The Two Reasons Stocks Won't Get as Cheap as They Did in 1982
Record low interest rates and corporate buybacks will keep stock market indices from hitting single digit price/earnings ratios.
Relative Value Vs Bonds
We've heard how cheap stocks were back then – in 1981, the S&P 500 earned $15.18 per share and closed at 122.55, for a price/earnings (P/E) ratio of 8.1, or an earnings yield of 12.4%. So why weren't people rushing into stocks?
Because bonds were just as compelling. The 10-year Treasury yield closed 1981 at 13.92%, so despite the fact that mainstream equity indices traded at a single digit P/E ratio, risk-free instruments still yielded more. And while inflation was still running pretty hot in 1981, the real 10-year yield defined as the nominal yield minus the trailing 12-month core consumer price inflation was at 4.2%. By comparison, today real yields are negative. If we had the kind of conditions today that we had in 1982, I would be advising friends and family to buy bonds, not stocks.
Changes in Corporate Capital Structure Preferences
Because debt was so expensive in the 1970s and early 1980s, corporations understandably tried to avoid issuing it. On a relative basis, they had a greater preference for issuing equity than they do today, when bond yields are so low. Additionally, large scale equity buybacks were less common, with investors preferring to receive retained earnings via dividends instead.
Between 1973-1982, for every $1 of net debt that corporate America issued, it also issued $0.04 in net equity. Compare that to today: Over the past decade, for every $1 in net debt that corporate America has issued, it has bought back $0.97 of net equity. And corporations haven't needed to raise much money, except for those overleveraged firms in 2008. As the chart below shows, they've bought back on average $300 billion in equity every year for the past decade, and have barely had to raise any net funds at all. Stagnant wages may be a problem for workers but it has meant booming corporate profits and high margins.
My friend Matt Busigin speculates that households judge equities based on their past performance but they judge bonds based on their yield, and I think he's onto something. But corporations aren't households. Their decisions about how to deploy or raise capital are based on their relative merits, and with debt so cheap and equity so dear, this means capital raising on the debt side and excess earnings going into share buybacks rather than paying down debt. And all else equal, this means higher equity valuations than we'd have otherwise.
Take the case of Intel (INTC). Over the past two years, Intel's stock price has risen by roughly 20%. Over that time, it has bought back roughly 10% of its shares outstanding. Because of those buybacks and a rise in earnings, one measure of its valuation, its enterprise value (market capitalization minus net cash) divided by its earnings before interest, taxes, depreciation, and amortization, or EV / EBITDA, has fallen from 6.07 to 5.73. Its stock has risen by 20% but it has actually gotten cheaper.
This has been the case with many stocks. The US continues to muddle through, sometimes looking like it will grow 1.5%, other times 2.5%, but throughout corporations are slowly growing and plowing their earnings into stock buybacks. It's not sexy, but it's shrinking share counts and padding earnings per share.
As someone who believes that interest rates in the US will remain low for many years, and the US is in no near-term danger of an economic or corporate profit recession, it's unlikely that stocks get much cheaper than their lows of last month. In fact, even if this mediocre recovery continues at about this speed, it wouldn't take much on the sentiment front to get US indices to new all-time highs by next year or early 2014.
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