What a buzz kill …

I was just beginning to think “Full Speed Ahead” was the order of the day. A tale of these potential woes was laid out this morning (8:57 ET–1/4/2020) in a post by CNBC markets editor Al Lewis. Though the article pulls no punches, it really is just a restatement of cautions that have been repeatedly given to us over the past 10 years, a period that has seen an almost fourfold increase in the the S&P 500.

Of course publication of this litany couldn’t come at a better time for market impact than the weekend after the U.S. takedown of one of the world’s really bad actors, Iranian Major General Qasim Soleimani. The market reaction following a week of new highs in the popular indices was pretty muted, down less than 1% on the Nasdaq, Dow and S&P 500. This muted response was pretty predictable in that the market has had 1 1/2 years to get use to the escalation of our hostile Iranian relationship. It started May 8, 2018 when President Trump abrogated the Joint Comprehensive Plan of Action (a.k.a. The Iran Nuclear Deal).

Since then we have seen an escalation of terrorist activity around the world. Not so much on US soil (except for acts of domestic terrorism) but on targets in the Middle East and Europe that are easier to get to. Yes, the Iranians will strike back and Americans will be killed. Cyber may become an issue but, like we’ve seen before, the violence will happen ‘over there’ and not ‘over here.’ Since most Americans do not travel outside the United States and most Americans do not have any skin in the game by having loved ones in the military and in harms way, my sense is that there will be little push back … the waste of life, human capital and our national treasure will continue unimpeded. This is depressing but I do not see it as a major increase in geopolitical risk. Geopolitical risk is a constant. it has been throughout our history.

The Litany Begins

— “A violent escalation of hostilities between the U.S. is nearly certain in the coming days, a game changer that will obscure everything else,” declared Greg Valliere, chief U.S. policy strategist at AGF Investments. “There’s a reason, finally for caution in the stock market.”

Earnings growth losing momentum

— Savita “Subramanian, chief quant and equity strategist at Bank of America Merrill Lynch, recently put out a note saying the corporate earnings outlook is flat and that the market “feels toppy.”

— “One of the upsides of doing the same Global Strategy job for over 30 years is that one can more easily recognize when the equity market is a pack of cards built on shifting sand,” Societe Generale analyst Albert Edwards wrote. “The US equity market has become totally detached from underlying profitability.”

Stock Overvaluation

“Historically, a forward-looking price-to-earnings ratio for the S&P 500 is around 15. Today, it’s about 18.”

“Frothy valuations have had many investors eyeing value stocks with lower P-E ratios since last September. Michael Wilson, chief U.S. equity strategist, believes this rotation will continue into 2020.”

This last comment about “frothy valuations” really gets my hackles up (although I do agree that the market party may be moving to lower multiple value-oriented stocks).

The standard comparison above between the historic forward PE on the S&P 500 and the current forward PE as a gauge, a benchmark for caution on the market, is a major red herring. Why? Because there is no context given about what other competitive investments may have been returning historically vis a vis the returns offered today.

The Perspective

A good proxy would be the risk-free alternative offered by the US Treasury 10-year note. Since 1970 that instrument has had an average yield of 6.3%. So 6.3% would be an alternative to the average historical 15 multiple seen on the S&P 500 (this multiple equates to a 6.7% earnings yield on the S&P).

There were times during the last 50 years that the risk-free yield was 12% (sometimes even higher) and we saw and 8 multiple on the S&P. Currently the yield on the 10-year is 1.88 which, using the same calculation should equate to about a crazy 50 multiple on forward earnings. Of course, we are nowhere near that level. But to suggest the current market valuations are “frothy” with the 10-year trading below 2% is ludicrous.

Frothy was the level at the peak in March 2000 when the yield on the 10-yr was just north of 6% and the S&P 500 multiple was 30 (3.33% earnings yield).

My point, beware of those with the current message that the market is overvalued based on a historical price/earnings ratios because they give no context with their warnings. You need to view this in the context of what returns alternative investments offer.

As a final thought, what I’m saying here does not mean that we are immune from normal market corrective action, even a bear market. Predicting when and why is above the my pay grade and not in the scope of what I’m am trying to do. My purpose is to push back on the fear, hype and misinformation about the market that is a steady offering of the media. I believe we are solidly in a secular bull market and that stocks have the potential to move higher from here.

What’s your take?