Photo: iStock
Photo: iStock

By two simple valuation measures, the S&P 500 is overvalued by the biggest margin in twenty years.

First, the S&P 500 level has run ahead of earnings per share to an extent not seen since 1999, right before the great tech crash.

Second, earnings per share exceed actual profits by the largest amount in the past twenty years, mainly due to equity buybacks. Buybacks are an effective way to boost earnings per share by reducing the number of outstanding shares. That works when interest rates are low and credit conditions are easy, but not so much when rates rise.

S&P levels predicted by EPS

The chart above shows the regression of the level of the S&P against earnings per share. The circled areas on the residual line show periods when the S&P rose much more than per-share earnings could explain. By this reckoning the S&P is a full 500 points (or 18%) higher than predicted by the long-term relationship between earnings and price.

That’s not the worst of it, though.

Corporations report their total profits to the Treasury Department for tax purposes, and the government uses this data to calculate the actual level of corporate profits. In the chart below, we compare after-tax corporate profits to reported earnings per share.

EPS deviation from GDP profits

Earnings per share are much higher ($10 per share, or 28%) than the total amount of after-tax corporate profits can explain.

Assuming that the level of the S&P reverts to the historical relationship between index price and earnings per share, and, secondly, that earnings per share revert to the historical relationship between EPS and total corporate profits as reported by the government, the index will fall by 18% + 28%, or 46%.

I’m not predicting a 46% decline in the S&P 500, to be sure. But the stock market is so rich by historical standards that it is a lot more likely to go down than to go up.

22 replies on “It’s time to sell US stocks”

Comments are closed.