Are U.S. Equities the Second-Most Overvalued in History?
Are U.S. equities at their second-most overvalued point in history, behind only 1999?
That is the opinion of multi-billionaire David Tepper, one of the top hedge -fund managers in the game.
The U.S. equity market prior to the May 13 decline was “maybe the second-most overvalued stock market I’ve ever seen,” Tepper said in a CNBC interview this week.
“I would say ’99 was more overvalued,” he added.
Tepper went on to say valuations of certain Nasdaq stocks were “nuts,” and that some of the smaller Nasdaq names were “ridiculously” overvalued.
Tepper is not a permabear. Quite the opposite in fact: He became a legend with one of the greatest bullish investment calls of all time in early 2009, taking huge positions in the left-for-dead banking sector in the depths of the global financial crisis.
At one point in March 2009 — the month the S&P 500 touched its financial-crisis low of 666 — Tepper was the only investor making sizable bids on banking sector equity and debt holdings.
Tepper’s epic bet on the banks generated $7 billion in profits for his hedge fund — including $2.5 billion for himself alone — by year-end 2009, with many more billions in the decade that followed.
After 2009, Tepper stayed bullish for years on end, rarely wavering from his optimistic stance.
But Tepper was no permabull either — he just saw that, after 2009, general conditions were favorable to equities for a very long stretch of time, thanks to what central banks were doing.
But now, in 2020, the view looks different. In describing “the second-most overvalued stock market I’ve ever seen,” Tepper is just calling it like he sees it.
Let’s play with some S&P 500 valuation metrics to see if we can reverse-engineer Tepper’s reasoning.
According to data from Birinyi Associates and the Wall Street Journal, the price-to-earnings (PE) multiple for the S&P 500 was 22.75 on a 12-month forward basis — its highest level since 2002.
To get the PE multiple for the S&P 500, you take the total earnings per share for all 500 companies in the index — all the earnings added together — and then divide the index value by the earnings amount.
For example, if the S&P 500’s forward estimated earnings are $127.47, and the current index value is 2,900, you would divide 2,900 by $127.47 to get a multiple of 22.75.
Over the past few decades, the S&P 500 price-to-earnings multiple has averaged in the high teens with a median value of 17.7, meaning the multiple is above 17.7 half the time, and the other half below it.
To get an idea of extremes, in 1980, near the bottom of a brutal bear market, the S&P 500 multiple fell to single digits, below 8 times earnings, and in the frenzy of 1999 it rose to nearly 33 times earnings.
And so, at its recent level of 22.75, the S&P 500 could be considered 25-30% overvalued, via simple comparison to its median multiple over the past few decades.
And yet the overvaluation percentage could be bigger — and possibly much bigger — depending on one’s opinion of forward earnings estimates.
The 12-month forward earnings estimate is based not on what companies have earned, but what Wall Street analysts are predicting companies will earn over the course of the next 12 months.
The trouble is that Wall Street analysts are an optimistic bunch — sometimes unreasonably so.
For instance, the Wall Street analyst consensus is that S&P 500 companies will see 26.9% year-over-year earnings growth in 2021, according to data from Factset Research.
When you take a 22.75 multiple — which is by itself a heady departure from the long-term average — and then consider the fact that the earnings growth estimates driving that multiple are aggressively, irrationally optimistic, you get an overall market valuation that feels like a tower of Jenga blocks.
It’s true that the S&P 500 could rise in 2021 — because 2020 is going to be a terrible year, thanks to the pandemic, and also because 2020 represents the first year of recession after a 10-year bull market. (Let’s hope the recession doesn’t morph into a depression, or stretch out for years on end.)
But if you cut Wall Street’s optimistic expectations in half — which would still be generous — and then apply the median multiple of 17.7, you get an S&P valuation roughly 30% lower than it is today.
To put it another way: If corporate earnings do well in 2021, but only half as well as Pollyanna Wall Street analysts expect — and if meanwhile the S&P 500 PE multiple contracts merely to its historic median, and not necessarily lower — the S&P 500 could easily drop 30% or more.
That is the “mildly optimistic” case. A more bearish case, still subdued and not full-on grizzly, could see the S&P 500 fall 30-50% from its current perch (around 2,800 as of this writing) without a stretch.
If you care at all about valuations as an investor, you have to be a hardcore optimist to be comfortable with a historically high-end S&P multiple of 22.75.
And you have to be a hardcore optimist twice or thrice over to be comfortable with analyst expectations for 26.9% earnings growth in 2021 on the backside of a 10-year bull market in the still-early stages of a pandemic with consumers morphing into savers, share buybacks ending, debt levels exploding, and COVID-19 capital expenditure costs looming.
In sum, when the legendary David Tepper calls out “maybe the second-most overvalued stock market I’ve ever seen,” he’s got a solid case.