There is no stock market bubble in place. For openers, the price trajectory of the SP 500 (SPX)
is not steep enough to qualify. However, there are shifting long term fundamentals you should
keep in mind. Over the past 20 years, SPX earnings per share have grown more rapidly than
over the very long term. Since 1994, earnings have compounded at near 7% vs. 6.5%
historically. That corresponds to a big change over time. Moreover, despite the rather evident
cyclicality of SPX net per share, investors and traders have tended not to shade the p/e ratio much
at all as earning rise to a cyclical peak. The SPX has come to be treated more as a stable growth
entity than as a cyclical one.
The SPX companies have been buying more of their stock in over time. This has been a plus
to earnings. Back circa 1980, successful companies were urged to buy in stock when the share
price was below book. The SPX has soared well over book value since then, but companies have
continued and enlarged the practice. This has increased the cyclicality of earnings because
firms tend to increase buybacks as cash flow from operations rises and slash them when net
and cash flow turn down.
There has also been a nearly manic emphasis on boosting profit margin as well. Business return
on assets % is a product of asset turns in sales times profit margin. In a globally competitive
world, achieving the pricing power needed to boost asset turnover is tough, so the emphasis
has fallen on advancing margins. Since the late 1990's business sales growth has fallen well
below the long term trend, but earnings growth has not lost a beat thanks to increasing profit
Many SPX companies with help from their outside auditors have also adopted the practice of
taking very large writeoffs during business downturns and claiming these losses as "special"
charges which are not counted in operating earnings (but do come off book value). And, yes
most acquisitions and mergers are done on a purchase basis rather than a pooling of interests
basis so that acquired earnings are additive and not dilutive. It is amusing to watch purchase
acquisitions boost earnings during business expansions and when they fail, be written off
as non-recurring expenses.
So, faster earnings growth over the past 20 years involves both solid productivity gains to
boost margins and smoke and mirror elements to help net per share on the way up and
artificially cushion it on the way down.
Investors have loved it all -- poor sales growth but improving profit margin and add-ons
to earnings from share buybacks and accounting gimmickry.
At peaks in the business cycle, we now have cyclically elevated earnings plus earnings
overstatement to pore through. In short, there has been an era of bubbly earnings coupled
with investors who have not discounted such performance until too late.
Net per share growth in the current cycle has yet to reach extended levels that should raise
eyebrows and given the available resources in the system, that moment may be a ways off.
The best bet is not just to watch market price action and the p/e ratio but the aging of the
cycle itself and the excesses that be developing.
True stock market bubbles are rare but exaggerated cycle peaks are not.
- Peter Richardson
- Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!