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The Great PE Multiple Expansion Of 2011-2014: Why The Market Must Eventually Crater

Tyler Durden's picture




 

Submitted by David Stockman via Contra Corner blog,

The earnings season is all over except for the shouting, but the outcome doesn’t remotely validate Wall Street’s happy times narrative. Reported Q4 earnings for the S&P 500 companies (with about two-thirds reporting) stand at $25.02 per share compared to $26.48 in the year ago quarter. That’s right. So far Q4 profits are down 5% but shrinking corporate profits is something that you most definitely have not heard about on bubble vision.

That’s because the talking heads invariably reference “adjusted” or “ex-items” earnings, which, almost by definition, exclude charges for every imaginable business mistake and bonehead executive action—-such as soured M&A deals and “restructuring” expense—- that could possibly cause earnings to go down. For the four-year period 2007-2010, as I outlined in the Great Deformation, the ex-items profit figure hawked by the Wall Street analysts was a cool one-half trillion dollars or 30% higher than the GAAP profits reported to the SEC on penalty of jail time.

But that’s just the tip of the iceberg. The real truth coming out of this earnings season is that we have had a tremendous inflation of PE multiples during the last three years in anticipation, apparently, of the US economy hitting escape velocity and the overall global economy continuing to power onwards and upwards. As is evident from the financial news and “incoming” data, however, that presumption is not remotely correct.

So when Wall Street calls a great multiple expansion party that doesn’t pan out—–what happens next doesn’t require a labored explanation. The untoward course of market action in the year after 1999 and 2007, respectively, speaks for itself. But the point here is that the eventual market correction this time could be a doozy. The magnitude of PE multiple expansion triggered when the Fed and other central banks went all in with ZIRP and QE has been enormous, and it has also gone largely unremarked upon.

Back in Q4 of 2011 reported earnings for the S&P 500 during the prior four quarters (LTM) clocked in at $87 per share, and that compares to an LTM result of $104.50 reported to date for Q4 2014. In the interim, however, there has been a change in accounting for pensions that is worth nearly $3 per share. So on an apples-to-apples basis, earnings are up by just 17%. This amounts to not only a tepid gain of just 5.3% per annum, but even that was largely accounted for by share buybacks with borrowed money.

Yet under the Fed’s all-out money printing regime it did not matter that even these modest earnings gains were coming from financial engineering rather than organic business growth. The S&P 500 index soared from 1100 at the beginning of Q4 2011 to yesterday’s close of 2050—-or by more than 85%.

Self-evidently, when the stock price index rises 5X faster than per share earnings, the PE multiple must soar. It did—–rising from about 13.5X during the last quarter of 2011 to nearly 20X today. Absent the drastic upwelling of animal spirits embodied in the PE expansion, therefore, the S&P index would be at only 1375 today. This implies that upwards of 75% of the stock market gain since late 2011 has been due to multiple expansion alone.

^SPX Chart

^SPX data by YCharts

And that’s the heart of the issue. Legitimate and sustainable multiple expansion of this enormous magnitude could only occur if the long-term outlook for economic growth had decidedly improved and the prospect for accelerating profit gains was warranted. But these outcomes are not remotely likely. So the gamblers and day traders in the casino have been essentially capitalizing hopium.

Stated differently, the huge multiple expansion since 2011 rests on the belief that central banks will keep juicing the economy with stock-boosting monetary stimulus until the macro-economy eventual responds, causing jobs, income, growth and profits to lift-off into the Keynesian nirvana of permanent full employment. Thus, the market has not been discounting incoming information; it has been merely pricing-in faith in the Fed.

But the actual incoming information embodies an altogether different story. And the first and most obvious point on that score relates to the lame rationalization that since interest rates are low the stock market multiple should be higher.

Quite the contrary. The current scenario is diametrically the opposite of what happened in the 1980s when there was a very legitimate case for PE multiple expansion. Owing to the eruption of double digit inflation in the late 1970s, the market PE multiple had dropped to 8X because reported earnings embodied a considerable element of pure inflation, and therefore were not entitled to be capitalized at historical rates. However, after Volcker had broken the back of commodity, consumer and wage inflation by 1983, the way was open for a sharp rebound of the corporate earnings capitalization rate, and the S&P 500 PE multiple did rebound to 15X.

In that era there still existed a “market” and it was correct in capitalizing earnings at a deep discount in response to the inflationary policies of the cowardly Arthur Burns and the clueless William Miller, but to also re-rate the value of current earnings once Volcker the Great had demonstrated a return to relatively sound monetary policy and more “normal” inflation rates.

By contrast, 73 straight months of ZIRP is not in the least bit normal or sustainable; nor is today’s 1.8% rate on the benchmark 10-year treasury note. Indeed, the fact that the last Fed policy rate increase—a mere 25 bps—-occurred 10 years ago is utterly abnormal, even freakish by the standards of prior history.

What has actually happened is that ZIRP was initially rationalized as a temporary policy to ameliorate the financial crisis, and, as such, it should never have been a basis to capitalize long-term corporate earnings streams. But once ZIRP was made quasi-permanent and is now intended to last 80 months at the zero bound, and persist at near-ZIRP for a “considerable” time after that—-it provides an especially  spurious basis for today’s high PE multiples.

As far as the eye can see, corporate earnings will be facing rising interest rates. The 33-year plunge of the treasury rate is over except for the occasional spasm of fear-driven flights to safety. This means that the discount rate on future equity returns should be rising, as well.

Indeed, as a practical matter the aberrant period of ZIRP and financial repression that is now coming to an end has caused a sharp deterioration in the “quality” of corporate earning, even apart from the appropriate discount rate or PE multiple. The S&P 500 companies alone carry upwards of $3 trillion of debt, and the business sector as a whole sports nearly $14 trillion. Accordingly, as interest rates eventually normalize, reported earnings will fall significantly as interest expense balloons. For the S&P alone a 300 basis point increase in average interest rates would reduce earnings per share by upwards of $10.

10-Year Treasury Note

Historical Data Chart

The same normalization dynamic as it relates to the dollar exchange rate will have an even larger adverse impact. The trouble with central bank financial repression is that it gives rise to deformations and malinvestments throughout the financial system. In this instance, the Fed’s massive QE program drove yields on government paper and blue chip credits to sub-economic levels, thereby eliciting a massive and relentless scramble for “yield” among money managers and punters alike.

Accordingly, upwards of $10 trillion in off-shore dollar debt has been issued by foreign governments and companies, and most of it in the EM world including more than $1 trillion by China alone. But as the global economy moves into its post crack-up boom deflation phase, and EM economies, especially, experience the double-whammy of rising current account deficits and weakening exchange rates, the massive “dollar short”  generated by the central banks during the last decade will go the way of all “shorts”. That is, it will generate a desperate scramble for dollars to liquidate unsustainable dollar borrowings, thereby driving the USD exchange rate steadily higher.

For roughly 13 years after the turn of the century, the global boom generated by the worldwide convoy of central bank money printers drove the dollar down and the reported earnings of the S&P 500 upwards. Since upwards of 40% of S&P profits are earned abroad, that beneficent headwind will now become a powerful tailwind. A return of the dollar exchange rate to the early 2000s level, for example, would reduced current earnings by $10 per share easily.

DXY dollar index

Historical Data Chart

Finally, there is the aberrant level of corporate profit margins, as well. That, too, is an untoward fruit of central bank financial repression. On the one hand, it caused a worldwide investment boom that emptied the rice paddies of China and elsewhere in the EM, driving down global industrial wage rates and leaving the US economy exposed to highly uncompetitive labor costs.

At the same time, it gave US businesses access to ultra-cheap debt to fund restructurings, downsizings and severance pay. Stated differently, the global money printing boom of the last two decades has made US labor expensive and debt capital cheap. That has been the driving financial force behind the relentless climb in the profit share of GDP shown below.

But like the inflation driven profits of the 1970s, the margin-driven profit gains of the last decade do not deserve to be capitalized at even normal rates—let alone historically top tick PE multiples. Profit margins are now nearly 2X the historical average, and even if they do not regress to the mean immediately, the odds that they can continue to rise are extremely limited.

In short, the $100 per share of S&P earnings recorded for the LTM period ending in Q4 2014 is the product of aberrant forces arising from an era of central bank bubble finance that is coming to an end. As share buybacks abate, interest rates normalize, the dollar rises and the worldwide deflationary adjustment gathers force, it is exceedingly unlikely that even the current $100 per share earnings level can be sustained.

What is quite certain, however, is that the huge PE multiple expansion of the past three years has nothing to do with honest price discovery. It is the bloated and unsustainable result of central bank driven inflation of financial asset prices and the relentless waves of carry-trade gamblers buying on the dip.

At some point soon the last home gamer will be led to the slaughter. Then the ultimate deflation will happen as PE multiples shrink back to reality.

 

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Thu, 02/05/2015 - 15:53 | 5748679 nink
nink's picture

Paper markets can't crash. But they can go up in flames. 

Thu, 02/05/2015 - 15:55 | 5748689 Burt Gummer
Burt Gummer's picture

Fuck the paper markets, buy gold.

https://www.youtube.com/watch?v=yloaBw80fV4

Thu, 02/05/2015 - 15:57 | 5748704 nink
nink's picture

Sure how many paper gold derivatives would you like to buy?  I can give you a negative interest rate loan if you want. 

Thu, 02/05/2015 - 16:00 | 5748719 Hitlery_4_Dictator
Hitlery_4_Dictator's picture

Non, jsut no, nothign will crash. Dow will be 35k soon and you haters will be poor

Thu, 02/05/2015 - 16:06 | 5748749 I MISS KUDLOW
I MISS KUDLOW's picture

6 years ago the dow was 6500 its now 18k what a joke its all become

Thu, 02/05/2015 - 16:08 | 5748759 Headbanger
Thu, 02/05/2015 - 16:47 | 5748967 BuddyEffed
BuddyEffed's picture

Just remember that crater is relative.   More likely to "crater" now at Dow north of 20,000 if you ask me.

 

The battle of the century is more likely to be between main street and wall street than between greece and others or ukraine and others.

 

https://www.youtube.com/watch?v=GTQnarzmTOc

 

https://www.youtube.com/watch?v=d0nERTFo-Sk

Thu, 02/05/2015 - 18:09 | 5749389 RaceToTheBottom
RaceToTheBottom's picture

I think that Amazon's PE should go up to 1000.

As good as any place to launder money....

Thu, 02/05/2015 - 16:24 | 5748852 ebworthen
ebworthen's picture

"Chart of the Day" for yesterday had support for the DOW at 5,000 and change:

http://www.chartoftheday.com/20150204.htm?H

S&P 666 true valuation.

Thu, 02/05/2015 - 16:06 | 5748750 I MISS KUDLOW
I MISS KUDLOW's picture

6 years ago the dow was 6500 its now 18k what a joke its all become

Thu, 02/05/2015 - 16:15 | 5748797 venturen
venturen's picture

8 years ago it was 14000. Kind of like a heart beat...up down up down...well till the patient is DEAD

Thu, 02/05/2015 - 17:24 | 5749181 StackShinyStuff
StackShinyStuff's picture

It's dead, Jim.  GET YOUR BULLION BACK AMERICA!!!

Thu, 02/05/2015 - 16:54 | 5749036 JRobby
JRobby's picture

Roberts English Series strikes again!

Thu, 02/05/2015 - 15:55 | 5748682 Tao 4 the Show
Tao 4 the Show's picture

Armstrong is right. Confidence is the name of this game.

Thu, 02/05/2015 - 16:07 | 5748752 ebworthen
ebworthen's picture

CONfidence game, CONgress, CONcupiscence.

Thu, 02/05/2015 - 15:54 | 5748688 Madcow
Madcow's picture

Nah.  The economy can collaspe to zero - but the Fed can keep bailing out the bailouts with new bailouts - until the US taxpayer is destroyed completely - and we are not there yet - 

Thu, 02/05/2015 - 15:56 | 5748694 Tsar Pointless
Tsar Pointless's picture

It'll all come crashing down when they're good and ready to let it come crashing down. One day, you'll (maybe) wake up and find the *markets* have been WTC 7-ed.

Thu, 02/05/2015 - 16:01 | 5748721 max2205
max2205's picture

But zirp isn't over.....it just isn't 

Thu, 02/05/2015 - 18:19 | 5749429 explosivo
explosivo's picture

Neither is QE. 

Thu, 02/05/2015 - 16:01 | 5748724 juggalo1
juggalo1's picture

If the prevailing interest rate is 1% wouldn't the implied P/E for a security be much higher than in a 6% interest rate environment?

Thu, 02/05/2015 - 16:09 | 5748765 madbraz
madbraz's picture

that's academic talk.  the price of a security is what real supply and demand call for.   Close the NY FED for a day or two and you will see what real investor demand is.  

 

companies are paying an average dividend of 1.9% (SP500).  their debt loads are increasing.  they can't afford to pay more.  fair value for stocks is at least 50% below today's levels (and a 3.8% dividend yield).

Thu, 02/05/2015 - 16:46 | 5748996 disabledvet
disabledvet's picture

Make it fifty billion for the Aircraft Carrier.

 

"Problem solved."

Thu, 02/05/2015 - 16:02 | 5748729 SheepDog-One
SheepDog-One's picture

When the banksters decide its time, then we'll get the next 'market crisis'.

Thu, 02/05/2015 - 16:03 | 5748735 Atlantis Consigliore
Atlantis Consigliore's picture

Griks, Rooskies, Crooks and Investors eun France;   sacre bleu,  all my money is frozen in Greece, and I cant get any return in a Banque....

 

oh we ll just buy dollar denom assets in US, stawks, and we ll be able to get out....LOL.

 

there will be liquidity in the FED game, ie  Der Markets....lol,  integrity?  liquidity?   hahahahahahah...

Thu, 02/05/2015 - 16:04 | 5748738 ebworthen
ebworthen's picture

Staples buying Office Depot, sheesh.  Why not throw in Radio Shack?

Then WalMart can buy Sears, and everything will be "fixed".

That last chart explains a lot about the suck ass economy.

Banksterism in the New Rome.

Democracy my ass.

Hang 'em High.

Thu, 02/05/2015 - 16:07 | 5748753 undercover brother
undercover brother's picture

the markets will only correct when it's absolutely apparent the fed will no longer intervene in the stock and bond market with the continual rollover of their 4 trillion stimulus hedge fund and once their holdings mature, they will pull those dollars out of the system by refunding them to the treasury.    

Thu, 02/05/2015 - 16:09 | 5748767 f16hoser
f16hoser's picture

Get out Now. Why stay in just to get another .5-1% return when you can lose a lot more...

Thu, 02/05/2015 - 16:13 | 5748790 City_Of_Champyinz
City_Of_Champyinz's picture

Long Volatility for a long time having my ass handed to me...only a matter of time until this mess implodes and my bet is vindicated...I do not see how this market that is so manipulated by these slimy politicians and bankers can continue like this.

Thu, 02/05/2015 - 16:16 | 5748813 Hohum
Hohum's picture

C of C,

Remember that all TPTB got is the stock market (and maybe a low interest bond market).

Thu, 02/05/2015 - 17:17 | 5749152 daveO
daveO's picture

$5 trillion in US pensions. Another potential $1+Trillion of imported Japanese pension money.

Thu, 02/05/2015 - 16:15 | 5748806 buzzsaw99
buzzsaw99's picture

the author must be retarded

Thu, 02/05/2015 - 16:28 | 5748822 orangegeek
orangegeek's picture

VIX has diverged from its low at the recent SPX high.

 

Options aren't buying this move.

Thu, 02/05/2015 - 16:28 | 5748853 ejmoosa
ejmoosa's picture

In 2005 Home Depot made 5.85 billion in profit and had a peak market cap of 93.45 billion.  Long term debt was 2.67 billion. 

In 2013 Home Depot made 5.385 billion in profit and had a peak market cap of 113.85 billion.  Long term debt was 14.67 billion.

As of today, Home Depot has a market cap of 141.7 billion and long term debt of16.70 billion.

So Home Depot trades for more than 50% more than it did in 2005, making roughtly the same amount of profit, and with more than four times the debt.

 

I'll let you draw your own conclusions from there.

Thu, 02/05/2015 - 16:31 | 5748895 orangegeek
orangegeek's picture

I conclude this to be a FULL RETARD market.

 

And in summary, FUCK YOU YELLEN!!

Thu, 02/05/2015 - 16:37 | 5748939 Hitlery_4_Dictator
Hitlery_4_Dictator's picture

I don't belive this. Have the BLS or CBO do thier home work and then get back to me.  Sounds like lies to me

Thu, 02/05/2015 - 16:42 | 5748971 Tsar Pointless
Tsar Pointless's picture

Posers. Just think if Home Depot would have run its debt up to 100 billion. The equity price would be moar better.

Moar=better, all the time.

Thu, 02/05/2015 - 16:57 | 5749049 Consuelo
Consuelo's picture

+100

 

Thu, 02/05/2015 - 16:34 | 5748920 londoncalling
londoncalling's picture

when the risk free return is so low (uk 0.5% base rate) poor yield (extreme p/e) in stocks is easier to swallow

when the risk free return is higher stocks at the margin will be less appealing and less generously bid

for all the conspiracy i guess it's really that simple

when rates rise (not if, they will, could be 3 months could be three years)

investors will want to pay less for stocks

signs of hawkishness and stocks falter, signs of dovishness stocks find a footing

my guess is we eventually get slighlty higher rates and low inflation (deflation) ie higher real rates and stocks shit the bed

Thu, 02/05/2015 - 16:40 | 5748959 Tsar Pointless
Tsar Pointless's picture

Well, all I know is the S&P has risen 82 points off the lows this past Tuesday, and all macro signs have been awful.

Therefore, S&P 2150 must surely be within our sights.

Thu, 02/05/2015 - 16:49 | 5749011 Osmium
Osmium's picture

Yep, not that far off.  DOW 18k tomorrow just in time for the weekend.  DOW 20k on deck, late Februray or early March?

Thu, 02/05/2015 - 16:52 | 5749026 Osmium
Osmium's picture

Eventually Crater.

ummm,, is that going to happen in my lifetime?  Been hearing this for six years now.

 

Thu, 02/05/2015 - 16:54 | 5749040 Consuelo
Consuelo's picture

"Then the ultimate deflation will happen as PE multiples shrink back to reality."

This assumes that a true, market clearing event will be ALLOWED to happen.   What do the past (7) years of intervention into the markets tell us about what will and will Not be allowed to happen...?

Thu, 02/05/2015 - 18:00 | 5749345 alangreedspank
alangreedspank's picture

The Fed will eventually get sidetracked by markets. An example in case, when Russia raised rates lately to strengthen the currency, the market called BS and dumped the rubble anyways.

It CAN happen, but the Fed is the central bank with the most "credibility" and they are abusing it. 

Thu, 02/05/2015 - 17:41 | 5749256 Matthew John
Matthew John's picture

Just BTFD!

Thu, 02/05/2015 - 18:22 | 5749445 Helix6
Helix6's picture

I don't think all the sheep are in the fold yet.  Not time to start shearing yet...

Thu, 02/05/2015 - 19:12 | 5749647 runnymede
runnymede's picture

+1. Then shall your journey to the dark side be complete

Thu, 02/05/2015 - 19:34 | 5749718 ArtOfLife
ArtOfLife's picture

What is Gold's P/E?

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