4th Quarter 2017: A High P/E and the DMV

A HIGH P/E AND THE DMV

My son flunked his driving test at the DMV last month. According to the DMV officer, Carlton (16) ran over the curb as he drove out of the parking lot. Needless to say, his mother was less than impressed with Carlton’s performance and we all enjoyed teasing him to no end when he got home that day. There had been quite a bit of build-up associated with his appointment with the DMV. First, we’d made it clear that Carlton wouldn’t be allowed to get his driver’s license until he had completed his Eagle Scout project. As you might imagine, Carlton waited until his sixteenth birthday was right around the corner to get started on his project and then he wanted to get it done immediately. He soon realized that building a kiosk for the mountain bike trails at Huntersville Elementary was not going to happen overnight. But he kept the pressure on me. “Dad, take me to Lowe’s to buy wood,” and, “Can you pick up eight 80-lb bags of concrete at Home Depot after work?” and, “Will you help me cut the rafters on Saturday?” or, “Can you drive me to the school to work on the project this afternoon?” This fall became quite the fire drill for me as Carlton pushed to complete his project before his birthday. Finally, it was done.

Dad sighed with relief but Mom quickly found herself in the hot seat as Carlton pestered her to take him to the DMV. It was no small task to get the appointment and it fell right in the middle of the busy Christmas holiday season. Alice and Carlton assembled the necessary documents including his learner’s permit, her driver’s license, his log of hours driven, his passport, the registration for the car, his social security card, two pints of blood and my left arm. They arrived at the DMV at 7:45 am and Alice breathed a sigh of relief as Carlton climbed into the car with the instructor. Finally, he’d have his license and this mad scramble would be behind us. Wishful thinking. Little did she know but she’d be right back two weeks later (he did pass on the second try).

Carlton blamed the curb incident on his having to take the driving test in his mother’s Chevy Suburban. “If I didn’t have to drive that big tank, I wouldn’t have run over the curb,” he said. He added, “And that lady was completely unreasonable. It was just one little curb. That’s no reason to flunk me…completely unreasonable.”

Speaking of unreasonable, several commonly used measures of US market valuations currently show that stocks are priced unreasonably high relative to historical norms. Two examples in charts are at the bottom of this page.

Why the exuberance? Are things different this time? We would suggest not. In a properly functioning market, the current value of a corporation (today’s price) is simply the discounted value of all cash flows expected in the future. So what is the market telling us today with the high multiple assigned to most stocks? Here are a few answers that might be helpful.

1. Earnings Growth: In the long run, stock prices are driven by corporate earnings. If the “E” in the P/E ratio increases dramatically, while the “P” remains constant, it follows that the P/E ratio will fall and valuations will look more reasonable. Said another way, earnings will have “grown into their high price.” Investors today have pinned their hopes on a faster-growing economy and higher corporate earnings, resulting from oft-discussed policies and legislation promised by a Republican-controlled White House and Congress. Measurable outcomes at this point are limited but the chart below (S&P 500 Earnings Per Share) shows that earnings have rebounded nicely since the financial crisis. It also shows analysts’ expectations for earnings for the next four quarters. Clearly, expectations are high.
   
2. Low Interest Rates: Low interest rates have driven prices of risk assets like stocks and real estate higher. Since the value of an asset today reflects the discounted value of all cash flows expected in the future, the interest rate used in the discounting formula is a critical factor. The lower the rate, the higher the present value of the asset. For example, the present value of ten equal annual payments of $50,000 using a discount rate of 2.0% is $449,129. The same stream of payments discounted at a rate of 6.5% is only worth $368,004. The following chart of long-term interest rates may explain why valuations of the last two decades have been persistently above the post-war average.
   
   
3. Investment Alternatives: Another way of stating the previous point regarding low interest rates is simply to say, “Where else will I invest the money? What is a better alternative? With cash yielding close to zero and a ten-year Treasury bond yielding 2.4%, where can I get a better return than in stocks?” This case for stocks being the best alternative is often further bolstered by the use of the “Fed Model” which compares the yield of Treasury bonds to the “yield” of the stock market. The calculation is simply the inverse of the price-to-earnings ratio (P/E) resulting in earnings to price (E/P). The output is the “earnings yield” of the market. When compared to the yield of cash or the yield of a ten-year Treasury, the current “earnings yield” of the market looks more reasonable. See the chart below provided by Ed Yardeni who also introduced the name “Fed Model” for this measure.
   Over time, when the earnings yield of the market is higher than the earnings yield of Treasury bonds, the market is arguably undervalued. Before getting too excited about this measure, remind yourself that Fed-tightening is underway, albeit at a very measured pace. Interest rates have risen very slowly. Thus far the yield on a ten-year Treasury bond has increased approximately one percentage point (from an all-time low of 1.4% in July of 2016 to 2.4% as of year-end 2017). Unless it really is different this time (and we don’t think it is), this correlation (interest rates and asset prices) will hold in the long term and is therefore very important to the future direction of stock prices.
4. Corporate Tax Cuts: Above-average valuations reflect investors’ expectations that a lower corporate tax rate will immediately increase the net earnings of most US corporations. As you have undoubtedly heard, sweeping changes to the US tax code were signed into law by President Trump in December. The new law reduced the corporate tax rate from 35% to 21%. Estimates for the earnings increase resulting from the lower rate vary from a low of 8% to a high of 12%.

In addition to the direct impact a tax cut will have on corporate earnings, there is the follow-on effect of the lower tax rate. Investors are optimistic that a lower rate will make the US more attractive for business. If more companies choose the US for their headquarters or for the location of their operations, this logically will increase economic activity, which means more jobs and growing earnings. And this takes us all the way back to Point Number 1.

We’ve laid out some possible explanations for today’s seemingly high valuations. Even as we’ve done so, we admittedly scratch our heads a bit as we observe the optimism and the duration of this rally. Valuations don’t appear as unreasonable as Carlton’s DMV instructor but they are a bit hard to understand. Markets don’t run forever. Corrections are normal and we think it makes sense to own a portfolio that is appropriate given your need for liquidity and your need for return. As stocks have outrun bonds, we’ve been trimming stocks at the margin and adding to bonds to maintain the balance called for in your investment plan.

On behalf of the team at Bragg, thank you for the opportunity to serve you. We wish you the best in the New Year!