Just about all of the analysts are calling for only single-digit returns for stocks in 2020. We shouldn’t just take their word for this though, and look into the matter more deeply.
The much more modest outlook for the stock market that just about everyone is predicting for the coming year is actually pretty easy to figure, as everyone is making their concerns and their reasons for this prediction pretty clear.
It all comes down to their belief that the ratio between the price of stocks and their earnings has become overextended. If such a thing were indeed an influential factor, we would see our current level of enthusiasm muted, with price gains being constrained by the current ratios, given that it is believed that they are not likely to increase further.
To make any sense of this, besides just accepting this to be true, we’re going to have to look at the relevance of this belief to see if it has any merit or not.
There are two main ways this ratio is used, which is to use the next 12 months’ earnings projection or the previous 12 months. It makes more sense to use real data than predicted data though, and this is all relative to price, so this is what we will use here for our price-to-earnings comparison.
The first thing that we need to do in order to understand all this is to first examine what this ratio tells us. If price followed earnings exactly, this ratio would be a constant, and it therefore measures deviations in price from earnings.
It is far from a constant of course, and we actually see quite a variation in these ratios, both among stocks and over time. We are over 24 now with the S&P 500, and while this ratio has risen from 13 back in September 2011 to almost twice as high today, this only represents the bullish outlook that we have been in, where we have been more and more willing to extend price beyond earnings.
Current earnings really don’t have that much to do with a stock’s price though, as this is not the reason people invest and continue to want to pay more for stocks over time. The main reason is that they expect the price to go up. The goal isn’t to grab a piece of a company’s profits, it’s to profit ourselves by seeing the stock price rise, where earnings growth may help us achieve our goal but is not the goal in itself.
The best way to understand this relationship is to assume that a stock’s price will rise or fall in accordance with its earnings generally, but is also influenced by a number of other factors, the sum of which gets expressed by the differential between price and earnings growth. This differential is not some sort of anomaly, it plays a fundamental role in deciding the direction and magnitude of moves.
Whatever differential that we end up with ends up telling the real story of what is going on, where if we just look at earnings, we will only get part of the picture. Investing already requires us to deal with incomplete information, but we don’t want to make it a lot more incomplete by ignoring a big part of the story that is being told to us, and rely instead on a very incomplete model that does not tell us that much in itself due to all the variation that manifests, and then wonder why we end up wrong so often.
Save from in 2018, when we gave back ground and put this ratio down for a time, the ratio has been steadily rising throughout our long bull market, after a period of adjustment over the first two years where stock prices caught up to earnings. Is there a good reason why it will stop here though?
It would seem natural to want to look at a chart of these ratios to see how this has played out over the years graphically, and when we do, we do see what we could call price-to-earnings resistance right at the area we are at now. That in itself should not serve to persuade us though, as we have to look at the legitimacy of this data first.
If We Want to Use History, We Need to Place it in Context
We can start by considering the first three peaks in the low to mid 20’s, in 1933, 1946, and 1961. This truly is ancient history though, and a time where market momentum played far less of a role than it does today. We didn’t have the big machine we have now back then, with so many people investing and so many companies buying back their shares.
The next trip there was in 1992, which was at least much more recent, but still pretty dated compared to almost 30 years later. We did bust through this finally in 1999, and we all know what happened next, as this was indeed a case of things being overextended, especially in the tech sector where this number was much larger at that point in time.
We blew the doors off this ratio in 2008, but this time it wasn’t caused by a runup in stock prices, it spiked due to the recession causing earnings to drop so much. Prices took longer to catch up as they tend to do, and when prices go down and the ratio goes up, can be a useful indicator, not that we should ever need one when prices are sinking like this.
We’re back to the mid 20’s again now, and it may seem that this should tell us to be careful and that we probably can’t take this number much higher. Based upon this, those calling for stock prices to move up more in line with the expected earnings growth seem pretty reasonable and perhaps even probably right.
The key to understanding why this may not be the case rests with understanding that we are never comparing similar situations when we look back at how these ratios have moved in the past, and today’s situation is indeed pretty distinct.
The few of us that are not willing to just accept the likelihood of a mediocre year are looking at 2020 and comparing it to other years in terms of not just the ratios, but overall. One of the key elements in seeing an expansion of price fail is that seeing stock prices rise beyond a certain point also tends to go along with rising inflation, and this normally serves as a natural roadblock to going too far beyond the normal highs that we see.
We do not have this affect at all now, and far from it, as the Fed wrestles low inflation to try to keep it up enough for their liking. The Fed hates inflation normally, but also does not want it too low either. It isn’t too low now, but barely not.
This allows stock prices to grow naturally without being fettered by macroeconomic concerns. We can even think of the Fed as the villain of this play, where the economic growth that has driven up stock prices starts to run too hot, and the brakes then get applied, putting the brakes on stock growth as well as the economy.
There are not any natural limits at all to stock prices, and something has to interfere to break our enthusiasm before it actually gets broken. The mere fact that things have broken down in the past in an area does not in itself cause it, it is caused by other factors, and we don’t have these other factors present now, save for the risk of tax increases in 2021, which may weigh in on 2020 results if the wrong person gets elected.
This has nothing to do with the price-to-earnings momentum that we have now, and our risking hawkish monetary policy to curb it, as the skies are perfect right now on that front. While we cannot say for sure that we will get a double-digit market return this year, we certainly have the potential for it if not interfered with by significant events outside the market, to the point of making this likely.
Price-to-earnings considerations therefore should not be expected to be a limiting factor, and while it is true that some investors back off in the face of this and therefore this prophesy is somewhat self-fulfilling, these forces are not enough to slow the train down very much should it wish to chug on.
We just need to stay away from things that will constrict the economy too much, the opposite of what we’re trying to do with this rate stimulus. If things remain rosy on this front, there isn’t really anything stopping us from going to 30 and beyond right now, even though that was the area that we were in during the crash of 2000.
These are different times, and in the present, it’s hard to imagine a better situation if you are rooting for stocks to go up, given how stable and favorable our economy is currently balanced.
As Long as We Hear the Drums Beating, the Beat Goes On
Meanwhile, the people who want to pay more and more for stocks are still at it, and we don’t want to be putting up stop signs where they don’t belong.
It pays to think about things a little more than others are, and there are people out there who have done so and are in a position to actually interpret all of this, even though their numbers may be so few. We wouldn’t think that it would be so hard to look at your assumptions and try to distinguish how the present may differ, but once an idea becomes so entrenched it becomes difficult to escape it.
We need to break free of current ideas of overvaluation and undervaluation when describing price-to-earnings ratios, as we so often point out in our articles. This is where the idea gets off track, and if we instead looked at this as a measurement of investor optimism, then and only then will we be ready to look at current levels of this and see if this is sustainable, not based upon what may have happened many years before, but what is happening now.
The end of increasing optimism expressed by increasing ratios may be near, but we can’t just rule it out because we assume there is some invisible hand that will step in and put a stop to it without any underlying causation. We need to take a closer look at this alleged force, and when we do, we see that it has no real power in itself and is just measuring the impact of other events, and it’s the other events that therefore matter.
In any case, as long as this momentum continues, we are wise to continue to ride it and see where it takes us, and expanding this ratio further is certainly not out of the question, if we choose to do it that is.