth. Not only does the range downshift, the expected long-term average P/E also downshifts. This has major implications for analyzing the stock market.”

“Going forward, we should expect a new paradigm. Slower growth drives the ranges for P/E lower, which will affect future assessments of fair value. Keep in mind that, had real economic growth averaged 2% instead of 3.3% over the past century, the historical average for P/E would have been near 11—not 15 or 16. In the future, the fair value for P/E when the inflation rate is low will be 13 to 15. With average inflation, expect P/E to be near 11. During periods of high inflation and significant deflation, expect the low range for P/E to be 5 to 8.”

With the markets still currently trading near 30x earnings, a revaluation of markets will likely be just as painful to investors in the future as they have in the past.

While this time may indeed appear to be different, it will most likely end the same as every other period in history.

Just something to think about as you catch up on your weekend reading list.

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“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett

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