At the beginning of this year, investors hoped that the stock market rally, which pushed up the Standard & Poor's 500 Index 30 percent in 2013 and 173 percent from its March 2009 low, would continue apace. So they seized on any optimistic data and forecasts to justify their hopes.
A number of warning flags are flying today. Among them:
1. High price-to-earnings ratios. These ratios aren't at record levels, but they certainly are elevated. Yale professor Robert Shiller’s CAPE (cyclically adjusted P/E ratio), based on the last 10 years of inflation-adjusted earnings to iron out cyclical variations, was 26.5 in mid-September, 61 percent above the long-term average of 16.5. Stocks would need to drop by more than half to reach the long-run average (and remember that declines usually undershoot the average, just as rallies do).
Also, because this ratio has been above average for most of the last two decades, it will probably spend many future years below 16.5 -- if the long-term average is still valid. It is now in the top 10 percent of its range, and when this occurred in the past, the real S&P 500 fell 1.4 percent a year over the next decade. The Shiller P/E isn't a precise forecasting tool, but its elevated level for so many years is a warning sign.
2. Slow economic and corporate revenue growth. Real gross domestic product growth since the mid-2009 expansion began has been the slowest in the post-World War II era. I expect tepid growth to persist at about 2 percent annually until financial deleveraging is completed in four more years or so.
Growth in corporate sales will probably continue to be minimal and pricing power almost nonexistent, resulting in further minimal rises in S&P 500 sales per share. Both consumers and businesses are forcing corporations to slash prices, and many households are again switching from national brand products to cheaper house brands.
3. Earnings depend on profit margins in the absence of meaningful sales volume and price increases. Profit margins are at an all-time high and have been on a plateau for a few years, as measured for the total economy by profits’ share of national income. Margin improvement, which is based on unsustainable cost-cutting and lower borrowing costs, isn't as solid a foundation for profit growth as sales volume increases and pricing power are.
Costs can always be cut further, but the low-hanging fruit has been picked, as seen by the slower productivity growth since the burst in 2009 when U.S. businesses took a meat ax to costs. Furthermore, corporate interest payments can’t decline indefinitely. They have fallen along with interest rates, even though the amount of corporate debt has risen in recent years.
Wall Street analysts expect even higher profit margins this year, a sign of over-optimism.
4. Fed tapering. The Fed hasn't started to reduce the huge $2.7 trillion in excess reserves that member banks have on deposit with the central bank, and it will need to do so before rapid economic growth can resume once financial deleveraging is completed. Otherwise, reserves above the required level will get lent, turn into money in circulation and risk driving the economy through full employment and into serious inflation.
Nevertheless, the Fed has been reducing the additions to these reserves as it cuts its monthly purchases of securities from $85 billion last year to zero next month. So the Fed has been adding less and less fuel to the fire that was the principal driver of stocks since August 2008.