State of Today's Markets
The market currently is overvalued by all measures. The P/E ratio of S&P 500 is at an all time high and is at the levels not seen since 2007. Another way to look at if the market is overvalued is using the CAPE ratio of S&P 500. CAPE stands for Cyclically Adjusted Price to Earnings ratio and is devised by Robert Shiller, the famous economist at Yale university. So, CAPE is also popularly known as Shiller P/E ratio. CAPE or Shiller P/E currently stands at 29. This is higher than 2007 levels. You can check the CAPE P/E ratio of any given day by using the link below,
http://www.multpl.com/shiller-pe/
What is then driving today's market extreme valuations?? To understand that first, we need to understand why does a stock increase in price, to begin with??
When you buy a stock of a company, you are not buying a paper. The ease of buying and disposing of the stocks or securities through online brokerages makes you to easily believe that. Instead, when you are buying a stock of a company, you are actually buying a piece of business of that company. That makes you an Investor in the company. Warren Buffett motto is to not buy a stock in the company unless you are willing to buy the whole company. If you are not willing to buy the whole company then there is no reason why you should even buy 1 share of the company. The logic that applies to multiple thousands of shares also applies to a single share of a given company.
What makes you invest in a business??
If there is a business that meets the above criteria, automatically there will be multiple people interested in buying that business. That increased demand will cause an increase in share price.
Now, this is all true if the markets are truly efficient. There was a time in 1970 and 80's when economists believed in EMT (Efficient Market Theory). Contrary to their belief, markets are frequently efficient and not always efficient. I think we are in a time now where in the markets are not efficient and the share price of many companies is not in sync with the intrinsic value of their business.
What is causing this disconnect??
The prolonged presence of money in the market at the extremely low interest rates since the great recession of 2007-2009. When the interest rates are this low, companies can easily borrow money for capital investments and at the same time restructure their existing Debt obligations to decrease the interest payments. This will translate into increased earnings per share. In addition to that, a lot of companies used the extra cash generated or borrowed to repurchase common stock of their own companies. This aggressive buyback of shares increased the earnings per share considerably resulting in an increase in stock prices. S&P 500 companies have spent about $2.41 trillion on buybacks over the course of the current bull market, according to S&P data, compared with a $2.37 trillion rise in the Fed’s balance sheet since the start of QE.
In addition to the capital returns to stockholders thru dividends and stock buybacks, a slew of merger/acquisition activity also put a premier price tag on many of the businesses. Please note that I will be using the term business or company interchangeably as they both mean the same to me. 2015 is the biggest year ever in a worldwide deal making, with $4.7 trillion dollars in announced mergers and acquisitions up 42 percent from 2014, and beating the previous record of $4.4 trillion dollars set in 2007.
Last but not least is the animal spirits that are causing the market to ratchet up to unseen levels before since the election. Election of Donald Trump is a major cornerstone in the history of the country and also to the history of stock markets. Even though no one can guess how it is going to end in 4 or 8 years, his election as a president has generated significant euphoria in the markets. The euphoria is not without reason. The following promised policies of his are causing this upswing,
Markets today have already priced all the above positive things into the rally. So, any failure on the part of Trump administration in fulfilling these promises will cause a drastic fall in the markets.
I would like to end this with one of my favorite quotes of Warren Buffett (my guru) that I feel is apt for these markets.
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful - Warren Buffett"
http://www.multpl.com/shiller-pe/
What is then driving today's market extreme valuations?? To understand that first, we need to understand why does a stock increase in price, to begin with??
When you buy a stock of a company, you are not buying a paper. The ease of buying and disposing of the stocks or securities through online brokerages makes you to easily believe that. Instead, when you are buying a stock of a company, you are actually buying a piece of business of that company. That makes you an Investor in the company. Warren Buffett motto is to not buy a stock in the company unless you are willing to buy the whole company. If you are not willing to buy the whole company then there is no reason why you should even buy 1 share of the company. The logic that applies to multiple thousands of shares also applies to a single share of a given company.
What makes you invest in a business??
- Business should be generating cash
- Business should have significant competitive advantage. In Buffett words, business should have a "moat"
- Business should have no or a very low debt. Low debt ensures that company can ride through economic downtimes without risk of bankruptcy.
- Business should be shareholder friendly.
- Business should be run by an efficient management team
- Business exhibiting consistent growth over a long period of time. Usually, the past 10 years is a good indicator in judging performance.
If there is a business that meets the above criteria, automatically there will be multiple people interested in buying that business. That increased demand will cause an increase in share price.
Now, this is all true if the markets are truly efficient. There was a time in 1970 and 80's when economists believed in EMT (Efficient Market Theory). Contrary to their belief, markets are frequently efficient and not always efficient. I think we are in a time now where in the markets are not efficient and the share price of many companies is not in sync with the intrinsic value of their business.
What is causing this disconnect??
The prolonged presence of money in the market at the extremely low interest rates since the great recession of 2007-2009. When the interest rates are this low, companies can easily borrow money for capital investments and at the same time restructure their existing Debt obligations to decrease the interest payments. This will translate into increased earnings per share. In addition to that, a lot of companies used the extra cash generated or borrowed to repurchase common stock of their own companies. This aggressive buyback of shares increased the earnings per share considerably resulting in an increase in stock prices. S&P 500 companies have spent about $2.41 trillion on buybacks over the course of the current bull market, according to S&P data, compared with a $2.37 trillion rise in the Fed’s balance sheet since the start of QE.
In addition to the capital returns to stockholders thru dividends and stock buybacks, a slew of merger/acquisition activity also put a premier price tag on many of the businesses. Please note that I will be using the term business or company interchangeably as they both mean the same to me. 2015 is the biggest year ever in a worldwide deal making, with $4.7 trillion dollars in announced mergers and acquisitions up 42 percent from 2014, and beating the previous record of $4.4 trillion dollars set in 2007.
Last but not least is the animal spirits that are causing the market to ratchet up to unseen levels before since the election. Election of Donald Trump is a major cornerstone in the history of the country and also to the history of stock markets. Even though no one can guess how it is going to end in 4 or 8 years, his election as a president has generated significant euphoria in the markets. The euphoria is not without reason. The following promised policies of his are causing this upswing,
- Tax Reform. Corporate tax rate in the US is 35% and is highest among the industrialized nations. To encourage multinational companies to invest in America, Trump plan is to cut the corporate tax to 15%
- Repatriation of Overseas parked money.Multinational corporations based in U.S have a whopping $2.1 trillion parked overseas.The new plan will offer companies a one-time 10 percent repatriation tax rate to bring offshore capital back home and spark reinvestment in U.S. equities, facilities and jobs.
- Regulatory Reform. Federal regulations are an enormous drag on business creation and growth.Compliance drains small business capital, reduces profits and impedes revenue growth.While he makes no specific mention of Sarbanes-Oxley, that legislation, in particular, has contributed to a dramatic long-term decline in the number of IPOs and publicly traded companies. Similarly, the cost of Dodd-Frank compliance has made it harder for smaller institutions to compete in the financial sector.
Markets today have already priced all the above positive things into the rally. So, any failure on the part of Trump administration in fulfilling these promises will cause a drastic fall in the markets.
I would like to end this with one of my favorite quotes of Warren Buffett (my guru) that I feel is apt for these markets.
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful - Warren Buffett"
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