Absolute or relative terms?
2000… The figure sounds like that of the new millennium (which was not recently!). It has the beauty of round numbers. 2000 is also the level hit this week by the S&P 500 index, an emblematic threshold, which invites us to reflect on the flamboyant health of US equities.
So much ground has been made up since the rock-bottom levels reached in 2009! In that year, on 6 March, during a turbulent day’s trading, the index plummeted to the level of 666 points: another symbolic figure, a palindrome (for fans of literary games) or the sign of the Devil for readers of the Apocalypse. But that’s enough ranting about numerology, let’s replace the recent rally in the US flagship index in stock market history.
200% growth over five years has clearly been a major upswing, albeit not the most spectacular ever seen in bullish markets. Note that bullish markets are described as being periods of growth during which retracement phases do not exceed 20%. Among the most memorable increases in the past century were the +495% for the Dow Jones from 1920 to 1929 or the +587% seen over 1987-2000. These both had the common factor of ending in a valuation bubble. Both of these growth records were also far greater in amplitude and far longer in duration than the current trend, but the latter has not run out of steam yet!
This historical reference made, we can now fine-tune the reading of the recent index rally by breaking it down. Over the past three years, 30% of the index growth has stemmed from earnings growth at the underlying equities, with the remaining 70% stemming from the hike in multiples (1). To speak of the most emblematic among them, the price/earnings ratio (2), currently stands at 19 in the US (meaning that the share is worth 19 times earnings per share). By adjusting this same multiple for the economic cycle (the ratio is calculated by using the average earnings per share over the past 10 years), the figure jumps to 26. Here the historical reference is not reassuring, since the long-term average of this ratio stands at 18: US equities are clearly not cheap.
Should we sell them off? The temptation is there, but a relative reasoning seriously nuances the conclusion. For the past two years, the yield on equities has been very clearly higher than that on their debt. An emblematic example: the dividend yield on McDonald’s stands at 3.5% whereas the company can borrow at less than 2% over five years. Comparisons are probably even more flattering in Europe, where bond yields are lower and dividends are higher. Seen from this angle, the bond market seems more expensive whereas equity valuations seem more reasonable.
Expensive in absolute terms, cheap in relative terms, US equities can be described in the neat sentence attributed to Talleyrand: “When I examine myself, I am worried. When I compare myself, I am reassured…”
Marc Craquelin
(1) On unchanged earnings, if a share’s P/E increases, the price of this share increases. This is known as market growth by higher multiples.
(2) Price Earnings Ratio (PER or P/E for short): also known as the “ratio of price to earnings” is calculated by dividing the market capitalisation by net profit.