Further Evidence of an Overvalued Market

By Lance Roberts, CEO, StreetTalk Advisors

Today’s chart of the day was the result of a question by my friend Richard Rosso who asked if corporate profits were suggesting that the current market environment was becoming overvalued.  The timing of the question was apropos as I was already pondering a statement made by Matthew O’Brien at the Atlantic who stated:

“Just because the price of something is going up doesn’t mean it’s a bubble. Even if it’s going up a lot. And even if it’s something you don’t like. After all, there might be a good reason it’s going up so much. A good reason like … record profits.”

While Matthew was addressing whether, or not, the artificially inflated markets have once again started to reach “bubble” territory, and there are certainly arguments that suggest it well could be, the importance of his argument really focuses around the notion of record profits.

The mistake that is likely being made by many is the assumption that when profits reach a new “record” it is the beginning of a new trend rather than the end of something that begin some time ago.  The issue comes when mainstream analysts begin manipulating data in order to justify current market dynamics.  In this instance in order to justify high market prices one must assume that the current “record” levels of profits will continue forward indefinitely.  The problem with that assumption is that this has never been the case historically and one that will likely not manifest in the future.

The chart below shows several things of importance relating to the current valuation of the financial markets.  The only valid measure of market valuation that is historically consistent is trailing twelve month REPORTED earnings per share.  Using other measures such as operating, or pro-forma, earnings to try and justify current market levels is both inconsistent and inaccurate when performing valuation analysis.  I have also included price to corporate profits (NIPA) per share for a comparative measure.




As you will notice each time that corporate profits (CP/S) and earnings per share (EPS) were above their respective long term historical growth trends the financial markets have run into complications.  The bottom two graphs shows the percentage deviations above and below the long term growth trends.

What is important to understand is that, despite rhetoric to the contrary, “record” earnings or profits are generally fleeting in nature.  It is at these divergences from the long term growth trends where true buying and selling opportunities exist.

Are we currently in another asset “bubble?”  The answer is something that we will only know for sure in hindsight.  However, from a fundamental standpoint, with valuations and profitability on a per share basis well above long term trends it certainly does not suggest that market returns going forward will continue to be as robust as those seen from the recessionary lows.

John Hussman recently summed this up well stating:

“The period of generally rich valuations since the late-1990’s (associated with overall market returns hardly better than Treasury bill returns since then) has created a tolerance for valuations that, in fact, have led to awful declines, and have required fresh recoveries to elevated valuations simply to provide meager peak-to-peak returns. At the same time, the intervening recoveries to the 2007 highs and again to the recent market highs, coupled with what Galbraith called “extreme brevity of the financial memory” have periodically convinced investors that the market will advance diagonally forever. History teaches a different and very coherent set of lessons:

  1. Depressed valuations are rewarded over the long-term;
  2. Rich valuations produce disappointment over the long-term;
  3. Favorable trend-following measures and market internals tend to be rewarded over the shorter-term, but generally only while overvalued, overbought, over bullish syndromes are absent;
  4. Market losses generally emerge from overvalued, overbought, over bullish syndromes, on average, but sometimes with ‘unpleasant skew’ where weeks or even months of persistent marginal advances are wiped out in a handful of sessions. The losses often become deep once the support of market internals is lost. When a broken speculative peak is joined by a weakening economy, the losses can become disastrous.”

While there may not be an asset bubble currently; valuations by both of the metrics (CP/S and EPS) studied here are clearly rich.  However, for investors, it is important to remember that valuation measures are horrible short term market timing devices.  In the long run valuations mean everything.  While I am not suggesting that the market is about to plunge into its 3rd major reversion for this century, even though that possiblity does exist, I am suggesting that future returns will likely not be anything to write home about either.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Lance Roberts

Lance Roberts

Lance Roberts is the CEO of STA Wealth Managment. The mission of STA Wealth Managment is simple - lead our clients to financial success by actively managing their assets while limiting risk to capture returns. Through the utilization of economic and technical analysis, historical research, and risk controls, we build portfolios which will create long-term investment results.

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  • http://howfiatdies.blogspot.com/ Vincent Cate

    Also, interest rates going up will eventually be bad for stocks.


  • Andrew P

    If you look at the reported EPS graph, the swings up and down are increasing in amplitude as the trendline curves upward. Each successive high (1999, 2007) and low (2002, 2009) deviates from the trendline ever more. If this pattern holds, we have not yet seen anything near the high for this cycle. But if you go by the “profits” curve, we could be close.

  • http://macronomy.blogspot.com/ Martin T


    Excuse my French Cullen, but it should be “à propos”



  • Anonymous

    The Fed (Banks) and Washington have to support these valuations at all cost. If the market corrects the severity of the ramifications will be catastrophic. The valuation metrics that are so often sited are wall street creations that are absolutely meaningless to any long term investor.

    In 2009 when Assad (Syria) gave his “Four Seas Strategy” pitch to united the Middle Kingdom, Europe, China and Russia with a pipeline to supply resources to the East, Saudi Arabia, Qatar and the United States went nuts. Since then Gazprom, China National Petroleum Corporation and a handful of other major oil players have invested billions into the infrastructure. This infrastructure poses a catastrophic shift in the balance of power; hence, we get the Arab Spring and an escalation to see who takes control over the Middle East. Russia is now moving its military into position to protects its assets……. we are on the verge of a major war equal to any of the major conflicts throughout history. China and India must have oil and gas to grow. Follow the pipelines and follow who holds or takes control over the middle east and you will get monetary policy right for the next decade.

  • Mark Caplan

    The CP/S graph looks like the graph of “Corporate Profits After Tax with Inventory Valuation Adjustment and Capital Consumption Adjustment” from the St Louis Fed’s FRED Economic Data series. But I didn’t think that data was tabulated on a per share basis since the profits pertain to the whole economy, not just the S&P500. How did you calculate corporate profits PER SHARE?

  • John

    The graph should be logarithmic, not arithmetic, to better reflect growth rates. The label for the left scale incorrectly indicates a log scale.

  • Old Dog


    But if this data is displayed correctly scaled the argument is weakened significantly.

  • GT

    Interesting. Sounds to me like a conspiracy theory. I’d like to read more about, can you post your sources?

  • Befuddled

    Yeah, right. Inflation. Sort of like Japan? Good luck with that trade!

  • Geoff

    Don’t get Vince started on Japan! But I do agree with him that Japan is in a precarious situation. Given their high level of debt/GDP, it would not take a significant increase in interest rates for inflation to accelerate out of control. If interest on govt debt exceeds NGDP, then debt servicing costs will become an increasingly large portion of the govt budget and Japan will become toast.

    Vince, what is the average rate of interest on Japanese govt debt right now? I’m going to guess it is around 0.5 percent. If NGDP growth remains above 0.5%, then Japan should survive, all else equal. A big “IF”, granted.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    They increased the money supply by 3.4% in the last 10 day period and are paying 0.27% per year on 5 year bonds. Even at these crazy low interest rates the interest payments are about half the taxes. What kind of idiot thinks it is good to hold bonds in Yen paying 0.27% per year for the next 5 years, for a grand total 1.35% when the Yen can drop that much in a day and they are regularly increasing the money supply by more than that in 10 day periods? Clearly there are many people who realize it is bad to hold these bonds and are dumping them but so far the central bank is buying them as fast as people are dumping them. I expect people to dump faster and faster and then we get hyperinflation.

    The inflation rate has gone up about 0.5% each month the last 3 months since this new policy started. They only need 3 more month to exceed their goal of 2% inflation. I am just sure they won’t stop at 2%.


  • Geoff

    Vince, you wanna know who’s buying JGBs at such low yields (besides the BOJ)? I’ll tell you. It is global government bond funds. Managers of these funds don’t give a sh-t how low the JGB yield is or how low the Yen will drop. All they care about is the fact that Japanese bonds make up over 30% of their benchmark index. Most of them are closet indexers.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Do you have any evidence that this is going on in significant amounts?

  • Geoff

    I’ll see what I can dig up but I’m sure you know that Japan is one of (if not THE) biggest bond markets in the world. Any mainstream, market cap weighted index like the Shitigroup Global Government Bond Index will be heavily weighted toward Japan.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Remember, the BOJ bought so many bonds in the last 10 days that they increased the money supply by 3.4%. I think the net for the rest of the people is selling. If there is any buying I strongly suspect it is on net small compared to the BOJ.

  • http://brown-blog-5.blogspot.com Tom Brown

    Hey Vincent, let me try this out on you (I’ve been pestering Sumner with this in his explanation of the hot potato effect (HPE)). Say we have two cases:

    1. Fiat money: Fed finds $1T of coins in the basement they didn’t know they had.

    2. MOA = gold: Fed finds $1T of *GOLD* coins in the basement they didn’t know that had.

    In both cases the Fed decides to put all the coins up for sale (and not destroy any of them) w/o remitting to Tsy (they’re anticipating they might need a Fed slush fund in year 3067), and they announce all this to the world!

    Sumner gave me two different answers. Partly that was my fault because my examples started out more complicated and I didn’t ask at the same time. And perhaps in the course of simplifying them to their current forms… I changed something crucial… but I don’t honestly think so.

    Sumner said that in case 1 the coins are not “base money” which is true, because “base money” is at the banks or in circulation: at the Fed it’s still money, but not base money (those coins are assets to the Fed). Thus he implied they would be of no significance.

    In case 2, he wrote:

    “If I understand your question (doubtful) then I’d say that after the gold was sold it would be owned by the public, and prices would rise. Indeed if it was known the gold would be sold, prices would rise in anticipation.”

    A very different answer! What say you?

    Here’s the article, BTW:


  • http://howfiatdies.blogspot.com/ Vincent Cate

    Tom you ask good questions. Clearly if you double the supply of something and demand is unchanged the hot potato effect should make the value go down. It should work the same no matter what thing we are doubling the supply of. So if you double the supply of gold or double the supply of money we should expect the value of each unit to go down (maybe not exactly half) after enough time.

    All the people who say “new money is not like finding new gold it is done as an asset swap where an equal value is removed” forget that the bonds the central bank buys from the government are just created out of nothing too. If the bonds are created out of nothing and the money is created out of nothing then together it is just like finding new gold.

    I would chance the question a bit though. We could imagine that the Fed might not use either $1 trillion it found in coins or $1 trillion it found in gold. But if you had the Treasury find these things in its vault we know they are spending far more than they get in taxes and will spend them. So change it to “There are 2 cases. In the first the Treasury finds it owns $1 trillion in US $2 bills coins made up by the Carter administration and in the second case it found $1 trillion in gold hidden away by Nixon administration.”.

    Ask Cullen this question. :-)

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Maybe add that after a legal challenge it is determined that the Treasury is free to spend what it found.

  • http://howfiatdies.blogspot.com/ Vincent Cate
  • http://brown-blog-5.blogspot.com/ Tom Brown

    Vincent, I’m sure Treasury would spend them! That’s why I didn’t tell it that way.

    I simplified case 1 quite a bit. This was my original:


    Scott didn’t answer that one, so I modified it to this:


    and then to the Case 1 in my previous post here.

    I’m purposely exploring the concept of “trapped” money here. Now supposedly coins are money the second they leave the Mint, and they are treated as such by the Fed, being assets on their balance sheet (while stored at the Fed). I made a mistake in that second link above though in calling this money “base money” because it’s not: base money is cash or Fed deposits at the banks or in circulation. Fed deposits at Tsy and coins at the Fed are not base money (though they’re both still money). Paper notes at the Fed are not even money: They doesn’t have their face value to anyone.

    So it was very interesting to me that Sumner told me my case 1 would do nothing since the coins are not base money, and yet said my case 2 would cause inflation! I re-presented them both to him in the simplified manner above to see if he answers the same again (he seemed confused by the questions both times before).

    BTW, one argument against case 2 causing inflation is “What are you going to buy the gold coins with if MOA = gold? More gold coins? How does a net amount of gold coins ever leave the Fed?” “TallDave” essentially made that argument.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Here’s TallDave’s response to the 2nd version of Case 2:


    The “magic box” he talks about can create gold.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Shoot, I meant “Case 1″

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Wow, that was fast Vincent!

  • Geoff

    Vince, if “money supply” as traditionally defined increases by 3.4%, it doesn’t tell us much, especially if it is only due to an asset swap. I would be more concerned if NFAs increased by 3.4%, which is certainly possible if interest rates rise high enough, causing the govt deficit to explode.

  • Mr. Market

    Nope, rising interest rates are actually deflationary because it makes bond prices go lower.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Krugman says that when we are near the zero lower bound for interest rates we don’t have to worry about inflation but that we will when interest rates go up.


  • Mr. Market

    Yep. it’s the usual misconception. don’t worry, you’re not the only one. A lot of other people have the same opinion.

    Krugman wants more inflation. Did he ever look at the stock & bond market since march 2009 ? That’s what I call “Inflation”.

    Inflation supposedly leads to rising interest rates. Yes, it happened in the 1970s. But if that’s the case then why did interest rates fall from 2000 (~ 6%) up to mid 2008 ( ~ 4%) when commodity prices went through the roof ? Seems there’s a different driver pushing rates higher or lower other than “Inflation”.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Tom, “Vincent, I’m sure Treasury would spend them! That’s why I didn’t tell it that way.”

    So imagine the following. The Treasury makes bonds out of thin air, sells them, and spends the money. The central bank makes money out of thin air and buys bonds. So on net this is as if the Treasury was spending money out of thin air, right? The same as if it had found some money and spent it, right? So it should be inflationary, right?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Vincent, deficit spending is inflationary. No question. Is it inflationary in a deflationary environment? Not necessarily. I think that’s what we have now. QE has little or nothing to do with it, except that it helps to make short term Tsy debt and MOE close to perfect substitutes.

    To a 0th order approximation I’ll grant you the following:

    private non-banks’ stock of money = L + B + F

    L = bank loans
    B = bank held Tsy debt
    F = Fed held Tsy debt

    private non-banks’ equity (however) is still T = total Tsy debt.

    Assuming Tsy spends ever $ immediately.


  • Geoff

    The hyperinflation view always comes down to the belief that the central bank is financing the deficit. If you believe that, then sure, there is the potential for some funny business in terms of inflation. You could certainly make a good case in Japan that the BOJ is financing the deficit. But inflation has remained low there because the deficit hasn’t been big enough!

    So far.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    I think you have put it well. The hyperinflation question really is, does the central bank fund the government’s deficit? During hyperinflation that is clearly what is going on. So the question is are we headed for that or is it still possible to avoid that situation. I don’t think Japan could avoid it any more.

  • Geoff

    Another important question is why does the CB have to finance the deficit in the first place? The answer probably has something to do with production, or lack thereof, which is ultimately the root cause of most hyperinflations as Cullen has written. Is production in Japan declining due to the nukes or the shrinking population?

  • http://howfiatdies.blogspot.com/ Vincent Cate

    The core problem seems to be that politicians like to spend money, even if they don’t have enough taxes for all they want to spend. They sort of buy votes by giving money to different groups. They are worried about getting elected, not about hyperinflation.

  • http://brown-blog-5.blogspot.com Tom Brown
  • Suvy

    One thing that wasn’t mentioned in this article is that we have very low discount factors. You can have relatively high P/E’s if discount factors are extremely low.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    They are spending twice what they get in taxes, so NFAs are clearly going up fast.

  • Geoff

    I was going to say “not fast enough!” but it does look like inflation IS finally beginning to pick up in Japan, which is the objective. But I guess you’re saying that once the genie is out of the bottle, it’s going to take off?

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Ya, I think Japan will pass their 2% inflation target in the next 3 months and accelerate from there.


  • http://howfiatdies.blogspot.com/ Vincent Cate

    Tom, thanks. For some reason I can not post to that site about inertia. Tried from 2 different computers and closed browser and got rid of cookies. Hum. Can you post saying Vince Cate says it is really a positive feedback loop but to a non-technical person it seems like inertia and link to my FAQ?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I tried posting with your name in there and it didn’t work. You must be blacklisted. Ha!

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Cool. Blacklisted at a sight I don’t even remember going to before. :-)

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Oh, post says I am not blacklisted. But I tried posting again and I still can not. Can you post for me? If I am not blacklisted it is not like we are getting around deliberate blocking.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    “I don’t even remember going to before”

    This should be a wake up call to you Vincent… flying off in a drunken rage (as I’m sure you must have done)… typing hurtful, indiscriminate messages on blogs you don’t even know anything about … and then blacking out and forgetting it even happened. Waking up days later in a stupor, iPad on the floor. Sad, very sad. I’m sure Marcus is still traumatized by what you wrote… Who knows how many others out there that you’ve hurt. Perhaps it’s time to admit you have a problem and take that first step towards making amends…


  • Geoff

    Vince, did you put in your email address as well?

  • http://brown-blog-5.blogspot.com Tom Brown

    Vincent, msg from Joao Marcus:

    “Ask him to explain that so I can post something that is understandable.

    tell you what… if you don’t mind me passing your email on to Joao, email me. Then I can exit the loop on this one.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    My good electronic friend Tom, I don’t even seem to have your email address. :-)
    Mine is vince cate at gmail and you can give it to anyone.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    So my problem is with all wordpress sites. It seems using “Vince Cate” or “howfiatdies” is now blocked on any wordpress site. Guess I have posted these enough times to bother somebody or something.

    Oh well. Now that I know I just have to use new names. :-)

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Vincent, you probably blacked out after a binge of hyper-hyper-inflationism … Maybe it’s time you step away from the keyboard and take a long hard look at yourself. It doesn’t have to be like this. You can get the help you need.


  • http://howfiatdies.blogspot.com/ Vincent Cate

    Tom, remember I am on a small island raising 4 boys. When they are asleep or watching a movie I sometimes sneak away and play on my computer. My favorite sport I call “intellectual jousting”. Stretches my mind in different ways than snorkeling with kids and playing on the beach.


  • http://brown-blog-5.blogspot.com/ Tom Brown

    Do you live on the Island year round?

  • http://howfiatdies.blogspot.com/ Vincent Cate

    Yes, year round. Even in the middle of hurricane season like now. Me, my boys, some palm trees, and 13,000 other people. :-) It is Anguilla, just East of the Virgin Islands.

  • http://www.orcamgroup.com Cullen Roche

    I find it rather ironic that you live in a country with a current account deficit, a pegged currency, foreign denominated debt, few natural resources and a heavy reliance on foreign investment, yet you’re perpetually worried about a USD crisis. The East Caribbean Dollar is a perfect candidate for a currency crisis….

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Looks beautiful!

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Cullen, take it easy on the place… they do have nice looking beaches. Sheez ;)

  • http://orcamgroup.com Cullen Roche

    Oh, it’s beautiful. Don’t get me wrong. I just don’t find the status of the East Caribbean Dollar to be all that impressive. :-)

  • Adrian

    The argument still stands and is very valid. You should be caution about stock market in US at a point in time in next few years and that moment is obviously closer and closer. At least relative to Europe for example or emerging markets, that are already in a downtrend.
    It is something that you have to keep watching and be aware.
    I think at this moment in time Europe is a way safer bet for stocks then US.

  • http://howfiatdies.blogspot.com/ Vincent Cate

    The East Caribbean Dollar uses a Currency Board. So they have enough US bonds to be able to redeem all EC dollars at the pegged rate. The only way we should get a crisis is if the US dollar gets a crisis.

    I really think the Yen falls first and have placed my bets. If I am right about hyperinflation the Yen should be in trouble soon. Wish me luck!