The equity market trades at only 17 times earnings (or some such number) and this isn't too very different from past historical numbers; ergo, there is no bubble in the equity market. This is an argument that I have heard often in the past couple of years.
The bears have offered something of a counterpoint argument by mentioning that corporate earnings are historically high at about 10% of GDP, and normalization at 6% presumes weak equity returns going forward.
I thought that I would take a look at these arguments and see if we could put a little Austrian spin on the debate. This debate is especially relevant given the extraordinary "inflation" that the economic system has been generating under the direction of central bankers.
I propose to do this by utilizing a simple model, one that uses data that looks very much like data from recent and past U.S. data, but I am going to simplify everything somewhat in our model by eliminating overseas earnings and overseas claims on the domestic system so that we can focus on a closed system and see how inflation and corporate profitability should impact P/E multiples in a system of financial market inflation.
Let's start by looking at a relatively healthy economy for our model, one that looked much like the economy of the U.S. before Bretton-Woods died and the dollar became untethered from gold. Our model will use some similar data from back in the 1950s and 1960s, real GDP expands almost 4% per year, corporate profits are 6% of GDP and the savings rate is 10% of GDP. In this environment, real wealth creation is equal to 14% of GDP per year, the savings rate plus real GDP growth. With corporate profits equaling 6% of GDP, corporate equity owners have a claim on about 43% of all of the increased wealth in society, that is their 6% of GDP profit margin divided by the 14% rate of wealth creation, and all of these incremental claims on wealth are 100% backed up by savings in this model. The corporate equity holders have a claim equal to 6% of GDP in terms societal output and savings per year then.
Now, let's take a look at how inflation, particularly if it is focused in the financial sector, can impact corporate equity holder's claims.
Since the equity market peak in 2000, household net worth doubled (hhnw) as it increased from about $43 trillion to about $85 trillion. On average, this represents a net worth increase of $2.8 trillion per year. GDP in 2000 was about $10 trillion and today is about $17 trillion and, therefore, averaged about $13.5 trillion over this period. The simple math shows that hhnw increased at a rate of about 20% of GDP per year for the past 15 years as compared to the 14% rate in the above example.
Corporate profits as a percent of GDP have been extraordinarily high recently, about 10% of GDP. The central bank's crushing of interest rates has destroyed the savings rate and secular real GDP growth rates however, and these figures have been running at 1% and 2% of GDP respectively.
Even if we allow for 5% equity price appreciation in addition to their 10% profit margins so that equity holders feel like they are generating a 15% rate of return, there exists a problem. Asset inflation is stoking 20% more claims against output every year, but society is only generating an incremental 3% in real wealth per year relative to GDP. That is, there exists almost $7 in incremental claims against every dollar of real output.
Equity holders in this world own 75% of these incremental claims (15%/20%), but those claims can only go up against the 3% of real wealth creation. That is, equity holders are only able to generate a real return of .75 x 3% = 2.25% of GDP.
In our first example, where the level of corporate profitability was far lower, but the savings and growth rates were higher, equity holders had a real claim every year equal to 6% of GDP, while in the world of financial asset inflation, their real claims on society's incremental wealth creation amounted to only 2.25% of GDP despite very high levels of profitability and soaring stock prices (5% per year on top of their earned profits).
Not only that, but growth rates in the first example are twice as high as in the latter example. So, if a P/E multiple of 17 was historically supplied in the first market, does the world of financial asset inflation justify as high a multiple?
With a claim on real wealth creation that is only 37.5% as high (2.25/6) and with half the growth rate, perhaps a multiple of 3-4 times earnings is more appropriate today.
All of this is a long winded way of saying that debasement is very high in the current environment. Bond holders are earning 1% in many cases, while total claims (hhnw) are rising at a rate of 20% of GDP. Equity holders think they are earning profits, but what can they claim with them in the future with so little in the way of savings and growth? Not much!
The reality is, you are much better off owning a decent sliver of a big pie than the entirety of an empty pie tin. The central banker's artificial crushing of interest rates has emptied the pie tin of savings and real growth. Equity holder's claims on real wealth creation are, in reality, very small relative to history despite soaring equity prices and high levels of corporate profitability. P/E multiples are way too high, even if corporate profitability could remain at these levels.
Disclaimer: Nothing on this site should be construed as investment advice. It
is all merely the opinion of the author.
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