By Gary Shilling PhD, FS
Stocks are very expensive in relation to corporate earnings. Even if rapid economic and profits growth resumes after the next recession, a secular decline in price-to-earnings ratios is likely to mute stock performance.
Prof. Robert Shiller’s cyclically-adjusted stock price-to-earnings ratio, based on real earnings over the preceding 10 years to iron out cyclical fluctuations, is now 46% above its long-term average of 16.9. So it would take a considerable drop in stock prices and/or unrealistic growth in corporate earnings to bring it back to its long-term norm. Furthermore, since the P/E has been about 16.9 for almost all the years since the early 1990s, if that long-term average still holds, the P/E in many future years will be below that long-term average.
Since being bailed out of the 2008 financial crisis by the Fed and Congress, Wall Street has enjoyed almost ideal conditions. The Fed cut its reference rate to almost zero and used quantitative easing to flood the markets with money, most of which went into equities. The cyclically-adjusted P/E more than doubled, pushing up stock prices well beyond the levels dictated by earnings growth. Low interest rates promoted heavy corporate borrowing and issuances of securities.
Collectively, stock market investors these days don’t seem to care about anything but the Fed. Late last year, equities swooned along with growing signs of economic weakness and an impending recession. But when the central bank paused in its credit-tightening campaign in January, investors overlooked the likelihood that the Fed was reacting to the sliding economy. So stocks took off like a scalded dog, reaching new heights recently, and futures markets swung in favor of a cut in the Fed’s policy rate this year.
The implicit assumption was that the Fed would effect a soft landing, only the second one in 14 credit-tightening efforts in the post-World War II era, with the other rate-hike campaigns resulting in recessions. As Insight readers are aware, however, we believe that if a recession is avoided, the Fed will resume credit-tightening later this year. It wants higher interest rates in order to have room for substantial cuts in the next recession, and frowns at the financial speculation sired by recent low interest rates. That would postpone the recession that we believe will commence in 2019 to next year.
The Fed’s signal of no rate cuts this year comes in the face of disinflation, with the core inflation rate, excluding the volatile food and energy sectors, rising just 1.6% in March from a year earlier, down from 1.8% in January and 2% in December. Powell noted, in frustration, that most of the central bank’s forecast errors on inflation “are on the downside.” The Fed is well aware that low inflation is self-reinforcing and spawns slow economic growth as potential buyers wait to purchase.
Nevertheless, like his predecessor, Janet Yellen, Powell believes decelerating prices are due to “transient” factors and that higher inflation is imminent. Still, the ongoing parade of “transient” deflationary forces looks more like a trend, as we’ve noted in past reports. If that continues, the central bank will sooner or later be forced to stop looking for live trees of inflation and start noticing the dying forest of deflation…