A Reader Question: When Will Equities No Longer Be Expensive?

An excellent question, not an easy answer.

I /we have been trying to tell anyone who would listen for some time now (especially last April, May, June, July... December) that low interest rates had given investors a sense of complacency. Many said: even if the Fed raises rates, what is a quarter of one percent?

What we always stressed were the underlying fundamentals: prices of shares were not representative of earnings (or company value) and that as long as companies preferred to buy back there own shares, they were not investing in long-term earnings growth, they were pushing the price of their shares higher to satisfy investors / shareholders.

Investors are very happy when share prices go up, but when they start to go down, not so much and they lose patience quickly.

So, to get to the question at hand:

The simple answer is: either when earnings start to rise or when prices come down to a more reasonable level (or a combination of both).

Lately analysts have been continuing to lower their earnings estimates, but if all goes as expected we will likely see a 3rd quarter of declining earnings growth because revenue growth has been on the decline for all of 2015.

In picture format, when the green dotted line (prices) reaches the blue solid line (earnings), that would be neutral. As the green dotted line as been above the blue line since 2013, equity prices have remained expensive over that period. At the time, many told us that it was justified and that earnings would catch up as the economy picked up and resisted the idea of caution. Some of those were at the same time, rather vocal about the overvalued housing market. In my former job I was out-voted on my caution. So I got a new job (where I own half the company) where my caution was appreciated and where our (my business partner, Paul and my) money is invested in the same models as our clients.

The ratio of share prices to expected earnings (over the next 12 months) reached a peak of a little over 17 times in May of 2015. Very expensive, but has fallen recently as equity prices have fallen to closer to 15. At the moment, the 10 year average is near 14. So based on that metric, we have still some room to the downside. Back in 2011, the green dotted line was actually below the blue solid line and equity prices were cheap.

So, it is possible to see prices fall to levels where equities will be cheap if the economy does not grow enough to allow revenues and earnings to grow and investors lose confidence.

Certainly corporations are going to have to do a better job of thinking and acting to facilitate long-term growth to re-establish investor confidence. Share buy-backs using low cost funding (borrowing at low interest rates) is now going to add risk to those who lent them the money for those share buy-backs (and that could possibly exacerbate the situation).

We (investors / traders) have become an impatient bunch, always looking to make money fast and looking for instant gratification. When the short-term runs out, we become frightened at how volatile things become.

So, the answer to the question, ultimately, is: when we finally grasp the understanding that it takes time to build a solid economy and regain true confidence, that is when stock prices will achieve levels of reasonable relative value and volatility will subside.

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