To better understand the problems with the PE10 for stock valuation, let’s review the great real estate bubble. Generous government sponsored (GSE’s) financing from FHA, Fannie Mae and later Freddie Mac began in the 1930’s. It grew slowly for 30 years due to the public’s bad memories of the Great Depression. Then in 1965 inflation suddenly grew yet interest rates were often kept at negative real levels. The combination of being motivated by inflation and being nurtured by negative real rates made real estate irresistibly attractive in the 1965-1979 era. Then in 1984 banks started offering Easy Qualifier “Liars Loans” which opened up a new market segment to those who basically couldn’t qualify. So the real estate market had four bullish eras with never a serious systemic integrated national crash for residential real estate.
Then in 1997 the fourth stage of the real estate bubble began when lenders became a lot more lenient in terms of loan approvals as securitization really took off. Before then securitized loans were very conservatively underwritten, however by 1997 lenders discovered they could pass on risk to buyers of loans such as mutual funds or pension funds. This enabled a more aggressive type of easy loan approvals which started a new 10 year extreme parabolic boom that lasted until 2007. The more that real estate went up in value the more that lenders thought there was no risk in lending because they assumed they could always resell foreclosed homes instantly at a profit and that collateral would never go down. The result of continuously larger booms with minimal crashes is that consumers and bond investors and private mortgage insurance companies assumed that real estate was a no risk invest so they offered loans with very low credit spreads over the risk-free Treasury rate. Mortgage insurance was available in the form of Credit Default Swaps at very low prices, which greatly enabled a boom. The four stages of the 76 year real estate boom:
I. 1932 to 1965 GSE lending by FHLB, FHA, Fannie, Freddie (in 1972) where lending occurred in moderation. A history of GSE’s is here.
II. 1965-1981 rising inflation and negative real interest rates create massive real estate bullishness
III. 1984-1997 Easy Qualifiers become more lenient every year creating massive borrowing
IV. 1997-2007 Extreme abuse of Easy Qualifiers securitized as MBS with fraudulent ratings by rating agencies with nothing down, no proof of anything.
The point is that the bubble fed on itself creating (or appearing to create) a fact pattern that implied that real estate was risk free. But it was not risk free; instead the bubble lured lenders and homebuyers into dropping their caution and taking too much risk. Finally Lehman and AIG and the entire banking system had their crisis in Sept., 2008. Could the same error happen with stocks? Are stock investors part of a multi-stage bubble that started with the Oct. 19, 1987 crash and bailout? A constantly rising bubble provides bulls with a chance to make mockery of the PE10 but the fact is that stocks can and did make the same mistake that the real estate market made.
The problem with investing is that sometimes non-professional investors get so emotional about being bullish that they pressure Wall Street to become bullish. Wall Street can’t afford the luxury of talking back to a customer so Wall Street has to go along with bullish myths. Thus the market has been abandoned by professionals and power in the market has been ceded to emotional amateur investors who mistakenly believe the Federal Reserve and Congress can bail them out.
The only way to judge the stock market is to use something other than price because price can be warped by bubbles as it was in the 1965-2007 42 year real estate bubble. By contrast, investment grade bonds due to their boring, low yield nature (and due to investors fear that another Volcker would appear out of nowhere and raise rates to 22%!!!) attract mainly professional investment advisors. To estimate a value for stocks I would start with corporate investment grade bond yields as a benchmark and then add on the Equity Risk Premium (ERP); also I would look at the sustainability and honesty of corporate earnings. Using an ERP of 4% or 5% and a 10 year corporate bond yield of 3% implies an earnings yield of 7% to 8%. The inverse of that implies a PE ratio of 14 or 12. Of course a growth factor needs to be added, but what about the risk of negative growth when the company gets old? So for starters the earnings yield gives credence to a PE in the mid-teens. Obviously a new tech company that is rapidly growing is a special case for growth factors but that can easily backfire as tech companies seem to fade into obscurity faster than non-tech companies.
Given all the bad news about Eurozone and Japan and the high hidden U-6 unemployment in the United States I feel the bull case of using today’s PE is not as strong as using a ten year average of earnings. Then what if my concerns about low growth in the EU and Japan and China are true? Then corporate earnings will go lower since U.S. companies are integrated into world markets.
I see the errors of the 42 year real estate bubble are being replicated in stocks where repeated bubbles make a mockery of fundamental analysis like the PE10. It boggles the mind and seems impossible that a bubble could last 42 years but it did for U.S. real estate. Using stock prices to judge the PE10 is like using a rigged jury to render a judgment. The best sources of an unbiased opinion are those droll bond experts that generate macro forecasts. Many bond experts worry that rates are too low and that the economy will recover, but many of them also worry we are going to be stuck in a Japan-style long term Soft Depression. The key to interest rates is to understand the Invisible Hand (including foreign governments) sets long term rates, not the Fed!
Despite the massive bond buying by the Fed’s QE it really is not much more than what China’s Central Bank has bought. There are two waves of Chinese buying of Treasuries. One is from the Central Bank, and the other is private flight capital. As China’s rich grow more sophisticated and more wary of problems at home they will seek to diversify into foreign sovereign debt and the U.S. is far safer than Euro or Japanese debt. This second wave has not yet begun as Chinese are now mainly interested in real estate and stocks. The worse things go for the EU’s and China’s economy the more they need to devalue the Euro and Yuan by buying our Treasuries which will make it easier for our consumers to buy China’s and the EU’s exports.
Thus I believe that bond prices are more efficient and rational than stocks or real estate. And I believe that the errors of the 42 year real estate bubble are analogous to the errors of the current stock bubble. Mispricing of stocks by irrational members of the general public doesn’t disprove the PE10 just as irrational buying of real estate fooled the issuers of mortgage derivatives into underwriting the mortgage bubble.
Investors need independent advice about the hidden risks of debt fueled bubbles in stocks and real estate. I wrote an article “Deflationary nature of global debt burden”.