Everybody is entitled to his own views but you can’t have your own facts. Between 2009 and 2012, I regularly posted to verify and often correct articles from notorious and not-so-notorious bears who were manipulating facts to fit their views. The one who kept me busy during those years was Dr. Doom, Nouriel Roubini, who proved prescient before the Financial Crisis but who pushed his luck a bit too much afterwards.
After a ten year bull market, we have gone 180 degrees with pundits and the media which are now more prone to talk and write bullishly, sometimes manipulating the facts to fit their views.
My old friend I. Bernobul sent me a note after reading this WSJ oped on January 11:
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Tax Reform Has Released the Bulls P/E ratios may seem high, but policy changes augur much better earnings in the coming years.
(…) By traditional measures of value, stocks do seem expensive right now. But those metrics have flaws, the worst of which is a tendency to look at the past rather than the future. Markets, by their nature, do the opposite.(…) what counts isn’t last year’s earnings, it’s next year’s—and all the years to come. (…)
One way to solve this problem is to use earnings estimates for the year ahead in the calculation. By that measure, today’s P/E ratio is a bit above average, but nothing scary. It’s well below the figures for 1999 and 2000, during the tech bubble, and generally consistent with the levels that obtained from the late 1950s to the early 1970s.
The facts are that the average P/E on forward EPS is 14.7 since 1927 and 15.4 since 1957, including the truly scary levels of the tech bubble and the Financial Crisis. At 17.9x (black dot), the current forward P/E is 16-22% above its long-term average and just about at its historical peak, excluding, of course, the dotcom and FC eras.
Keep in mind that the chart above uses post-fact data, i.e. the actual one-year-out earnings whereas we are now using one-year-out estimates. Analysts have a demonstrated tendency for earnings optimism early in the year. McKinsey & Co. calculated that between 1985 and 2008,
(…) analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent. Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession. On average, analysts’ forecasts have been almost 100 percent too high.
Analysts have thus been 4-6% too optimistic on average since 1985 which makes the current P/E of 17.9 equivalent to 18.8 if we apply a 5% discount factor. 
Let’s review the past periods when forward P/Es reached current levels:
- 06’59 to 03’62: the forward P/E (FPE) reached 17.9 in June 1959 after the S&P 500 rose 45% in 18 months thanks to sharply declining inflation and interest rates more than offsetting a 15% drop in EPS. Equities then marked time until December 1960 (18 months) on flattish earnings and rising inflation before jumping 24% in 1961 even though earnings declined a little and interest rates rose a little. The FPE reached 19.7 in November1961, exactly one year after the election of John F. Kennedy. During the first 6 months of 1962, profits, inflation and Fed funds rate rose while the S&P suddenly tanked 25% to a FPE of 14.3.
- 1969: the FPE reached 18.0 again in November 1968 after a 2-year 40% bull run and remained there until December 1969. Earnings were essentially flat during 1969 but inflation rose from 4.4% to 5.9%. Fed funds rates were jacked up from 6% to 9% while 10Y Treasury yields rose 170 bps. The S&P 500 corrected 15% during the year but lost another 20% during the 1970 recession.
- 02’91 to 06’92: in typical fashion, equities troughed 6 months before the end of the recession in April 1991. Earnings were still declining when the FPE reached 18 in February 1991. It stayed between 18 and 20 until June 1992, just after profits bottomed. Inflation peaked at 6.3% in October 1990 and declined to 3.0% in mid-1992. The Fed dropped its Fed funds rate from 7.7% to 4.6%. Equities rose strongly throughout 1991 and 1992 on their way to the historic dotcom bubble but not before FPEs went back to 12 at the end of 1994 after profits jumped more than 50% and inflation stabilized between 2.5% and 3.0%.
- 04’97 to 08’2002: it is important to recall that inflation declined from 3.3% in December 1996 to 1.4% in April 1998, bringing 10Y Treasury yields from 6.9% in mid-1996 down to 4% in October 1998, setting the stage for the initial 40% equity rally even though earnings remained nearly unchanged. EPS started rising strongly in Q4’98, clocking a 30% gain by Q2’2000 when investors were looking far beyond internet companies’ losses with psychedelic glasses. From April 1997 when the FPE reached 18 to August 2000 when it peaked at 35, the S&P 500 Index appreciated 90%. By the time the FPE dropped back below 18 in September 2002, the S&P 500 had returned all its previous gains.
There were thus only 4 episodes of forward P/Es at or above current levels during the last 60 years. Three ended badly for investors. The friendlier 1991-92 episode was right after the 1990-91 recession and featured sharply lower inflation and interest rates.
Mr. Luskin is not scared by the current lofty levels, relying on forward earnings and his expectations of powerful economic side-effects from the tax reform.
- First, let’s recall that earnings estimates for 1991 and 1992 proved to be 30-35% too high while those for 2001 and 2002 were some 40% overoptimistic.
- Second, economic forecasts have also proven to be generally way too optimistic.
- Third, the fiscal stimulus stemming from the Trump tax reform is ill-timed, coming when the economy is reasonably strong and unemployment near a cyclical low. Given the already stretched resources, inflation could come back to haunt both investors and the Fed.
- Fourth, Mr. Luskin totally avoids talking about the risk associated with the fact that this tax reform will increase the deficit of an already indebted U.S. by $1.5T over 10 years. Let’s really hope there is no recession for a while.
He concludes with:
Once again, it’s policy, not valuations, that is determining stock prices.
Mr. Luskin is right mentioning the importance of policy. But history clearly demonstrates that monetary policy always trumps fiscal policy. This is not post recession 1991-92. This is year ten of an economic recovery with rising inflation risks and a Fed determined to normalize interest rates.
