In recent posts I have alluded to stock market valuations as a risk to investors. By most metrics, these valuations were too high before the election. Subsequently, they have risen nearly another 10%.

Euphoria over the Trump victory and a return to freer markets appear to be the driving forces. Productivity and the ingenuity of the entrepreneur and worker are expected to generate real economic growth in a less regulated economy.

Even if the Trump effect materializes, it doesn’t mean that stocks will continue to rise or maintain their current levels. Ultimately market valuations tend to regress to their mean, levels that are real and sustainable. Levitations beyond or below reasonable market valuations are generally short-lived.

Reasons Why Market Valuations May Be Too High

Even if the expectations of Trump’s economic program are met, market levels may still be too high. Here are some of the reasons to expect a downward revaluation:

1. Over (and under) valuations usually revert to the mean. At this point, a reversion means a drop in valuations.
2. Reported earnings are likely less real than they used to be. If so, the overvaluations in markets are even larger than the price-earnings (P/E) ratios suggest.
3. Economic growth is unlikely to raise earnings fast enough to bring valuations into line at these price levels.
4. Rising interest rates will increase the discount rate implied in valuing future earnings, a factor which tends to lower P/E rather than raise them.
5. Rising interest rates will increase the burden of debt, making some of it unserviceable and headed to default.
6. Rising interest rates will expose malinvestment — investments that should not have been made but were in the expectation that interest rates would remain low.
7. Regulatory and tax reform will change the calculus between good and bad investments. Malinvestment will be exposed when new and different competitive forces affect existing markets and industries. Many of these succeeded beyond where they should have as a result of protective regulations and tax policies which precluded new competition.
8. Much of the smoke and mirrors used to cover market and economic weaknesses will be revealed and re-priced.
9. Historically, they are at levels usually preceded by a crash (see Historical Perspectives below).

Perhaps markets can hold long enough for the underlying economy to catch up to the over-valuations. I doubt it, however.

An Example of Phony Numbers

A recent post by Wolf Richter details difficulties in the automobile sector. This industry has its own characteristics, but it is not unique with respect to Potemkin Economics — the appearance of doing better than you are.

According to Mr. Richter the auto manufacturers have stuffed the inventory channels at dealerships (a practice that enables manufacturers to report higher sales and profits even though the cars sit unsold at dealerships). This front-loading produces overstated results. Inventory-stuffing is at 2008 levels when bankruptcy and bailouts occurred for Chrysler and General Motors (GM).

Compounding this problem is the quality of auto loans. Richter observes:

… six million Americans are 90-plus days delinquent on their auto loans!

The term sub-prime loans applies here. While this practice was stopped (for a while) in the mortgage arena, it has been prevalent in the auto industry for a number of years. Not only are reported car sales overstated because of inventory stuffing, sub-prime loans financed by the manufacturers and reported as actual sales represent a liability in the form of coming debt write-offs. Whether these two factors are enough to threaten the solvency of these companies cannot yet be determined.

Implications

The auto industry imbalances have implications for jobs, growth and perhaps survival prospects. See Richter’s full article for more details.

The condition of the auto industry reflects the smoke and mirrors used to present a better picture than reality affords. It will impact the economy regardless of  Trump’s policies. Other industries have their own versions of smoke and mirrors. Overstatements of true economic conditions make it harder to improve because these overstatements eventually must be reversed.

Whatever was “gained” via rose-colored reports will eventually be remedied. These reversals are unlikely to conveniently wait until the economy regains real strength. Most will surface and reduce earnings. Valuations will then have to increase to maintain stock prices or prices will decline. If valuations decline as a result of  re-evaluation of company prospects, declines could be substantial.

Perhaps my interpretation is too severe. Perhaps we can skate through this interim period of adjustments prior to economic growth without a major market correction. However, before any of these adjustments occur, valuations are dangerously high.

Some Perspective on Market Valuations

One of the best sources for stock market data and market valuations is Crestmont Research. Their approach, as stated by them, is scholarly and analytic:

The objective of the research and its publication on this site is to present rational perspectives based upon a diligent analysis of historical data. Through understanding and developing perspectives on that data, vital new knowledge is formulated. Armed with that knowledge, we can then start to make informed decisions.

Crestmont’s research is intended to be observation-based rather than prediction-oriented. Its purpose is to provide information and perspectives to assist in rational decision-making. The research does not provide predictions or recommendations on investment alternatives, although you may find its implications for investment strategy quite compelling.

Crestmont utilizes an approach similar to that of Robert Shiller who uses a 10-yr average of earnings to calculate his Price-Earnings ratio. To understand their approach, see their P-E Report. Below is a graph showing P/E ratios using traditional reported PEs and the Crestmont and Shiller ratios. The thick yellow line was added by me as an “eyeballed” average P/E over the period.

The green line is Crestmont. As of the date of this chart, this P/E ratio is over 25 times earnings. There are only two preceding times when the Crestmont P/E was over 25. One immediately preceded the Great Depression in 1930 and the other preceded the two 50% plus drops in the first ten years of the new century.

Michael Sincere commented on the Shiller PE ratio which tracks very closely the Crestmont metric:

The cyclically adjusted p/e (CAPE), a measure created by economist Robert Shiller, “now stands over 27 and has been exceeded only in the 1929 mania, the 2000 tech mania, and the 2007 housing and stock bubble,” says Alan Newman in his Stock Market Crosscurrent letter (source: CNBC).

If you are in markets, be thankful for the Trump bounce. If you are not in, it probably isn’t a good time to jump on board thinking valuations are going to continue to increase. Obviously, they could but it doesn’t seem to be a good bet.

Another point to be made from the above graph is the range of P/Es. Below 10 is not uncommon until recently. Is there an economic justification why this level cannot be reached again? None to my knowledge.

The lowest P/Es were in the 5 range. These occurred three or four different times. Were market valuations to return to these levels and earnings remain where they are, an 80% loss in the S&P index would occur.

No one expects market valuations to drop 80% (actually someone does although I cannot remember the name). But a drop of 50 – 60% is not unrealistic. Remember, there were two drawdowns of this magnitude (from peak to trough) within a ten year period. The following chart shows the distribution of annual stock market returns. The first decade of this new century looks a bit like the 1930's in terms of the number of large losses:

None of these comments refer to the possibility of a recession. In terms of normal cycles, we are overdue for one. If one were to occur, both the P and the E in P/E calculations would likely decline.

Conclusion

I strongly encourage anyone interested in markets to visit the Crestmont website. It is filled with data and provides good perspective on markets.

Even if you are optimistic about Trump and his economic policies, protect yourself against what could be a substantial valuation correction. A few of the factors which might precipitate such a correction are the following:

• the economy of the last eight years was like a Potemkin Village, mostly show and lacking in substance
• political disruption and turmoil is coming to Washington
• geopolitical risk abounds
• sovereign defaults are likely

Until interest rates rise, equity markets are likely the only game in town. That game has gotten more dangerous.