Valuation Multiples May Not Matter Anymore — but Only Up to a Point

By John Banks

When someone says U.S. equities are historically expensive, what do they mean?

It depends on the measurement being used. Different yardsticks will measure different things — and come back with different results.

For example: It has been pointed out that, in 2020, there were 28 stocks in the S&P 500 trading above 10 times sales. That is a staggeringly high valuation. In the heat of the dot-com bubble, prior to the year 2000 bust, there were only 29.

One could also consider the earnings multiple for the S&P 500.

At its current level of roughly 22 times earnings, the S&P’s valuation is historically high. To be considered cheap — again in historical valuation terms — the S&P 500 would have to fall 30% or more.

But what if that doesn’t happen? What if the valuation multiple expands from here instead?

Imagine a future where the following two things occur (both plausible scenarios):

  • The international bid for U.S. Treasuries disappears. The Federal Reserve is forced to support the U.S. Treasury bond market single-handedly. In so doing, they unleash a flood of new dollars (the currency that is used to buy the bonds, and thus keep the market propped up).
  • In 2021, due to extreme economic conditions, Washington approves a “permanent stimulus” in the amount of $2,000 per month for means-tested households (a proposal already being floated by Democrats). In this manner, both Universal Basic Income (UBI) and Modern Monetary Theory (MMT) are fully realized via the back door.

In a scenario like that — where the twin engines of monetary and fiscal policy are kicked into high gear, or even into hyperdrive — you would have an unprecedented economic outcome, and an unprecedented market outcome to boot.

Even as the U.S. dollar rapidly lost value, all Americans — including the 60% of the country within touching distance of the poverty line, or even below it — would have spending cash. That would mean they keep watching Netflix, and eating McDonald’s, and ordering doodads from Amazon.

In a situation like that, historic valuation multiples might go out the window.

As the value of fiat currency eroded, companies selling basic household goods, and core forms of entertainment, would keep earning revenues and profits. Uncle Sam would permanently stimulate the consumers on the lower 60% of the economic rungs, while the upper 40% would look to own stocks.  

The bottom line here is that, if the Federal Reserve continues to do things it has never done before, at a scale it has never tried before — and the U.S. government joins in too, essentially wielding UBI and MMT at the same time — we have no idea what market valuations would do.

In a truly dystopian post-pandemic scenario, with fiscal and monetary policy blasting off to parts unknown, the typical multiple for the S&P 500 might balloon to 30- or 40-times earnings. We can’t say it wouldn’t. We can only note how odd it would be for much of the country to have “free money,” at a time when fiat money was steadily becoming confetti.

Would this scenario mean joyous, happy days for investors? Not necessarily. If a scenario along these lines unfolded, some companies would do great — but others, not so much.

Take the current crop of “mania” stocks, for example, many of which are money-losing companies yet to produce a profit. Even in a multiple-expanded world, profitless companies that lack real prospects are headed for a brutal hard landing, if not total oblivion, when the current levels of extreme sentiment wear off.

That is because the multiplier effect on earnings per share of “zero” is zero; you can’t leverage a cashflow stream that doesn’t exist.

Companies with solid revenue-and-profit streams that continue to do well in a post-pandemic world, on the other hand, could see their multiples expand to nosebleed levels by historic standards.

As a form of investment, these companies would potentially offer inflation protection, through their ability to raise prices in line with inflation’s return. The shares of a company that maintained pricing power and strong purchase interest, against a dystopian economic backdrop, would be in high demand.

As such it is hard to say what markets will do, because different parts of the market are taking divergent paths now.

For example, there are the tech juggernauts, a group of six names that make up the lion’s share of the Nasdaq; there are the broad-based pandemic winners, the companies that will continue to thrive in the current business environment; and beyond that there are the mania names, along with a slew of bankrupt entities and profitless small caps. All of the latter will be washed away when sanity returns.

But what will the rest of the market look like? Will the S&P 500 multiple continue expanding, even as COVID-related fallout gets worse, in anticipation that twin turbo stimulus power (monetary and fiscal policy) is on the way? We might be about to find out.