Back in January 2012, all was well with the centrally-planned world: Gluskin Sheff's David Rosenberg was staunchly bearish, while his arch-nemesis, Wells Capital's Jim Paulsen, was the opposite. This rivalry culminated with Rosenberg writing an extensive breakdown of his showdown with "bullish strategist" Paulsen at a CFA event (see "David Rosenberg Explains What (If Anything) The Bulls Are Seeing") in which he said that the one thing that he could "identify as market positive" was valuations, to wit: "we do understand that P/E ratios at current low levels do serve up a certain degree of confidence that there is some downside protection to the overall market here."
Fast forward three years, and the world, while still centrally-planned more so than ever now that the BOJ has and the ECB is about to join the massive monetization fray, has been thrown into conventional wisdom turmoil. The reason is that while David Rosenberg infamously flip-flopped from bear to bull (because somehow, somewhere he foresaw rising wages) in the early summer of 2013, none other than Jim Paulsen has just thrown in the permabull towel and in a letter to Wells Capital clients titled "Median NYSE Price/Earnings Multiple at Post-War RECORD", admits that the market is about as overvalued as ever, based on numerous criteria but mostly due to the median (not average) P/E multiple surging to fresh all time highs!
Incidentally this is not new to regular readers: it was almost exactly one year ago, on January 11, 2014, when we wrote that as Goldman then stunned its bullish fans that "The S&P500 Is Now Overvalued By Almost Any Measure" adding that "the current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock." Incidentally Goldman stuck with its call for about 6 months, until July, when Goldman on one hand admitted that the market was still about 40% overvalued, but because it had to goal seek what now appears relentless central bank multiple expansion at all costs, it raised its S&P500 year end target from 1900 to 2050 despite numerous repeated warnings that there is now far too much downside risk in equity valuations.
In any event, it is now Wells Capital's turn to point out what many have known for about a year, and while for the major part Paulsen's take can be summarized as: stocks are massively overvalued but in this fake, centrally-planned world this is not a sell signal but merely "indicates vulnerability." Because nobody, and we mean nobody is willing to put their neck, or year end bonus, on the line and comment that screaming overvalued fundamentals are a sufficient and necessary case to sell risk in a world in which any time there is a 10% 5% correction, some central banker makes "soothing noises" and we have a instantaneous V-shaped recovery.
With that caveat in place, here is what Paulsen sees as a screaming case of if not selling everything with both hands and feet, then at least politically correct, central-planner "vulnerability."
The S&P 500 begins the new year with a price/earnings (P/E) multiple of about 18 times trailing 12-month earnings per share. This represents a valuation higher than about 74% of the time since 1945. While a relatively high valuation, it remains far below its post-war record of more than 30 times earnings in early 2000, and as recently as the 1990s, the stock market delivered nice returns from valuation levels at or above today’s P/E multiple.
Most U.S. stocks, however, are much more expensive than suggested by the S&P 500 Index. The median New York Stock Exchange (NYSE) stock is currently at a postwar record high P/E multiple, a record high relative to cash flow, and near a record high relative to book value!
This is not the first time there has been such an unprecedented diversion between the mean and median, albeit in the opposite direction: "In the late 1990s, surging technology stock prices caused the overall S&P 500 P/E multiple to reach record highs even though the median stock’s P/E multiple never became excessive. Conversely, today, although the S&P 500 P/E multiple remains far below record highs, median valuations are at a pinnacle. Whereas most recognized the headline S&P 500 P/E multiple was at a record high in 2000, far fewer are aware of just how expensive the median stock is today."
Some further details:
"[A]s Charts 2, 3, and 4 show, the median U.S. stock is indeed much more aggressively priced than is widely perceived. These charts were derived from an extensive online database compiled by professor Kenneth R. French recording annual calculations (for June of each year since 1951) for the median NYSE stock’s P/E multiple, price to cash flow multiple, and price to book value ratio. As of June 2014, the median U.S. stock was priced at a post-war high at slightly more than 20 times earnings! Similarly, at about 15 times, the median stock is also currently priced at a record high relative to cash flow. Finally, the median price to book value ratio has only been higher than it is currently in two years since 1951 (in 1969 and in 1998 which were both followed by significant declines)!"
The charts in question:
Some more on the unprecedented shift in stock valuations just over the past two years:
Chart 6 highlights just how much the valuation profile of the U.S. stock market has shifted in the last few years. The black bars represent the current ranking of each fifth percentile P/E multiple among all NYSE stocks relative to the entire 64-year history since 1951. Today, values across the stock market are extremely high relative to historic norms. The fifth to 40th percentile P/E multiples in today’s stock market rank number two among all 64 years, the 50th to 70th percentile P/E multiples are the highest of any year since at least 1951, and the 75th to 95th percentile P/E multiples currently rank between second highest to sixth highest!
The gray bars illustrate the valuation profile in 2012. Between June 2012 and June 2014, the overall U.S. stock market went from most stocks being priced only slightly above average to almost all stocks being priced near post-war valuation records.
Ironic, because late 2012 is roughly the time Rosenberg was starting to turn bullish.
Sarcasm aside, what, according to Jim Paulsen, are the implications of this record fundamental overvaluation?
- First, the valuations of U.S. stocks are much higher today than widely perceived or as suggested by the valuation of the popular S&P 500 Index. Moreover, today’s valuation extreme is not limited only to a subset of stock market sectors but rather is very widespread whereby nearly all P/E multiple percentiles are at or close to post-war records. Finally, the current valuation extreme is not the result of poor performance from a single valuation metric. U.S. stocks are broadly and richly priced compared to earnings, cash flows, and book values.
- Second, because valuation dispersion is relatively low today, there are not many areas to hide from overvaluation. In 1973 or 2000, investors could reduce extraordinary valuation risk by simply diversifying away from the Nifty Fifty or new era tech stocks. Today, because values are both high and tight, lessening valuation risk may not be possible except by allocating away from U.S. stocks.
- Third, this valuation extreme has only recently materialized. Charts 2, 3, and 4 show that until 2014, although median stock valuations were relatively high, they were not at the acute or record highs they are at today. Indeed, the current excessive valuation profile is a product of this recovery cycle. The median U.S. stock began this bull market below 12 times earnings in 2009. In the last five years, however, the median P/E multiple has risen by about two-thirds to slightly more than 20 times earnings. It is important for investors to fully appreciate just how much this bull market has already elevated the valuation landscape.
- Fourth, is the current widespread valuation extreme more dangerous than a concentrated extreme simply because concentrated extremes tend to be more obvious and eye-catching? When the Nifty Fifty or dot-com stocks exploded to outlandish P/E multiples, most investors realized the stock market was getting a bit frothy. Today, even though a larger portion of the overall stock market is aggressively priced, it has not garnered nearly as much attention. A concentrated valuation extreme tends to loudly announce itself whereas a broad-based valuation extreme seems more stealth and, therefore, perhaps more dangerous.
- Fifth, how important have record low bond yields and a zero short-term interest rate throughout this recovery been in producing the contemporary broad-based stock market valuation extreme? And, how will this highly valued stock market react should U.S. interest rates soon finally start to rise? Many believe since interest rates are so low today, they could rise for some time before negatively impacting the stock market. However, what if today’s widespread extraordinary valuations actually make the stock market much more sensitive to interest rates?
- Sixth, historically when the valuation of the median NYSE stock has been as high as it is today (e.g., from Chart 2 consider 1962, 1969, 1998, 2000, 2005, and 2007), the overall stock market has usually either suffered an outright bear market (i.e., in 1962, 1969, 2000-2001, and 2007-2008) or a correction (i.e., in 1998). Only in 2005, from a similar median stock valuation, did the overall stock market avoid a correction or bear market until 2008. At a minimum, this historic record suggests investors should proceed with greater caution.
- Seventh, the current valuation profile of the U.S. stock market argues in favor of S&P-like indexation. When the stock market is characterized by a concentrated valuation extreme (like during the early 1970s Nifty Fifty or the late 1990s dotcom eras), investors are best served by avoiding indexation. Often, however, during such stock market manias, investors become frustrated by being unable to match the strong advance in the S&P 500 Index and ultimately are enticed to simply index. For example, during the late 1990s, just as valuation risk became acute among the S&P 500 stocks, more and more investors piled into S&P 500 Index funds. Today, by contrast, some exposure to indexation seems reasonable. The S&P 500 Index may possess less valuation risk than does the median U.S. stock. While the median P/E in Chart 2 is at a post-war high, the S&P 500 market-cap weighted P/E multiple is still far from an extreme.
- Eighth, overweighting international stocks may be an approach to diversify away from the widespread valuation extreme evident in the U.S. stock market. Perhaps international stock markets also are highly valued today. However, since most have significantly underperformed the U.S. stock market in recent years, international markets are far less extended on a valuation basis.
... rather than suggest an imminent bear market, the widespread overvaluation of the U.S. stock market mostly indicates vulnerability. Since last summer, the S&P 500 Index has now suffered four significant selloffs. When the median stock is at a record valuation level, is the overall market simply more vulnerable to potential risks (be they fearing a deflationary spiral, eurozone woes, an oil price collapse, or potential changes in Fed actions)? Until the extreme valuation character of the median U.S. stock improves, the stock market may simply struggle to make consistent gains. This could, of course, be resolved by a correction or a bear market. Alternatively, simply a flattish stock market this year while earnings continue to rise may be enough to refresh median P/E valuations for 2016.
And that completes the world's bizarro transformation, because former permabull Jim Paulsen has now become the voice of skeptical rationality, even as David Rosenberg has trown all caution to the wind, and continues to cheer each and every uptick in the S&P with a CNBC appearance, seeing only a future in which nothing can possibly dent the Birinyi ruler extrapolation to +infinity.
Whether Paulsen is wrong or right is irrelevant, and yet the fact that such flip-flopious analysis even takes place is a testament to just how perverted the "markets" have become courtesy of every central bank's no longer invisible finger. We expect an answer will materialize in due course, but until then we sit back in a comfortable chair and await as David Rosenberg comes up with his 3 years later retort why "bearish strategist" Paulsen couldn't be more wrong, or something about how the Wells Capital pundit "should subject himself to a New Year’s resolution: show respect because there are in fact two sides to every debate."