The Phony Bull Market

We're constantly told there is a bull market in stocks. By CNBC. By The Wall Street Journal. By everyone under the Sun.

This is a lie.

There has been a bull market in corporate earnings. But these gains are not reflected in stock prices. People are paying less-and-less for every dollar of earnings ever since 2000. Thus the market has been treading water -- sometimes a bit up, sometimes a bit down.

The ratio of a stock's price to its earnings per share, sometimes called the P/E ratio or earnings multiple -- was at record highs before the Dot-Bomb. It has since fallen to around  near its historic median of 17. (Chart courtesy The Big Picture.)

This is called earnings compression. This is not the sign of a bull market, but a bear market.

Look at the right side of the chart. See what was happening in the 1990s? People were paying more-and-more for each dollar of earnings. That's a bull market. See what has been happening since? They have been paying less-and-less. That's a bear market.

In the long run, earnings compression is a very good thing. Stocks should trade near their median P/E ratio. They should trade below it during bear markets, above it during bull markets.

Oh, with interest rates rising, earnings compression should continue. Why? A 5% bond is a P/E of 20 -- you pay $100 to get $5 every year, and 100 divided by 5 is 20. A 6% bond has a P/E of about 17, a 7% bond a P/E of about 14, and a 10% bond a P/E of 10.

If that's what you get for relatively low risk, you should get a higher return for the higher risk of stocks. Thus the P/E of stocks should fall when bonds rise, and stock prices should fall.

A lot of what has been happening has been hidden from view by the extremely low interest rates of the last decade. A 4% bond has a P/E of 25, a 3% bond a P/E of 33, so as you can see with loan rates low stocks or real estate have been the only places to go.

No more.

The historical relationship between stock and bond prices is being re-established, historical patterns are being re-established, and if you thought the last five years were a bear market for stocks (as I do), well you haven't seen anything yet.