This post is an update to various past posts concerning the stock market bubble, most recently that of November 21, 2013 titled “Is The Stock Market Experiencing A Bubble?”

Many people don’t believe that we are currently experiencing a stock market bubble because their primary reference regarding stock market bubbles is that of the mid- to late-1990s, in which there was a stock market bubble with immense speculative activity, wildly resplendent “price action” in the technology and internet sectors, and many exceedingly high (in some cases stratospheric) company valuations.  It was an amazingly notable period for many reasons.

Today’s overall stock market bubble is not as “overt” and “flamboyant” in nature and many “bubble” aspects aren’t necessarily (widely) recognized or necessarily understood.  However, just because the obvious signs aren’t glaringly obvious doesn’t mean that the bubble’s magnitude is smaller.

One of the problems in identifying an asset bubble is that there is no standard definition of one, and many – if not most – bubbles are identified “after the fact.”  As there is no standard definition of an asset bubble, there is no definitive measures to “prove” or “disprove” of one’s existence.

However, there are many underlying financial conditions that historically have led to asset bubbles.  While the list is extensive, among the more notable conditions are (ultra) easy monetary policy and the accompanying ultra-low interest rate environment, both of which have been extant for a number of years now.

My posts concerning the existence of the stock market as being in an asset bubble date back to 2011.  While I base this view both on technical analysis and fundamental analysis factors, in this post I will primarily focus on fundamental measures.  While a full discussion of these factors would be exceedingly lengthy and, at times, very complex, below is discussion of some of the more notable factors, including earnings and valuations.

Earnings

Perhaps the most common equity valuation metric in use today is the P/E ratio.  By this measure, stocks don’t necessarily appear exceedingly expensive.  One way to look at it is the from the FactSet Earnings Insight of February 13, 2015 (pdf), which says:

The current 12-month forward P/E ratio is 17.1. This P/E ratio is well above the 5-year (13.6) average and the 10-year (14.1) average.

However, my analyses indicate that earnings are being impacted by a variety of special factors that likely will prove transitory in nature.  Among these factors – which are further discussed in the November 21, 2013 post mentioned above – are ultra-low interest rates and share buybacks.  As well, the decline in corporate taxes has played a role, as discussed in the June 3, 2014 ProfitabilityIssues.com post titled “Long-Term Trends And Sources Of Corporate Profitability Growth.”

Other factors that have increased profitability is cost-cutting, subdued hiring, and continually-low increases in (nominal) labor costs.

As a result of myriad factors, the S&P500 net profit margin is notably high from a historical perspective.  According to the Wall Street Journal article of February 1, S&P500 net profit margins “averaged 8.4% between 1999 and 2013,” and are now 10.1%  (Historical and projected S&P500 net profit margins are seen in the February 5, 2015 ProfitabilityIssues.com post titled “S&P500 Net Profit Margins – 2 Charts.”)

Of note, this occurred during a recent period of low revenue growth.  Additionally, as one can see from both the net profit margins chart mentioned above as well as in the Wall Street Journal article, consensus analyst expectations are for a further rise of net profit margins to over 11% by 2016.

Other metrics illustrate how distended the aggregate level of profitability is from a long-term historical perspective.  One measure that can be used is (After-Tax) Corporate Profits as a Percent of GDP.  This chart is seen below.  From 1947 through the 3rd quarter of 2014, the average is 6.5% and the median is 6.2%.  The Q3 2014 value is 10.8%:

Stock Market “Price Action” And Valuations

Stock market “price action” and valuations are other notable aspects of today’s stock market bubble.  For reference, here is a long-term chart of the S&P500 since 1925 (depicted on a LOG scale through February 13, 2015):

(click on charts to enlarge image)(chart courtesy of StockCharts.com)

While, admittedly, the recent overall stock “price action” isn’t as “frenzied” as it was in the late 1990s, there are many pockets of extreme stock valuations and/or continuously sharply rising stock prices.  With regard to the former, there are many large-cap stocks that appear highly overvalued based upon measures including (continual) lack of profitability.  With regard to the latter, there are many stocks – including those in the biotech sector – that exhibit “frothy” stock “price action.”  This can be seen in the parabolic advance seen in various biotech indices, including the BTK Biotechnology Index seen below:

(click on charts to enlarge image)(chart courtesy of StockCharts.com)

As well, there are many valuation measures that would indicate that stocks are expensive, if not very much so.  When one uses stock market valuation measures other than the P/E ratio, one often sees the stock market as either being (very) expensive or in “bubble” territory.  These other valuation measures include the Q-Ratio and CAPE (“Shiller PE”), etc.  (note:  these factors are discussed in Doug Short’s “Market Valuation Overview.”)

As well, there is the stock market capitalization to GDP measure,  which is seen in Doug Short’s post of January 7, 2015 (“Market Cap to GDP:  The Buffett Valuation Indicator“):

In addition to these many instances of notably rich public stock valuations, there is also the tangential issue of notably high private company valuations.  This issue has been recently discussed in the January 22, 2015 Fortune article titled “The Age of Unicorns,” subtitled “The billion-dollar tech startup was supposed to be the stuff of myth.  Now they seem to be … everywhere,” as well as the Barron’s article of December 8, 2014 titled “This Time It’s Different.”

Size Of The Stock Market Bubble

While the above discussion indicates a stock market that is overvalued, if not very much so, there are many reasons why the stock market bubble is far larger than any before it.  One of the reasons is the current distension – and forthcoming mean reversion – of many of the measures discussed above.

While a detailed mean reversion discussion would be very lengthy and complicated – and as such isn’t suitably discussed in a brief manner – it is highly relevant with regard to the potential downside and associated financial and economic dynamics that will come into play.  As well, the consequences of mean reversion will determine the magnitude of the ultimate stock market price decline, which will be the main measure as to this bubble’s magnitude.

While projections are difficult to make due to a number of factors and the uncertainty that would accompany such a rapidly changing environment, changes in overall stock market valuations will certainly be far greater than most would assume.  It appears that this issue of mean-reversion and the resulting revaluation greatly lacks recognition.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 2096.99 as this post is written

Recently there have been a variety of discussions as to whether the stock market is experiencing a bubble.  Among the main drivers of such discussion is the stock market’s seemingly near-constant price advancements, frequent record-high closes, and the duration of the advance, all of which are against the backdrop of the (at best) slow-growth economy.  For reference, here is a daily chart of the S&P500 from 2009, with the 50dma and 200dma:

(click on chart to enlarge image)(chart courtesy of StockCharts.com; chart creation and annotation by the author)

One such article discussing whether the stock market is experiencing a bubble is the Saturday, November 16 Barron’s article titled “Bubble Trouble?”  An excerpt:

The S&P 500 is valued at 16 times projected 2013 operating profits of $109 and at 15 times estimated 2014 earnings of $120. Those price/earnings ratios are about equal to the long-run average. Even if next year’s earnings growth is closer to this year’s projected 5% than to the aggressive current estimate of 10%, the S&P 500 forward P/E is 15.6, which doesn’t look excessive at a time of near-zero short-term rates, a 2.71% yield on the 10-year Treasury note, and sub-6% average yield on junk bonds. The S&P 500 dividend yield is 2%, but the earnings payout ratio is historically low at about 35%, meaning companies have room to further boost dividends.

As well, Janet Yellen, during her testimony on Thursday, was asked about asset bubbles.  Here is what she said (as seen in the Bloomberg article of November 14 titled “Yellen Signals Continued QE Undeterred by Bubble Risk”) concerning the stock market:

“Stock prices have risen pretty robustly but if you look at traditional measures,” such as price-earnings ratios, “you would not see stock prices in territory that suggests bubble-like conditions,” she said.

My comments:

My posts concerning the existence of the stock market being an asset bubble date back to 2011.  I view the argument as to whether the stock market is experiencing a bubble based upon two general areas:  technical analysis and fundamental analysis.

While I believe there to be many reasons to believe stocks are in a bubble based upon technical measures, in this post I will focus on fundamental measures.

In particular, the common (and seemingly predominant) argument made that stocks are fairly or attractively valued is based upon a (forward) PE basis.  Various year 2014-2015 S&P500 earnings forecasts continue to portray attractive growth in earnings.  While, as indicated by the Barron’s article mentioned above, stocks don’t appear to be in a bubble based upon (forward) PE-based valuation measures, current levels of earnings are, in many ways, favorably impacted by various factors.

Even if one assumes that EPS is – or should be – the primary stock market valuation metric – these numerous benevolent factors within the current earnings environment seem to lack general recognition.  Whether these factors will persist – and whether they “deserve” to be accorded full valuation – should perhaps be the focal issue.

While a full discussion of these factors would be exceedingly lengthy and, at times, very complex, below are some of the more notable factors:

(Ultra) Low interest rates –  While, due to numerous factors, it is difficult to accurately quantify how much the (ultra) low interest rate environment has directly and indirectly bolstered earnings, the (ultra) low interest rate environment has had a (very) significant impact on earnings.  I discuss this in the ProfitabilityIssues.com posts of September 25, 2013 (“Corporate Interest Cost Savings“) and the July 29, 2013 post (“Impact Of Low Interest Rates On Corporate Profitability.”)

Lagging Revenue Growth – While S&P500 earnings have no doubt been robust, corporate revenue growth has consistently lagged.  This is problematical in many ways, both from a corporate performance standpoint as well as a general economic standpoint.  From a corporate performance standpoint, it raises many issues, including both the “quality of earnings” as well as to the sustainability of earnings.  From a general economic standpoint, it strongly appears as if employment growth, among other factors, would likely be considerably higher if revenue growth was higher.

Share buybacks – While, from an overall perspective, share buybacks aren’t a predominant factor, this is yet another area in which EPS has been significantly bolstered. (note:  this share buyback factor, as well as others, is also discussed in Lance Roberts’ post titled “Analyzing Earnings As Of Q3 2013.”)

Also of note is that various levels of profitability – including the S&P500′s operating margins, operating profits, and After-Tax Corporate Profits as a Percentage of GDP – are at or near record-high levels.  Cumulatively, these levels raise questions about the sustainability of corporate earnings growth.  As well, they raise the issue of what a decline in corporate earnings may look like.  These “decline” scenarios, although estimates, often look rather precipitous, especially if one starts thinking about such issues as long-term mean reversion as well as a “reversal” of the positive earnings factors mentioned above, such as the ultra-low interest rate environment.

As to the valuation of the stock market, when one uses stock market valuation measures other than PE, one often sees the stock market as either being (very) expensive or in “bubble” territory.  These other valuation measures include the Q-Ratio, market capitalization to GDP, CAPE (“Shiller PE”), etc.  (note:  these factors are discussed in Doug Short’s “Market Valuation Overview” updates as well as various of John Hussman’s commentaries, including that of November 11, 2013 titled “A Textbook Pre-Crash Bubble.”)

Cumulatively, on an “all things considered basis,” my analysis continues to indicate that not only is the stock market experiencing a bubble but – although it doesn’t necessarily outwardly appear as such – also that this stock market bubble is enormous.  While some choose to use (forward) PE ratios as the main determinant of whether the stock market is a bubble, I believe this is misleading.  

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1781.37 as this post is written