Milestones

For all the talk about Dow 20,000, there are a couple of other interesting milestones taking place right now.  We are all well aware that the S&P 500, the most commonly used index to track US stock prices, is now well into record territory following the dramatic swoon during the Financial Crisis.  In fact, the index is now sitting some 45% above its pre-crisis high set on October 9, 2007.  The first chart below tracks the S&P 500 since 1990, a period during which the index rose nearly six-fold.  Not including dividends, the index rose at an annual rate of 7.4% over that time frame.  The recovery in housing, on the other hand, has been far slower to develop.  One index of home prices, the S&P CoreLogic Case-Shiller US National Home Price Index, is just now eclipsing its previous high set prior to the Financial Crisis.  We included the performance of this index in the second chart below.  You can see that home prices are up a much more modest 140% since 1990, which translates to a compound annual growth rate of about 3.3%.  Still, it’s good to see that homeowners, at least on average across the US, have now recovered the hefty losses sustained when the housing bubble burst.

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*Source: Standard & Poor’s.

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*Source: S&P CoreLogic Case-Shiller US National Home Price Index.

We thought it would also be interesting to gauge where stock and housing prices currently stand after adjusting for inflation.  We found that our analysis produced another major milestone.  In the charts below, we deflated housing and stock prices by the Consumer Price Index, or CPI.  The chart with the orange line shows that inflation-adjusted stock prices have just recently surpassed the prior record set in mid-2000.  We also found that the inflation-adjusted compound annual growth rate in the S&P 500 has only been about 4.8% since 1990 – far below the 7.4% rate prior to adjusting for inflation.  As for housing prices, they remain well below the pre-crisis peak after adjusting for inflation and have grown at an inflation-adjusted CAGR of just 0.9% since 1990.

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*Sources: Standard & Poor’s, US Bureau of Labor Statistics.

housingadjusted

*Source: S&P CoreLogic Case-Shiller US National Home Price Index.

We’ve been critical of Fed monetary policy in part for its propensity to artificially inflate asset prices.   It remains to be seen whether asset prices will adjust lower now that the process of normalization has begu n.  However, taking a long-term view of asset prices and adjusting for inflation, as we have done in the analysis above, suggests that prices may not be nearly as frothy as they were during the dot com and housing bubbles.  For stocks, it has taken over 16 years to return to the inflation-adjusted highs from the year 2000.  For housing, prices remain well below the bubble-year highs on an inflation-adjusted basis.

Is this the correct way to gauge asset prices?  Yes and no.  Inflation-adjusted growth of less than 1% does not seem outrageous for housing prices.  As for stocks, though, simply adjusting for inflation may be inadequate.  Stock prices need to be compared to underlying earnings power in order to get useful valuation metrics.  Earnings growth has been very weak over the past three years, and so the increases in stock prices we’ve seen reflect P/E multiple expansion rather than earnings growth.  As such, stock prices may be reflecting the expectation of higher earnings growth in the future – the triumph of hope over experience.  The ultimate outcome remains to be seen.  But if earnings growth does not materialize, then interest rates are unlikely to rise meaningfully.  Which brings us back to where we started: the current level of stock prices is much more defensible if interest rates remain depressed.