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The seven deadly sins of the US stock market

US stocks are expensive by any measure. Absent a crystal ball it’s impossible to say whether this means a crash is imminent. But it does make it highly likely that US stocks will be poor medium to long term investments. Today we highlight another measure that’s near to the tech bubble highs of year 2000. It’s the seventh measure we’ve identified that points to overpricing. US stocks are living on borrowed time.

OfWealth has highlighted previously that the US stock market is trading expensively. As long as I continue to come across bullish commentary on US stocks – and I still see plenty – I’ll continue to highlight the risks of owning them. Buying already expensive stocks is rarely likely to deliver decent profits, and could result in big losses for investors.

Most recently I pointed out that the price-to-sales ratio (P/S) is near tech bubble highs (see here). The P/E10 ratio – also known as the cyclically adjusted price to earnings (CAPE) or Shiller P/E – is near the top of its historical range (see here for explanation).

What’s more the US market scores extremely poorly for price-to-book ratio (P/B), price-to-earnings ratio (P/E) and dividend yield (see here). Finally, something known as the q ratio is also at one of its highest levels since 1900 (see here for more and an explanation of the q ratio).

That’s already six financial indicators that are all saying the same thing: that US stocks are expensive. Today I’ll add a seventh.

It’s a measure that compares price to an adjusted measure of profits. This is known as price-to-EBITDA ratio (P/EBITDA) – pronounced “ee-bit-da”. EBITDA stands for – are you ready? – “earnings before interest, tax, depreciation and amortisation”. Let me explain what that oversized mouthful of jargon means.

Earnings are simple enough: company profits after costs have been deducted from sales revenues, or turnover. But EBITDA is “before” a lot of those costs have been taken into account. In other words certain things are added back to give a higher number. Interest refers to the cost of servicing company debts. Tax is the government’s take of business activity. So far, nothing too complex.

But then we get the non-cash costs that are deducted from profits – depreciation and amortisation. Depreciation refers to how much certain tangible (physical) assets are written down in value each year.

The idea is that everything has a useful life, so it’s value to the company is reduced over time, until it eventually has to be refurbished or replaced. So a building could be depreciated over say 50 years, vehicles over 10 years, fixtures and fittings over five years, computers over three years and so on.

This depreciation is a non-cash expense charged to company profits, since it doesn’t represent cash going out of the door – just asset values being reduced over time in the company’s books.

…the depreciation charge is meant to be a proxy for capital expenditure. In an ideal world the two items would be the same, although they rarely are.

At the same time most companies do actually spend cash on new assets every year – something which is called capital expenditure. But this results in new assets on the balance sheet, and isn’t charged directly to profits. Instead, the depreciation charge is meant to be a proxy for capital expenditure. In an ideal world the two items would be the same, although they rarely are.

Amortisation is similar to depreciation, but refers to the write down of intangible (non-physical) assets such as expiring licences, patents, brands, and so on.

Also goodwill resulting from past acquisitions is written down from time to time. Goodwill is the premium over net assets that one company pays when it buys another company, and shows up as an asset on balance sheets.

(I don’t want to get into too much detail, but goodwill arises from a strange accounting fudge that essentially exists to boost corporate acquisition activity. Without it a great many investment bankers, accountants and lawyers that advise on deals would be out of jobs.)

So that’s EBITDA explained. A sort of measure of cash-type profits (excluding depreciation and amortisation) before certain cash costs (interest and tax) have been deducted.

It may all seem a bit arcane and weird, but since this measure is favoured by a lot of financial analysts it’s worth knowing what they’re going on about.

And now we get to the nub. P/EBITDA has risen to around 10.4. That’s pretty much in line with the peak of the technology bubble in late 1999 and early 2000, as seen in the following chart. (Apologies that it’s not too easy to read, but it was the only up-to-date chart that I could find. At least it makes the point.)

PEBITDA-tech-bubble

This is just one more indicator that US stocks are expensive. Added to our previous six, the market now has seven deadly sins to repent. Interestingly, the seventh deadly sin of Catholic teaching is pride or hubris, and is considered the most serious of all the sins. (The others are greed, lust, envy, gluttony, wrath and sloth. Taken together they almost amount to a self-help manual for aspiring hedge fund managers.)

Taken together they almost amount to a self-help manual for aspiring hedge fund managers.

So are we seeing pride before the fall? One thing’s for sure, whether it’s pride or price we’re talking about, too much of it is a bad thing.

Certainly P/EBITDA isn’t my favourite measure, but it still adds weight to the argument that US stocks are trading too richly. When compared to its own historical times series – which is the really crucial thing when looking at any of these measures – this ratio is flashing red, along with everything else.

S&P-valutation-ratios-

P/S and P/EBITDA are both near to their tech bubble highs. The other measures aren’t, but it’s worth remembering that the tech bubble was a real outlier and aberration.

For example, the P/E10 is well into the top 7% or so of its historic range since 1871, and top 3% if the brief period of dotcom insanity at the dawn of the millennium is ignored. Apart from then it has only been exceeded once: just before the Great Crash of 1929. That’s not exactly a great omen.

Of course no financial indicator is perfect. Each has its advantages and disadvantages. Financial pedants can pick holes in the usefulness of each measure. It’s certainly true that individual ratios can be misleading at times.

But when all valuation metrics are saying the same thing the arguments become pointless.

But when all valuation metrics are saying the same thing the arguments become pointless. It’s like debating which of Kevin Costner’s films was the worst, when pretty much all of them were dreadful (in my humble opinion).

Whatever anyone says, US stocks are very expensive. And what has gone up too far usually comes down…eventually. In fact US stocks have had big falls roughly every six years since 1871.

The last downturn started in mid-2007, accelerating into a full blown crash in mid-2008 before bottoming out March 2009. In other words, it’s already been eight years since the US stock market last started heading south.

The S&P 500 rose very strongly between mid-2011 and the end of 2014. But since then it’s been treading water, albeit sinking below the waterline during August and September, before bobbing back up again.

At the time of writing the S&P 500 trades at 2,086. One year ago it was at 2,070, which means it’s up just 0.8% in 12 months. This is despite the huge amount of share buybacks that should drive share prices higher, all other things being equal. Here’s a chart of the S&P 500 index for the past year.

S&P2015performance

Even if there isn’t a crash, investors in US stocks shouldn’t expect much more than zero to low single digit percentage returns in coming years. In fact returns could even be negative after inflation is taken into account (see here for more).

This looks like a market that’s living on borrowed time. After inflating prices to such high levels, with its money printing and market manipulation, the US Federal Reserve will eventually realise that it hath many sins to repent.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.