Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's,, calculations by

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's,, calculations by

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: (for treasury prices), (for historical inflation), calculations by

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors,, calculations by

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.


Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

The United States of Debt – Part I

The economy of the United States is highly leveraged. Through the boom times of the 1980s through the 2000s, total US private and public debt to GDP has risen sharply. Since the 2008-2009 recession, private debt has started to fall while public debt has risen, while the country's total indebtedness has remained relatively stable. Most US citizens have the nagging feeling that our debt burden has gotten too high. If we know that debt to GDP needs to come down, however, we don't know to what level it should come. I have decided to analyze this issue in a series of posts called "The United States of Debt".

In this the first installment, I will run through the big picture. The first section discusses how the recent run-up is not surprising in the context of the long cycle, and that we have seen these financial booms before, during the Gilded Age following the Civil War and during the Roaring Twenties. The second section dissects the recent debt buildup between the private, public and financial sectors. The last section discusses why the recent financial boom has been so long lasting and powerful relative to the Gilded Age and Roaring Twenties.

The next three installments will analyze the financial health of the Household, Business and Government sectors and to make policy recommendations on how to promote the financial health of those sectors.

The long wave debt cycle

It's no secret that the United States has a debt problem. This long term chart of total, economy-wide debt to GDP demonstrates it pretty well.

Chart 1

The long term pattern of debt peaks corresponds with the long wave, or Kondratiev Cycle (for a more detailed description of this concept, see here). During the "autumn" phase of the "financial bull", inflation is falling, thus interest rates are falling and asset values are rising. While asset values are rising, the cost of borrowing is falling, which creates a perfect environment for using leverage for investment, whether in the financial markets, real estate markets or for corporate investment.

Eventually, the asset bubble pops, marking the transition to the "winter" phase, or the "real bear". It is at the bottom of the first winter recession that the debt-to-GDP ratio peaks (previously in 1875 and 1933). Why? Because as asset values start to fall, the high level of underlying debt results in a deflationary spiral of forced asset sales and financial failures. Nominal GDP falls while the level of debt remains roughly the same (or rises).

Eventually, the economy bottoms and debt-to-GDP turns down. The decline in debt-to-GDP comes from a combination of rising real GDP, rising inflation (which reduces debt in real terms) and debt destruction trough defaults.

Chart 2

At the beginning of the Great Depression in 1929, the bulk of US debt was corporate debt tied to the investment bubble in auto manufacturing, electric utilities, houshold appliances, radio and other sectors that made up the "new economy" of the Roaring Twenties. Corporate debt to GDP collapsed from over 100% in 1933 to under 30% by the mid-1940s. Household debt fell from 50% of GDP in 1933 to roughly 15% in the same time period. Much of the drop in total debt to GDP came during the 1933-1936 period, when the dollar was devalued by 50% and economic growth was very high (albeit from an extremely low base). The ratio rose again when the economy relapsed in 1937-38, but resumed its decline when the economy recovered modestly in the pre-war years. The end of the long depression years came when government debt to GDP began to expand during World War II in the early 1940s. Government debt to GDP balooned from under 50% to about 100% of GDP during World War II, while private debt to GDP declined.

Total non-financial debt to GDP remained between 125% and 140% from the end of World War II to the early 1980s. During that time, government debt to GDP fell from about 100% to 40%, while private non-financial debt rose from 40% to 100% by 1980. During the same time, financial debt to GDP rose from under 5% to about 20% by 1980, returning to roughly the same level that prevailed in the late 1920s.

The consumer and financial debt explosion since 1980

Table 1

Table 1 above walks us through how our debt load has evolved since the early 1980s. For the sake of cyclical consistency, I show the recession years of 1982, 1990, 2001 and the recent recession trough of Q2 2009. There has been a steady increase in private sector debt, particularly among households and the financial sector. During each business cycle, the private sector tacked on 50-60 percentage points of indebtedness. The government sector, on the other hand, has see-sawed in a one-cycle-up, one-cycle-down pattern.

The largest increase in indebtedness has come from the financial sector, having increased by 93 percentage points between 1982 and 2009. As can been seen in Chart 2, about half of that increase came from the Government Sponsored Entities ("GSEs"), namely Fannie Mae and Freddie Mac. That debt has from a practical standpoint become government debt as well.

Since the 2009 recession has ended, total debt to GDP is has declined by three percentage points. Private sector debt has dropped by 14 percentage points while government debt has risen by 11 percentage points. So far the government has been filling the classic Keynesian deflation-fighting role by borrowing and spending to offset a decline in private borrowing and spending.

The problem with this analysis so far is that while interesting, it doesn't mean a lot without knowing what the optimal debt to GDP level is. Just because debt to GDP used to be 150%, doesn't mean that was the right level. In fact, for all we know, 150% was way too conservative and presented a great opportunity to lever up to the optimal level north of 300%. My gut tells me that the truth lies somewhere in between these two extremes.

The Second Gilded Age

So what happened in the period from 1980 to 2009 that led to an explosion of US indebtedness? We have had a confluence of factors that created the ideal environment for the greatest bull market in the history of the world:

  1. A roughly 90% devaluation of the dollar in nominal terms against gold;
  2. A general policy mix of tight monetary policy and loose fiscal policy;
  3. A decline in long-term interest rates from nearly 15% to 4%;
  4. Tax policies that reward borrowing and equity capital gains; and
  5. Financial deregulation and the expansion of the GSEs.

With the devaluation of the dollar (also known as "inflation"), the denominator in which the S&P 500 is quoted has declined, providing a lift to the nominal value of the S&P. That said, however, over the past 50 years, the price of gold and the S&P have merely kept pace with each other (see Chart 3). Since 1955, 100% of the excess return of the S&P 500 over gold is attributable to dividends.

Chart 3

Source:, Standard and Poors,


Or looking at it another way, Chart 4 shows the S&P 500 expressed in terms of ounces of gold.

Chart 4

Source:, Standard and Poors,

If you ignore the outlying years of 1997 to 2001, the pattern is pretty clear: a steady buildup to about 3 ounces of gold before the plunge to below 1. The only question now is how low the ratio goes. The previous bottom was 0.22 in 1980. That would imply the S&P falling to 265 at today's price of gold, or conversely, gold rising to 4,881 at today's level of S&P.

Nevertheless, since 1955, the price of gold has risen from $35 to $1,205 and the S&P 500 has risen from $35 to $1074. The ratio of S&P 500 to gold seems to spend 15-18 years above 1 and 15-18 years below.

The other factor that drove the bull market in stocks and bonds has been the relentless decline of interest rates from 1980 to 2000. As can be seen in Chart 5 below, since the early 1960s, the earnings yield (the inverse of the price-to-earnings valuation multiple) of the S&P 500 has pretty closely followed the yield of the 10-year treasury bond. Prior to the 1960s, when inflation was very low or even negative, earnings yields were far higher than treasury yields.

Chart 5

Source:, Standard and Poors,

As can be seen in Chart 3, in the 1970s, when the value of the dollar plunged and the price of gold rose, stocks did not follow because of the rise in interest rates which provided stiff competition to stocks. As treasury yields rise, the required return from stocks' earnings yield goes up as well. That pattern reversed in 1980. Tighter monetary policy gradually brought down interest rates, but loose fiscal policy kept inflation positive. The combination of falling interest rates and moderately positive inflation is the ideal combination for stock returns.

Now that we are likely shifting to a deflationary environment of falling debt to GDP, we may be seeing a shift to rising earning yields while interest rates remain low. This was the combination that prevailed in the 1930s and 1940s. We are already at a spread between earnings yields and 10-year treasuries not seen since the mid-1950s. If inflation stays as low as it is currently (around 1%), goes lower or even consistently negative, we will very likely see earnings yields back to the level of the early 1950s by the middle to end of this decade.

Rising Asset Values lead to Higher Indebtedness

As asset valuations rose from 1980 to 2008, investors had the opportunity to use financial leverage to supercharge returns. Just witness all the people who made a fortune in real estate over the past thirty years: inflation made the value of rents and real estate rise while financing costs fell. Leveraged buyout practitioners could borrow money and benefit from the combination of rising cash flows and valuation multiples while benefitting from falling interest rates. It's pretty simple. In a thirty-year bull market in asset values for stocks, bonds and real estate, the use of leverage to "get-rich-quicker" is a natural outcome.

The Government has encouraged leveraged speculation

Many of the "supply side" tax policies of the past thirty years have encouraged the use leverage as well. Ostensibly, policies like cuts in upper-end income tax rates, dividend tax rates and capital gains tax rates are meant to encourage savings and investment. In reality, they don't directly encourage savings or investment, they encourage the reward from investment profits. Businesses are the ones that actually invest. If you wanted to directly encourage investment, you would allow for the full deduction of capital expenditures in the year incurred and make the R&D tax credit permanent. If you wanted to directly encourage savings, you would impose consumption taxes or large deductions for money put into investment accounts.

We do, however, directly encourage the use of debt by making interest tax-deductible for businesses and real estate investors, while dividends, on the other hand, are double-taxed at the business and individual level. The government even further subsidized residential real estate interest rates through their "implicit" (now explicit) guarantee on securities issued by the government sponsored entities ("GSEs") Fannie Mae and Freddie Mac.

Private equity and real estate investors had this figured out. Take the subsidy for borrowing money and use it to generate subsidized capital gains profits. Benefit from rising asset values as interest rates fell. And benefit from rising cash flows driven by government-generated inflation. In such an environment, it's frankly a wonder we have as little debt as we do.

I bet this makes you wish you had this all figured out in 1982.

The Long-term, Real Return on Stocks is only 4-5%

Caltech Professor Bradford Cornell has written a great paper published in the Financial Analysts Journal called "Economic Growth and Equity Investing". He has performed a detailed, eloquent analysis that backs up my stock market valuation model (described here, updated many times here, and most recently conducted here).  He posits that long-term, real earnings and dividend growth is unlikely to exceed 2% (I use 1.7% for the S&P 500 based on the historical trend).  When combined with the dividend yield you are looking at a total real return of 4-5%.

Professor Cornell's paper is here: Download Economic Growth and Equity Investing I warn you, it is "wonky".

So if trend earnings growth is fixed, and the dividend yield is known at any given time, the variable in valuing the market is the assumption for future inflation.  (Projected Return = dividend yield + real trend earnings growth rate + long term inflation rate.)  Provided the long term inflation assumption is moderate, and thus interest rates are reasonably low, inflation and equity prices are positively correlated.  I explain here how sensitive the market multiple is to changes in inflation expectations.

The key to beating the market short term is determining whether the market assumption for long-term inflation expectations is too low or too high.  The rise in inflation expectations from 1.3% in March to 2.7% in January can explain virtually all of the rise in the stock market in that time.

I believe that investors should err on the side of assuming inflation will be lower than normal.  I know this conflicts with what alot of people believe given our aggressive monetary and fiscal stimulus.  The problem is, that monetary and fiscal stimulus is just offsetting aggressive deleveraging in the private market, particularly among consumers and banks.  Private deleveraging will continue until the housing market stabilizes and the banking system's leverage stabilizes.  The banking system will not stabilize until after it has digested the proposed financial system reforms.  Since the United States can not simply devalue its currency the way that smaller countries can, it can only deleverage via a period of belt-tightening.  Deleveraging and belt-tightening mean struggling with deflation.

In my previous article "These are not Unprecedented Times" I discuss the long wave pattern called the Kondratiev Cycle.  Google that term and you can learn all about it.  While I don't think it can be used as a market-timing system and I realize that each cycle is different, the pattern it describes provides a good framework for understanding what is going on.  Most economists have been building models with data that goes back to World War II and have left out a key part of the long cycle: the Kondratiev Winter.  When the Autumn-season leverage-driven asset inflation has run its course, a long period of debt and asset deflation sets in.  While stimulus may offset actual deflation, it will be difficult for inflation to be above average if the banking system is deleveraging and without a large currency devaluation.  I'm not saying it's impossible.  It's just highly unlikely.

The current market assumption for long-term inflation is 2.6%.  That is slightly above the Fed's implied target of 2.0% to 2.5%.  This with Federal deficits of 10+%, the Fed Funds rate of 0% and a large bout of "quantitative easing".  The foot can not be on the stimulus pedal much harder than it is.

I don't make short-term market calls.  Clearly, the stock market could continue to rise for a whole host of reasons.  The next recession, whenever it comes, will likely be deflationary (no more bullets are in the stimulus gun) and the stock market will be hammered anew.  Investors beware.

Market Valuation Model

I have been working on a stock and bond market valuation model, and have been updating it a little more than once a quarter.  The links are below:

How to Value the Stock Market (8/25/08)

The Stock Market is Overvalued, Potentially by alot (11/6/08)

First Quarter 2009 Market Update (3/31/09)

Revising my Stock Valuation Model (4/24/09)

The Recent Market Rally Explained (6/15/09)

Q2 Market Update (7/7/09)

Q3 Market Update – A low return world (10/2/09)

Year End 2009 Market Update (1/6/10)

The Long Term, Real Return on Stocks is Only 4-5% (2/9/10)

Predicting Inflation: Gold versus Bonds (3/28/10)

Q1 Market Update: The Stock Market is Now Overvalued (4/16/10)

Q2 Market Update: Sometimes cash is the “least bad” option (7/14/10)

Q3 Market Update: The Fed’s War on Savings (11/14/10)

2010 Market Review: Beware an Emerging Market Inflation Crisis (2/6/11)

Q1 2011 Market Review: It’s Time to Raise Interest Rates (4/10/11)

Get ready for a Dollar Bull Market (5/17/11)

Q2 2011 Market Update: The “Rounded Bottom” Scenario (4/6/11)

Are stocks Cheap? Not Quite, But Close (8/10/11)

Q3 ’11 Market Update: The Beginning of the End (10/8/11)

Q2 2012 Market Update: Have Corporate Profits Peaked? (7/1/12)