S&P 500 bubble risk
First, please read the Disclaimer.
S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.
PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.
Payback model
Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:
- highest trailing earnings of 139.47;
- a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
- a payback period of 12 years — normally only used for stable companies with a strong defensive market position.
The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.
Conclusion
Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.
Quote for the Week
'In God We Trust' may be imprinted on our currency, but the hand that activates our government's printing press has been all too human.
~ Warren Buffet
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Disclaimer
Colin Twiggs is director of The Patient Investor Pty Ltd, an Authorised Representative (no. 1256439) of MoneySherpa Pty Limited which holds Australian Financial Services Licence No. 451289.
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Author: Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.