Tools, jewels and P/E ratios
There are two basic reasons why an asset has value and this understanding should be foundational knowledge for anyone running a portfolio. They can be prized for their efficiency (a tool) or desired because of their scarcity (a jewel). Investors’ preferences for jewels versus tools will shift through time, but what does not change is the fact that scarcity cannot lead to economic growth; only the application of efficient assets allows society to progressively expand its output, and along the way enrich those who have invested in the means of production.
By way of example, I shall in this piece use silver as a proxy for scarcity (the gold price was controlled until 1971) and the S&P 500 as an efficiency measure of the US economic system. It follows that a ratio between these two variables will illustrate the relationship between efficiency and scarcity. In periods when the relationship is rising it follows that US economic policies are conducive to growth. Conversely, in periods when the ratio is in decline, the reverse situation must be true.
In addition, during phases when investors perceive the outlook for growth to be favorable for years to come price/earnings ratios tend to rise. This can be thought of as markets expanding the duration of the cash flows that they are willing to discount into the future. Hence in good theory there should be a clear relationship between the S&P 500/silver price ratio and the long term evolution of P/E ratios. And, indeed, this is the case as shown in the chart overleaf where it can be seen that the Shiller cyclically adjusted P/E ratio (a smoothed form of the classical P/E) and my tool/jewel ratio tracks to such an extent that since 1920 the two variables have a correlation of about 0.9.
My next task is to test whether economic policies did, in fact, prove to be conducive to growth, or not as the case may be. For this purpose, I use the real interest rate offered by three month treasury bills—negative real rates reflect “bad” policy settings unconducive to growth, while positive real rates denote “good” settings.
And remarkably it turns out that good economic policies are usually associated with higher P/Es, and bad economic policies with lower P/Es. Put another way, in each phase when overtly Keynesian policies have been adopted (read long stretches of negative real rates) silver has, after a while, begun to outperform the S&P 500, while in these phases, P/E ratios have tended to either fall or simply go nowhere.
As a result, my decision rule is that when silver outperforms the S&P for 18 months straight, I become fairly certain that P/E ratios will enter a period of structural decline. It should be noted that in the last 18 months, silver has outperformed the S&P 500 by 13%, so it seems likely that a long term market derating has probably started. Since the US equity market is starting from a hefty 25x P/E, there is potentially a long way to fall.
With corporate America mid-way through an unremarkable earnings season it is worth noting that for the market to offset a decline in the P/E ratio, earnings would need to rise markedly. Yet, over the last two years the 12 month trailing EPS of the S&P 500 has declined by about 9% a year.
US equity prices were able to stay stable over the last two years not because of higher earnings, but due to a P/E expansion that probably resulted from the grinding decline in long rates. Yet, it should be noted that over the last 18 months this P/E expansion did not prevent the stock market from underperforming silver.
Given the confluence of bad economic policies and the bad signal coming from the efficiency/scarcity measure the conclusion must be that US equities look precariously balanced.