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7 Reasons To Be Cautious

Doug Kass outlines 7 reasons to be cautious about the current equity market valuation: 1. Price-to-revenue ratios for S&P 500 companies are at historic highs exceeding levels seen in 2000. 2. Shiller P/E ratios are above 25, a level only seen in the late 1920s and late 1990s bubbles. 3. Market cap-to-GDP ratios have surpassed 2007 levels and are approaching 2000 extremes. 4. Implied profit margins used in Shiller P/E calculations are 18% above historic averages, inflating valuations. 5. Record high profit margins are unsustainable as they inversely correlate with declining government and household savings. 6.

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Nico A. Cotzias Jr.
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76 views1 page

7 Reasons To Be Cautious

Doug Kass outlines 7 reasons to be cautious about the current equity market valuation: 1. Price-to-revenue ratios for S&P 500 companies are at historic highs exceeding levels seen in 2000. 2. Shiller P/E ratios are above 25, a level only seen in the late 1920s and late 1990s bubbles. 3. Market cap-to-GDP ratios have surpassed 2007 levels and are approaching 2000 extremes. 4. Implied profit margins used in Shiller P/E calculations are 18% above historic averages, inflating valuations. 5. Record high profit margins are unsustainable as they inversely correlate with declining government and household savings. 6.

Uploaded by

Nico A. Cotzias Jr.
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Thursday, December 05, 2013

10:09 PM

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7 Reasons to be Cautious
By Cullen Roche Comments (8) Wednesday, December 4th, 2013
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In a recent piece by Doug Kass at TheStreet.com he highlights some reasons to be cautious about the equity markets. I dont like the
concept that everyone is in the pool, as he mentions, because it implies something like the cash on the sidelines fallacy , but I do
think his piece is well thought out and worth considering. Ive attached his 7 reasons to be cautious:
The median price-to-revenue ratio of the S&P 500 is now at an historic high, eclipsing even the 2000 level.
The Shiller P/E is above 25, exceeding all observations prior to the late-1990s bubble except for three weeks in 1929.
Market cap-to-GDP is already past its 2007 peak and is approaching the 2000 extreme. (This ratio is stretched at over two standard
deviations above its long-term average.
The implied profit margin in the Shiller P/E (denominator of Shiller P/E divided by S&P 500 revenue) is 18% above the histori cal norm.
On normal profit margins, the Shiller P/E would already be 30.
If one examines the data, these raw valuation measures typically have a fraction of the relationship to subsequent S&P 500 to tal
returns as measures that adjust for the cyclicality of profit margins (or are unaffected by those variations), such as Shille r P/E, price-torevenue, market cap-to-GDP and even price-to-cyclically-adjusted-forward-operating-earnings.
Because the deficit of one sector must emerge as the surplus of another, one can show that corporate profits (as a share of G DP)
move inversely to the sum of government and private savings, particularly with a four - to six-quarter lag. The record profit margins of
recent years are the mirror-image of record deficits in combined government and household savings, which began to normalize about
a few quarters ago. The impact on profit margins is almost entirely ahead of us.
The impact of 10-year Treasury yields (duration 8.8 years) on an equity market with a 50-year duration (duration in equities
mathematically works out to be close to the price-to-dividend ratio) is far smaller than one would assume. Ten-year bonds are too
short to impact the discount rate applied to the long tail of cash flows that equities represent. In fact, prior to 1970, and since the
late-1990s, bond yields and stock yields have had a negative correlation. The positive correlation between bond yields and equity
yields is entirely a reflection of the strong inflation-disinflation cycle from 1970 to about 1998.
Read more at http://pragcap.com/7-reasons-to-be-cautious#cIFAWsRVfZkG5H9j.99
Pasted from <http://pragcap.com/7-reasons-to-be-cautious>

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