Over the weekend, we first reported that none other than Nobel prize winner Robert Shiller said that in his opinion, unlike 1929, this time everything – stocks, bonds and housing – was overvalued.
Curiously, none other than Goldman’s chief equity strategist, David Kostin echoed this sentiment when in his latest weekly note to clients he said that “by almost any measure, US equity valuations look expensive. The typical stock in the S&P 500 trades at 18.1x forward earnings, ranking at the 98th percentile of historical valuation since 1976. For the overall index, the aggregate forward P/E multiple equals 17.2x, a rise of 63% since September 2011, compared with the median expansion of 48% during 9 previous P/E expansion cycles. Financial metrics such as EV/EBITDA, EV/Sales, and P/B also suggest that US stocks have stretched valuations. With tightening on the horizon, the P/E expansion phase of the current bull market is behind us.”
Don’t tell that to the SNB, the BOJ or any of the other central banks once again buying Emini futures hands over fist with freshly printed money and a complete disregard to cost basis or downside and losses.
Of course, for Goldman to say all of this, it means either the bank is already full to the gills with ES puts, or is just hoping to buy up the S&P to 3000 and above. Here is what else Kostin says on record valuation:
US equity valuations are also historically extended when adjusted for the extremely low interest rate environment. For example, during the past 40 years when the real interest rate (10-year Treasury less core CPI) was between 0% and 1%, the S&P 500 forward P/E multiple averaged 11.2x, well below the current level. Moreover, since 1921 (94 years) when real interest rates have been 0%-1%, the trailing P/E multiple has averaged 13.5x, which is 27% below the current trailing S&P 500 index multiple of 19x.
Valuation looks even more striking in the context of current profit margins—the highest in history. Since 2011, margins for S&P 500 (ex-Financials and Utilities) have hovered around the current 9% level. Information Technology has been the driving force for the overall margin expansion. Profits are highly sensitive to small changes in margins: every 50 basis point shift in S&P 500 margin translates into a roughly $5 per share swing in EPS. Given the current P/E multiple, a $5 shift in EPS would translate into a swing of nearly 90 points to the valuation of the S&P 500.
The current P/E expansion cycle has lasted 43 months, the second longest since 1982, but will likely end when interest rates rise. After each of the three prior “first” Fed hikes, P/E multiples contracted by an average of 8%. In the meantime, we expect the 2% dividend yield to generate the entirety of the total return we forecast the S&P 500 index will deliver during the next 12 months. We expect the market will rise to 2150 around mid-year but fade after Fed liftoff in September and end the year at 2100.
But what is more interesting is that after telling Goldman clients to weeks to put their cash in companies that are most likely to engage in stock buybacks, Kostin now rages at the practice:
Corporations have so far used record profits to return cash to shareholders. S&P 500 firms have spent more than $2 trillion repurchasing shares during the past five years.
However, like investors, managements are often poor market timers. In 2007, companies allocated more than one-third of their cash use to buybacks ($637 billion) just before the S&P 500 plunged by 40% during the following year. Conversely, at the bottom of the market in 2009 firms devoted just 13% of their annual cash spending to repurchases ($146 billion).
We forecast buybacks will surge by 18% in 2015 exceeding $600 billion and accounting for nearly 30% of total cash spending. We recognize activist investors often advocate for firms to return excess cash to shareholders via buybacks. Tactically, repurchases may lift share prices in the near term, but in our view it is a questionable use of cash at the current time when the P/E multiple of the market is so high.
Although buybacks do not represent an optimal use of cash at the current time, they will be positive for near-term stock performance…. As noted, most firms should do something with their cash other than buyback shares. However, we expect firms will repurchase shares and investors will reward these actions and shares will post near-term outperformance.
As for the long-run, well just ask Keynes.
And while all of the above is well-known, there is one take home from Goldman’s note: what Goldman says, or rages at, quickly becomes policy.
As such, don’t be surprised if one of the upcoming executive actions by that Supreme Fairness Distributor, president Obama, will be to determine just how much stock buybacks corporations will be allowed to engage in.