When discussing the current stock market valuation, so many people tell me that since current earnings are putting the market at 15 times earnings, I am off my rocker for thinking it’s overpriced. What people always forget is that the current profit margin as a % of GDP is at 11%, which is almost double the historical average. Of course, everyone wants to extrapolate that out, but when looking at profit margin levels in the last 10 years, this 11% rate is even an anomaly.
So I ask this question: Back in 2008, the earnings on the S&P 500 got as low as $13 per share, I believe. If you extrapolate out a 15X earnings on that, historically, it said the S&P 500 should have been at 195. Instead it bottomed at 666 or so. So was the 666 level really worth 3.5 times more than the market should have been selling at? Of course not, and no one who I ask that question to says it was. Their response is some variation of “Well, that was an extreme one time situation.” Why can’t the same extreme one time situation occur on the upside too!?!?!
Every other Friday, I teach a class at my old high school where I teach investments. One of the analogies I always make is that if you were always a C student but suddenly, you got an A on a test because the teacher let you use an open book, are you going to apply to colleges and say you are a straight A, 4.0, student? Of course not!
If you are a solid 4.0 student and all of a sudden you forgot, from some fluke occurrence, that you had a test today, and upon taking it, you earned an F, is your high school going to kick you out for poor grades?!?! Of course not. Yes yes, one test may be too short of an example, so make it 1 quarter of grades…1 semester…1 year. Whatever. The bottom line is that if your fundamental study habits haven’t changed, why would your outlook change drastically?
There are good years and bad years in everything in life. This is why we can’t extrapolate one good year to infinity and beyond and we can’t extrapolate one bad year to infinity and beyond. You have to look at fundamentals of why things are the way they are. If there is a shift in some sort of supply or demand, then I can understand that.
But that’s not the case here. In fact, the thing driving profits is low interest because of massive Fed spending. We can all agree that that will not occur in perpetuity. Well, we don’t know that for sure, but every time it does happen, it leads to bad economic outcomes which would then, in turn, drive stocks down.
Please don’t think short sided when things are GOOD or BAD.