I know, I wrote about this only just last month, but I’ve since come across several graphs that are too interesting not to share. The subject? That the US stock market is overvalued. In my last Graph of the Week on this subject, I cited the Shiller PE, Tobin’s Q and the market cap level as a percentage of GDP, each of which led me to the same conclusion: that the US market has gotten a bit too carried away.
Now of course you can always find reasons why the markets could still move higher, such as strong earnings growth (check), consistently high levels of central bank liquidity (check), the fact that the Republicans have finally come up with a tax reform plan (half check), a lack of cheap investment alternatives (double check) and the fact that demand is greater than supply (duh). In short, it is easy to come up with a convincing scenario to support the claim that stock prices could rise even further. Just because something is expensive, doesn’t automatically mean a correction will occur the month after. Of course, in 1996, we saw a classic example of this phenomenon when Alan Greenspan speculated that Internet company valuations might already have overshot, after which prices tripled on the NASDAQ. In general, valuation certainly plays a role in the long run, but it the short term, it can pretty much be ignored.
With that in mind, here goes part two in the series, ‘Yikes, US stocks are expensive!’.
Earnings growth is nothing spectacular
One very easy way to illustrate the tendency on the part of the US stock market to ignore the real economy is by comparing the increase in the S&P 500 to the growth in earnings of the underlying companies. When earnings rise faster than stock prices, stocks effectively become cheaper because you get more earnings for your dollar. If, on the other hand, stock prices rise faster than earnings, then on balance, stocks become more expensive. In that respect, the graph below leaves little to the imagination. In the last six years, the reported earnings per share rose 22% (an annual increase of 3.3%), while the S&P 500 gained 115%. While I’d be the first to admit that by taking 2011 as the starting point for this graph, I chose the best possible moment to illustrate the effect, that doesn’t really weaken my conclusion that earnings have lagged stock price gains for years.
While the S&P 500 doubled, earnings only grew 20%
Source: Robeco & Bloomberg – August 2017
A second graph which shows, albeit somewhat less directly, the US stock market’s, ‘dominance’, if you will, looks at the weight of US stocks in the MSCI World, the index encompassing a well-diversified basket of global stocks. A decade ago, about 42% of it consisted of US stocks. Since then, that weight has increased to 53%. Given that the share of the US in the world economy hovered for years around 25%, 53% seems a bit on the high side. That’s partly due to the fact that a larger part of the US economy is listed on the stock market, but also certainly due to valuation, or overvaluation, as the case may be. There are no two ways about it: the US is currently the most expensive region for stocks. Remember that this isn’t the first time we’ve witnessed such an overweight, but that was largely due to the dot.com bubble, which mainly affected the US markets. And we all know how well that ended…
Has the weight of the US market hit a new high?
Source: Robeco & Datastream – August 2017
Finally, presenting the graph that earned the distinction of being this week’s graph. This one, which comes from Bank of America Merrill Lynch, shows changes over time in the number of hours of work needed to ‘buy’ the S&P 500. In 2009, during the darkest days of the financial crisis, the average American had to work 33 hours to buy a basket of S&P 500 stocks. That figure has since risen to over 100. Based on the graph, that looks like a record, as even in 2000, the figure was lower. The graph also indirectly illustrates the disparity that exists in the US: whereas the market bounces from record to record, compensation in the form of wages leaves a lot to be desired.
Which, all in all, brings me back to my original conclusion: US stocks are expensive.