Value investors, this one’s for you:
The S&P 500 PE multiple at fair value has been trending upward since the Fed and other major central banks have made the decision to continuously monetize excessive debt in the system, since the GFC. This fair value multiple expansion may be partially, but significantly, explained by such currency debasement, and/or the global liquidity catalyzed by debt monetization, which makes its way into scarce assets.
Coincidentally mega cap tech stocks whose hyper growth is based on the network effect, built on, or around the rails of the internet, and thusly driven in a relatively frictionless fashion…
Zhang, Xing-Zhou; Liu, Jing-Jie; Xu, Zhi-Wei (2015). “Tencent and Facebook Data Validate Metcalfe’s Law”. Journal of Computer Science and Technology. 30 (2): 246-251.
…compared to more traditional S&P 500 companies, have come to dominate the index on a weighted basis:
These companies command much larger PE’s, based on either massive earnings growth…
…or on the fact that fair values have little to do with their PE’s, but instead price to cash flow ratios…
AMZN may have a PE of 51, but if its P/OCF is in the 20 to 25 range, then it’s at around fair value. PE is an afterthought.
Other mega caps like Apple (AAPL) and Microsoft (MSFT) on the surface may not have the earnings growth to justify their higher PEs, but instead have solidified their premiums as top world brands with awesome balance sheets and wide moats. Perfect for liquidity-driven PE expansion.
Thus, this tech mega cap dominance of the S&P 500 over the last ten years has naturally caused its PE at fair value to also rise.
And again, circling back around, this rise to dominance, by way of capitalization growth, likely has to do with the global liquidity phenomenon mentioned above, as the hyper growth mega caps are considered a kind of ‘long duration’ asset that is sensitive to monetary policy and liquidity.
As a result, until major world economies fix their debt problems, investors in the SPDR S&P 500 ETF (NYSEARCA:SPY) or Vanguard S&P 500 ETF (VOO) should expect to pay for shares at higher multiples than what their pre-GFC, long term historical averages would recommend, but without this particular phenomenon negatively affecting long-term returns, at least at the magnitude suggested by such.
Here I encourage readers to familiarize themselves with macroeconomist Raoul Pal’s thesis on how debt and global liquidity have become the leading driver of asset prices since the GFC. The thesis is entitled, The Everything Code, and is published through his company, Global Macro Investor. I’ll provide a brief summary below:
US GDP growth has been trending down for decades, secondary to demographic trends (slower population growth, and slower growth of the total number of working age people and labor participation rate).
Yet, US debt growth has been trending upwards, to the point well past what GDP growth can service. And thus, to avoid a credit crisis and deflationary spiral, the Federal Reserve has been monetizing the public debt, freeing up the capital born from GDP growth to service the private debt.
Fed net liquidity versus US debt as a % of GDP growth (Global Macro Investor )
And it’s not just the Fed, but all major central banks are roughly doing the same thing, causing global liquidity to rise exponentially in the long term:
The quantitative easing obsessed gold bugs from the 2010s ended up being correct. A significant amount of the price action of the SPY or VOO can be explained by this increase in global liquidity. In other words, if you divide SPY price action from 2008 to present by the GMI global liquidity index series, you basically get a flat line.
I did my own version of this a while back using the St. Louis Fed graph tool, when I was writing my article on ARKK vs. STMZF. There, I divided the S&P 500 by the Fed balance sheet. Your market gains are kind of meaningless if you’re in the market for a new home, every time the Fed prints:
To test this thesis, I examined the fair value PE ratios of S&P 500’s top ten equities from the GFC onward, at intervals quantized at 3 years. For each discrete snapshot in time, I calculated each set of ten’s weighted average PE at fair value.
The PE values I used to represent these multiples of fair value are the historic ten-year median PEs for each company, i.e. what traders, on the whole, were on average willing to pay for these stocks over ten years. Data from Gurufocus:
Weighted Average Fair Value PE’s of Top Ten S&P Companies for Select Years Post GFC (Andrew Feazelle )
With the rise of mega cap tech, the fair value of the S&P’s top ten equities has also risen from 18 handle to 42 handle.
Further, if we know that the top 10 stocks in the S&P 500 make up 1/3rd of the weighting, and their current fair value PE is 42, then even if all the other stocks were at their median historical fair value PE of 18 (backward looking median PE’s from 1871 onward, using GuruFocus data), it follows that the S&P 500’s trailing fair value PE as of January 2024 is 26 = (42 + 2*18)/3.
This is likely why the SPY has continued to perform well, even when it looked like stocks were ‘in a bubble’ in the pre-pandemic years:
In March of 2017, the S&P had rallied into the $2,300 range, providing a blended PE of 19.9. Here it was beginning to peek above the long term historical average, which was in the 18 handle range. This prompted legendary value investor Chuck Carnevale to caution the investment community that stocks were no longer cheap.
Ultimately, the proof is in the pudding: Since its post GFC nadir in the third quarter of 2011, the S&P’s monthly trailing PE has afforded a series of higher highs and higher lows, discounting the local effect of the Covid-19 disruption on the multiple. And as a value investor at heart, I say that any type of market phenomenon that can last 10 years or more is likely (9 times out of 10) justified by some underlying fundamental quality.
Monthly Trailing PE’s for S&P from 2011 nadir to 2024. Trend line by Andrew Feazelle (multpl.com)
What is also noteworthy here is that as some of these mega caps start reaching middle age, and focus more cash flow onto earnings, buybacks and dividends, there may be a bit of deceleration of this trend. Such has informed which trend line I ultimately used, on the above graph, and which I’ve used to project out future bull case fair value PE’s for the S&P in the next section below.
What should value investors be willing to pay for the SPY going forward?
If the monthly PE long-term trend from the GFC nadir held, then the fair values for the S&P look something like this:
I don’t think it’s appropriate to extrapolate out past December 2025. Past that point, the global liquidity cycle should be winding down, based on its historic periodicity:
Periodicity of the ISM shown by superimposing it onto itself, one period removed (Global Macro Investor) Global liquidity cycle follows the ISM and should go negative in 2026 (Global Macro Investor)
Based on this cycle, central banks will try to reduce their balance sheets, and/or cool inflation by pulling liquidity out of the system in 2026, and equities will do what they do every 4 years since the GFC, and find gravity.
However for long only, diamond-hands investors with decadal investing horizons, the bull case projection suggests that buying the SPY under $556 for 2024, and under $640 in 2025 is appropriate.
The ultra bull case is made by plotting my average fair value PE’s for the top ten S&P companies onto GMI’s liquidity vs federal interest expense chart. One can see how all three of these phenomena are strongly correlated. GMI has projected out federal interest expenditures into 2025, as all of the pandemic spending comes home to roost, and it is not pretty:
Such theoretically implies that somewhere in 2025, the fair value PE for the top ten S&P companies could peak at as much as 66! And this then implies an overall S&P fair value PE at 34, were its bottom 2/3rds to retain its historical trailing fair value PE of 18!
This could be a perfect storm scenario, where something in the system goes horribly wrong, giving the Fed the excuse it needs to rapidly monetize all that pandemic incurred debt, eventually catalyzing a tech rally on the other side of a panic. Basically, something similar to what we went through in the pandemic.
If this seems outlandish, consider that in February of 2020, the S&P’s monthly trailing PE was 26 and its price was somewhere in the $3300 range. This would be considered over 40% overvalued by traditional value investing methods, not taking into account currency debasement and/or the rise of big tech. The Fed’s balance sheet then went from around $4T up to almost $9T in Q2 2022…
…and the S&P subsequently peaked at around $4700 in December 2021. That’s a 42% gain from a point that was statistically more likely to fall than rise. Admittedly, it did fall before it rose, but likely you can’t get to the sweet, sweet rush of liquidity without there being some type of painful event.
Based on my trend line fair value methodology for the S&P’s PE, and a rough estimate of trailing earnings as of June 2024, the fair value of the S&P is currently $5,200. A similar 42% gain from here would put the S&P at $7,400.
I doubt anything past $8000 is probable, as the Fed may be more cognizant of inflation and the US’s massive deficit spending contributing to such, this time around. A rapid balance sheet expansion likely could put significant upward pressure on housing, which then would show up down the line in PCE.
No doubt they do want to monetize the debt, to avoid pain regarding GDP growth, but at the same time they want to not contribute to price instability. So likely those middle ground numbers on the chart above (mid $7,000’s) are more probable during a massive liquidity surge.
But don’t get too caught up on the exact numbers; these aren’t price targets; the concept is this: if I see Federal Reserve net liquidity rapidly rising to 8, 9 or 10 trillion dollars, then I would feel comfortable adding to my long SPY position anywhere in the $600 to 699 range or below, and would consider those prices to have a significant safety margin for the long run, or at least up until the global liquidity cycle breaks. And whatever event would cause the Fed to react in such a manner would likely give me that opportunity to be a buyer in that range and likely below it.
In the less aggressive case, I’ll respect that there may be a local attrition of the S&P’s top ten equity average fair value PE.
Tesla has at present moved out of the top ten companies, so its massive 104 PE at fair value for the last ten years is no longer as influential as it once was:
And again, as these companies focus more on earnings and dividends, their fair value PE’s should come down over time. A linear recession, based on the January 2021 peak and January 2024 data point, provides the following:
The major risk to this thesis is anything that disrupts the liquidity cycle or its periodic trend that’s been occurring since 2008.
On a smaller investment horizon, this could be a political disruption secondary to the financial insecurity from this monetary driven, asset price inflation.
On a medium term investment horizon, this could be an AI driven sustained productivity boost (and accelerated technological innovation rate secondary to such) that allows GDP growth to service debt more efficiently, taking the pressure off central banks to monetize debt. Because it would be productivity that’s increasing GDP growth, likely this would not be as inflationary as other drivers of growth, such as population growth, or debt growth. I’d say this is the most likely scenario, and we may only get a few more cycles that mimic what’s been occurring since the GFC.
On a much greater investment horizon, productivity should also rise as clean energy technology eventually puts downward pressure on energy prices. But that is rather irrelevant to this article.
Because of the massive debt in the major world economies, central banks have chosen the lesser of two evils, and have seemingly collectively decided to monetize that debt, rather than let a Great Depression event unfold.
Such has caused the S&P 500’s fair value PE multiple to inflate past what would be considered reasonable before the GFC. As a result, value investors have to become more comfortable owning SPY and VOO at higher multiples.…Read more by Andrew Feazelle
