Why You Should Be Bearish
Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors are constantly looking for ten baggers in the latest trends, like 3D printing, an aging population, and the Chinese growth miracle. Without looking at the big picture it is easy to ignore the possibility that stocks as an asset class are overvalued.
Corporate profits after tax are at super high levels. This is not a simple anomaly from the latest quarterly earnings, but a substantial change over the past couple years that has become the new normal. As the chart below shows, there is a high correlation between corporate profits and the total return of the S&P 500. This is quite logical, as shares offer fractional ownership of their respective companies and greater corporate profits logically imply more profits and income for each shareholder.
US Corporate Profits After Tax as % of GDP data by YCharts
The chart below shows that the corporate tax rate is far above it's long term average. With the Federal Reserve placing interest rates at zero and the subsequent compression throughout the yield curve, it is not hard to understand where these profits are coming from. As others have pointed out, government deficits play a huge role in financing these enormous corporate profits. Giving a portfolio an equity allocation that is dependent on continued federal deficits is a scary proposition.
US Corporate Profits After Tax as % of GDP data by YCharts
Investments to Avoid
S&P Depository Receipts (NYSEMKT: SPY) is a great, low cost ETF. With a yearly expense ratio of .10% this ETF is the definition of efficiency. The average P/E ratio of 15.1 and 1 year forward P/E ratio of 13.78 look very reasonable on a short term basis. Sadly, P/E ratios hide the fact that earnings are overvalued. A 40% decline in corporate profits as a percentage of GDP to a more reasonable 6% would create a 40% decline in the stock market, given an equal P/E ratio.
The Ishares Trust S&P 500 Index Fund (NYSEMKT: IVV) is more expensive than SPY with its P/E ratio of 19.55, but over the past 10 years IVV has underperformed its index by only .07%. Even though the expense ratio is lower than the SPY the fund does not provide a way to shield investors from the future decline of abnormal corporate profits.
iShares Russell 2000 Index (NYSEMKT: IWM) is another broad market ETF that provides greater exposure to the U.S. stock market. As the name suggests, the ETF gives a more diversified look at the stock market, with close to 2,000 different holdings. With an expense ratio of .23%, a P/E ratio of 25.6, and a price to book ratio of 3.37, it is trading at much higher valuations than SPY. Since inception, the IWM has underperformed its index by only .12%; but regardless the current P/E ratio of 25.6 makes the fund very expensive. Given the high P/E ratio and very high corporate profits, this ETF is definitely an investment to avoid for long term investors.
Given the negative sentiment for the broad market it may appear logical to put some capital in Short S&P 500 ProShares (NYSEMKT: SH) and UltraShort S&P500 ProShares (NYSEMKT: SDS). However, given the short term nature of these ETFs and the general volatility of the market I believe this is a very poor choice. SH has an expense ratio of .89% and tries to return the inverse of the daily return of the S&P 500. Over longer time frames a significant amount of tracking error develops; for instance, over the past 2 years SH is down close to 30%, while SPY is up 20%. The average price to earnings ratio is only 14.67, which can appear reasonable considering that it is nowhere near the highs seen in the 90's tech boom.
SDS has the same expense ratio of .89%, average PE ratio of 14.67, and daily index, but twice the leverage. Coupled with an average price to book ratio of 2.24, the firm's holdings are not very expensive on a short term basis. Given that a decline in corporate earnings to more reasonable levels will only occur after years of adjustment, the focus of these ETFs on daily returns make them poor instruments for the task at hand.
Conclusion
A decrease of corporate profits from 10.68% of GDP to a more reasonable 6% at an equal P/E ratio of 15 will cause a decline of approximately 40% in the broad market. The decline in corporate profits will not occur instantaneously and is not very relevant for the short and medium term, but the long term picture is not as rosy. Abnormally low interests rates and high government deficits over the past couple years have created a sublimely deceptive environment where high corporate earnings appears normal and logical. Investors need to look beyond stock picking and examine the state of the entire stock market if they wish to make wise investment decisions. Long term investors who do not want to re-balance their portfolio to account for declining corporate profits should be ready for paltry returns over the long term.
MrCanadian1 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
