US Shares – Hope & Debt

The S&P500 was a rollercoaster again last night but finished almost where it started.  It is still near record highs.  To many this seems at odds with the broader economic environment and we agree.  We write often that this is a rally on central bank stimulus and not fundamentals.  So let’s look at that a little more…

We are well into US ‘earnings season’ right now, where listed companies report their last quarter’s earnings.  About a quarter of the way through on Friday and already the S&P500 is set to post a 3.7% decline in earnings for the 2^nd quarter.  That is the 5^th straight quarter of declining earnings, matching the longest such stretch since the GFC.  Now given that you traditionally buy shares with the view they will increase earnings per share and deliver you both capital gain and dividends, it should ring alarm bells that the market is rallying when there are these sorts of real results.  And yet you get charts like the following that illustrate ever so clearly the “hope” basis of the current market.  To the left of the green line is actual earnings.  To the right is projected earnings.  Which side of the line reflects reality and which reflects unrealistic hope?

Indeed, unsurprisingly, on Price Earnings (P/E) shares are over valued.  The more telling ratio, the CAPE or Shiller P/E takes the price divided by the average of 10 years of earnings (the moving average) and adjusts it for inflation.  Right now this ratio shows the S&P500 is 61% more expensive than its historic average.  For context, since the late 1800’s there have only been 3 times when that has been higher – just before the Great Depression, the Dot-com crash, and the GFC.  At the moment we have the double P/E whammy of high price AND declining earnings.  

So why is the market so high this time in such a poor environment?  As we’ve explained before, US companies are still buying record amounts of their own shares.  In the first quarter of this year S&P500 companies bought back an incredible $161.4 billion of their own shares using record low cost debt and of course boosting prices and the aforementioned earnings per share in the process.  In addition, when bonds and bank interest are near zero and so is the cost of debt, ordinary people are now also margin lending at near record highs to buy shares in a desperate hunt for yield.

So we have the world’s biggest sharemarket at a level the third most overvalued in history, propped up by earnings growth ‘hope’ and debt accumulating share buy backs and margin lending due to central bank stimulus, in an environment of declining earnings and global growth forecasts. What could possibly go wrong….?