As the market continues to exhibit signs of instability, an interesting paper identified a correlation between the U.S. stock market and an index of the U.S. Financial Conditions. This index measures the assessment of the probability of a crisis.
The conclusion is that an imminent crisis mentality pervades equities markets today and implies that pricing is largely disconnected from fundamentals. On this blog we’ve discussed the topic of fundamentals and marveled at how pricing seems to be largely exclusive of it.
The case is made by the following chart:
The first chart shows the share price (blue) and the earnings per share (EPS in green) as well as several multiples of EPS. During the period of 2006 through 2008 the stock ranged between a P/E of 35 and 45. beginning with the collapse in confidence due to the banking crisis, the share price fell to within a range of 15 and 25. Now, with Apple’s growth accelerating above 100%, the stock price seems to be sliding below the 15 P/E bottom.
In the second chart I show the P/E in blue and the P/E/trailing Growth. Adjusted for earnings growth the equity is cheaper now than at the bottom of the last recession. You can also observe the trend or slope of the decline in the P/E/tG. It might be alarming to see the decline but it also might be comforting to know that the P/E/tG cannot go to zero. Either Price has to go to zero or earnings or growth have to go to infinity. The closer P/E/tG goes to zero however (it’s at 0.17) the more undervalued Apple appears to be.
Naturally these metrics of P/E are arbitrary and the price is simply what the buyers are willing to pay for the equity. But the value of any metric is the trend. The value can be compared to a different time or to a different equity. The trend here is that Apple, at least, is being discounted at a time when it’s growing more robustly than ever.
Which is why finding an explanation is so important. This is where the paper sheds some potential clues. The author concludes that there is a pervasive crisis phobia which affects multiples. Paulsen writes:
If cultural mentalities were less crisis-phobic today, what would the PE multiple be on the stock market coming off a 12.8 percent profit quarter with a 2.2 percent Treasury yield and only about a 1.6 percent core consumer price inflation rate? Certainly, much higher than 12 times earnings! 16 times earnings? 17 times? This simply illustrates just how much the crisis-centric mindset is depressing investment potential and it also suggest how much opportunity there is to increase stock valuations just by improving the cultural mindset. Long term, the real investment opportunity is not a dramatic improvement in economic or profit growth (although either or both could occur), but rather is just a slow but steady decay in “crisis-fears” similar to what we experienced during the last recovery.
- A Crisis Phobic Investment Culture, James W. Paulsen, Ph.D. Wells Capital Management.