James W. Paulsen, Ph.D.
Perspective
Economic and Market
August 28, 2014
Bringing you national and global economic trends for more than 30 years
A Rare Stock Market Run?!
Since 1950, the U.S. stock market has experienced 15 periods
of significant valuation enhancement. In 11 of these cases, the
price-earnings (P/E) multiple rose while earnings declined.
Most frequently, rising P/E multiples reflect falling earnings
rather than improved valuations. In two other cases, the P/E
multiple rose while earnings were essentially flat. In only two
market cycles, the late 1990s and today, has the stock market
been driven higher by a simultaneous rise in both earnings
and the P/E multiple. Consequently, although the character of
the current stock market run during the last couple years is
not unique, it is certainly rare.
Chart 1 overlays the S&P 500 P/E multiple with trailing earnings per share. On each series in this chart, the triangles represent major P/E bottoms and the circles illustrate major tops
in the P/E multiple. We highlight 15 cycles of significant P/E
advances and focus on what happens to earnings during these
periods of valuation enhancements. As illustrated, usually a
substantial portion of any rise in the P/E multiple is due to a
reduction in earnings. Similarly (although not highlighted in the
chart), P/E multiples also often decline when earnings rise.
a stock market trend to become excessive. For example, if
earnings growth and P/E multiples mostly rose and fell together, stock market trends would tend to be more exaggerated
and probably tend to excess much more frequently.
Fortunately, as this chart illustrates, rarely do both earnings
growth and valuations rise together even though both improved earnings and higher valuations almost always contribute to a bull run. For example, typically early in a bull market,
even though earnings are still declining, the P/E begins rising
pushing the stock market higher. Then, once earnings recover,
P/E multiples often contract. This inverse relationship often
helps sustain a bull run. While faster earnings growth drives
stock prices, valuations are typically refreshed allowing them
to later drive stock prices while earnings growth refreshes. In
this fashion, a stock market run is continuously reset. Ultimately, bull markets are the product of both better earnings
and higher valuations, but rarely at the same time.
Why do P/E multiples and earnings typically move inversely?
First, although the valuation of an earnings stream certainly
depends on the speed and sustainability of earnings expectations, it also is importantly impacted by investor expectations concerning inflation and interest rates. Moreover, the
same forces and reports which often raise economic growth
forecasts (and thus inflation and interest rate concerns) also
boost earnings growth. What Chart 1 illustrates is faster
(slower) earnings growth typically also produces aggravated (a
lessening in) interest rate and inflation expectations thereby
lowering (expanding) P/E multiples.
Of the 15 P/E expansions highlighted in Chart 1, 11 were of
traditional character whereby when the P/E multiple rose,
earnings declined. Two of them were short cycles (one in the
1950s and one in the 1960s), characterized by a significant
rise in the P/E multiple and a very modest rise in earnings.
Between September 1953 and April 1955, the P/E multiple
rose from about nine to about 14 and earnings improved
marginally. Similarly, between June 1962 and April 1964, the
P/E multiple expanded from about 15 to 20 while earnings
rose only slightly. A more extreme example of this rare
stock market character occurred in the late 1990s. Between
December 1994 and June 1999, earnings rose substantially
while the P/E multiple also rose dramatically from about 15
to more than 30!
Second, the predominantly inverse relationship between P/E
multiples and earnings growth may exist because it helps
sustain longer-term stock market trends. Since the two components of a stock’s price (i.e., its P/E multiple and earnings)
most often move in opposite directions, it is more difficult for
Finally, Chart 1 shows the current stock market rally also
exhibits this rare character of a simultaneously rising P/E
multiple and rising earnings. Since September 2011, earnings
have been rising and the P/E multiple has increased by almost
one-half from about 12 to about 18!
Economic and Market Perspective
2
Chart 1: S&P 500 Stock Price Index
P/E multiple versus trailing EPS
Left scale: P/E multiple (Solid)
P/E muliple based on trailing 12-month earnings per share (EPS)
Right scale: EPS (Dotted)
EPS based on trailing 12-month EPS
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Economic and Market Perspective
3
Implications of the stock market’s rare
run???
Chart 2: S&P 500 Composite Stock Price Index
January 1954 to December 1958
Although the current stock market run is not unique, nor is it
nearly as extreme as was the late 1990s, it is still dominated
by a highly unconventional simultaneous rise in both the P/E
multiple and earnings. Given its rare character, what are the
potential implications for investors?
First, none of the other three rising P/E-earnings stock
market cycles since 1950 (i.e., 1950s, 1960s, and late 1990s)
provided a good sell signal for the overall market when the
P/E multiple finally peaked. For example, as shown in Chart
2, despite the P/E multiple peaking in April 1955, the stock
market rose another 25% in the following year. What is also
illustrated in Chart 2, however, is from the time the P/E
multiple did peak in 1955, the stock market was essentially at
the same level (flat) two and one-half years later in December 1957. A similar story emerges from examining the 1960s
rising P/E-earnings cycle in Chart 3. The P/E multiple topped
in April 1964 and although the stock market climaxed about
15% higher, the level of the stock market was essentially the
same about two and one-half years later at the end of 1966
as it was when the P/E multiple peaked in 1964. Finally, as
shown in Chart 4, once the P/E peaked in 1999, the stock
market only rose about 10% more during the 1990s cycle
and suffered a severe selloff thereafter. At a minimum, these
historic precedents suggest stock investors should proceed
cautiously during the next few months.
Second, normally when a stock market is driven higher by
rising valuations, earnings typically are being refreshed and if
earnings drive stock prices higher, the P/E multiple typically
cheapens. In this fashion, if one foundation for the bull market
fails, the other (refreshed foundation) is able to step up and
minimize downside risk. Today, since both foundations underlying the stock market (i.e., both earnings and the P/E multiple) have been concurrently responsible for the rally since late
2011, both are probably “simultaneously” becoming stretched.
Could the stock market require a “refreshing period” when
either the P/E multiple or earnings decline?
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Chart 3: S&P 500 Composite Stock Price Index
January 1963 to December 1967
Chart 4: S&P 500 Composite Stock Price Index
January 1998 to December 2002
Economic and Market Perspective
4
Finally, the rare character of this stock market advance seems
likely to continue as long as there is no inflation/interest-rate
consequence from economic growth. Indeed, in each of the
previous three stock market cycles since 1950 when both P/E
multiples and earnings simultaneously rose, “growth without
consequence” was a common theme. During both the 1950s
and 1960s episodes, despite ongoing economic growth, the
annual rate of consumer price inflation never rose above
1.5% in either stock market cycle. Similarly, during the late
1990s run, the 10-year bond yield fell from about 7.8% at the
end of 1994 to about 5.7% when the P/E multiple peaked in
mid-1999. Essentially, in all three cases, the rare stock market
cycle of a simultaneously rising P/E multiple and earnings was
prompted by an ongoing economic recovery without any
obvious show of overheated/inflation/yield pressures.
Today, “growth without inflation/Fed tightening consequences”
is at the epicenter of the ongoing stock market run. In our
view, economic growth has upshifted in the last 18 months,
growing more broadly and consistently than at any time in
this recovery. For example, excluding the weather distorted
first quarter, real GDP growth has been between 3.5% and
4.5% in three of the last four quarters! Despite this upshift in
economic performance, however, bond yields have declined
steadily this year and most inflation measures remain benign. Consequently, both the Federal Reserve and investors
seem to be assuming the recovery can continue to grow at a
healthy clip without overheated consequences. Ergo, earnings
are rising because economic growth is reasonably strong
while the P/E multiple continues to be boosted by lower bond
yields and low inflation.
Investors should consider whether and for how long this
economic recovery can continue “without” overheating consequence. As long as it does, the relatively rare rising P/E-earnings stock market rally should persist. However, in our view,
the pace of real economic growth is now probably sustaining
near 3% and with the labor market and factory utilization
rates firming, inflation and interest-rate pressures will likely
soon intensify. If improved economic reports and worsening
inflation evidence does force the Federal Reserve to quicken
its exit strategy, even if earnings continue to do well, the stock
market may be headed for an intermediate period of P/E
multiple contraction.
Summary
We continue to believe the long-term potential from stocks
remains very favorable. However, the bull run will not likely be
a straight line and investors should expect some turbulence
along the way. The rare stock market cycle we have experienced since late 2011, where both foundations for the bull
market (i.e., the P/E multiple and earnings) have simultaneously risen, probably suggest elevated risk in the stock market
over the intermediate term. Because the longer-term outlook
for equities remains so favorable and bonds yields remain
woefully too low, we continue to recommend maintaining a
large secular overweight toward equities. Nonetheless, our
concerns that bond yields and the federal funds interest rate
are too low relative to the improved pace of real economic
growth, the recent tightening of resource markets and the
increasing likelihood inflationary pressures will soon become
more evident, keeps us cautious about stocks and bonds
during the next several months.
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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | ©2014 Wells Capital Management