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A Note Of Caution - General Equity Market

Tekoa Da Silva
Posted Sep 16, 2018

I write to you today on a subject in which I am a novice observer, that is, the price level of general U.S. Equities (the stock market). Please take my comments with a grain of salt, due to experience. 
The S&P 500, viewed as a representative index of ‘US Stocks’, bottomed in March 2009 at about 666, following the 2008 financial crisis. Following that bottom, the index steadily advanced to 2,876 (where it stands currently) – a rise of over 300%, over nearly 10 years. It is a strong and historically long-duration advance. 
So is this rise normal, and is it cause for concern, in terms of downside risk? 
The total numerical quantity of the move is normal, when viewed historically. Prior markets have exhibited larger total advances than the current one. Moreover, ‘numerical advance’ alone, may not be enough to determine whether a market is priced dearly or cheap. 
A common metric used to gauge valuation of representative indices like the S&P 500 is the ‘PE Ratio’ – which stands for, ‘Price to Earnings Ratio’. This metric looks at annual profits of a business, and divides it against the price of the business. This metric can be applied to rental real estate, a local laundromat, or a convenient store. It simply tells us, ‘How many years does it take to earn my money back’ – based on annual profits generated by the business. 
The current average PE Ratio for companies represented in the S&P 500 Index is about 22x as reported by S&P Global. That figure is based on actual ‘reported’ earnings, as opposed to ‘estimated’ future earnings (which are a guess by companies and analysts as to what companies might make). 
Is a PE Ratio of 22x considered expensive? Looking back over nearly 150 years, U.S. representative stock indices have traded at an average of about 16x earnings. Periods in which the market proved itself to be priced ‘dearly’ – averaged PE ratios north of 19x. This included (or was exemplified by) strong equity markets during 1929, and 1999-2000—both of which experienced large subsequent price declines.

PE Ratio Following High Periods

In Chapter 3 of the Intelligent Investor, “A Century of Stock Market History,” author Ben Graham indicates that corrective periods in equity markets (declining prices), often pull-down average PE Ratios to between 6x-10x earnings. This reversion embodies, “The Rule Of Opposites”—a phrase coined by Graham, suggesting extreme variations in price are often followed by continued extremes—in the opposite direction. 
Indeed, life is a series of ‘Rule of Opposites’ experiences – night follows day, winter follows autumn, upset stomachs follow over-indulgent eating—in other words, periods of abundance are followed by periods of scarcity.
If the PE Ratio is a reliable indicator—what should we do about it? Can it be inaccurate or wrong?
A rebuttal to the assertion of a ‘High PE Ratio’ could be that companies will earn larger quantities of net income (profits) in the future, than is currently reported. This argument is impossible to dispel, as nobody knows for sure, whether a company (or basket of companies) will earn greater quantities of profit in the future, than they do today. All one can do is conclude on a set of probabilities, and measure against the amount paid for such an outcome. 
If one concludes the current PE Ratio prices the market dearly (relative to historic examples of pricing) – they have a few choices. One choice could be doing nothing, comfortable in the viewpoint that over long periods of time, shares of high-quality companies will generate continuous and growing earnings—which will outweigh short-term setbacks. If one is comfortable holding stocks for 10-30 years (without selling), that viewpoint makes lots of sense. 
A person may also wonder about the duration of corrective periods, following dearly-priced markets. History has shown market corrections can be as brief as a year or two before going on to make new all-time highs. However, there have also been markets (such as post-1929), where representative indices required 15-20 years before generating new highs. 
In consulting our dear friend of past-time, Ben Graham – he concludes, in Ch. 3, A Century of Stock Market History, that if one suspects they are amidst a dearly-priced market and wishes to be on-guard, but not fully exit the market—they might consider: 

  1. Eliminating holdings of common stocks ‘On Margin’ 
  2. Pausing increase in any proportion of funds directed to common stocks
  3. Reduce common stocks to half (or lower percentage) of one’s portfolio (relative to bonds, cash, etc.) 

A person may be concerned with inflation risk, also known as Currency Debasement. Over time, representative common stocks tend to be beneficiaries of price inflation, as when pricing of goods and services within an economy increase—so too, do corporate ‘bottom line’ profits. However, that process takes time as companies adjust. Monetary debasement is one method to decrease PE Ratios of representative Indices, without the market having to endure a steep price correction—but it is not without unpleasant societal side-effects.  
An asset that preserves purchasing power well over time, is gold. Over thousands of years gold has preserved it’s purchasing power relative to other commodities. It has endured the collapse of nations, civilizations, and thousands of fiat currencies. Gold and other precious metals tend to be sensitive to inflation, and can assist in offsetting the currency risk of cash holdings. (This is a reason Central Banks often hold large quantities of gold) 
An additional asset that may be useful for U.S. dollar ‘cash’ equivalent holdings, are short-term US Treasury bills with a duration of 1-year or less. These instruments now yield 2.00% +/- annually, and diversify bank-deposit risk. Admittedly, as one of Graham’s most celebrated students has also warned – the US dollar will likely be worth less, over time. 
Your faithful writer is observing the market with limited first-hand experience, outside of that gathered by mentors during and before our time. Please take these viewpoints with a grain of salt in reaching your own conclusions. 
However, if history is a reliable (or repetitive) guide – US general equity markets may experience a wide range of recorded PE Ratios in the future, anywhere from historical lows of 6x-8x, to recent highs of 20x-25x. Please prepare accordingly. 


Tekoa Da Silva
email: TDaSilva@sprottglobal.com
website: www.sprottglobal.com

Tekoa Da Silva joined Sprott Global Resource Investments Ltd. in February 2014 after 10 years of focused study and investment in the resource sector. He currently serves the firm as an Investment Executive.

In his prior role as an investment publisher Tekoa conducted interviews with mining CEOs, fund managers, economists, and newsletter writers, serving an annual audience of many hundreds of thousands of readers. Notable published commentaries include opinion from Rick Rule, Eric Sprott, Marc Faber, European Central Bank President Mario Draghi and many others.

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