EQUITY VALUATIONS ARE STRETCHED, BUT DOES IT MATTER?
I find valuation metrics to be notoriously dreadful ways to make specific investment decisions. For instance, the PE ratio is essentially an inefficient price divided by the future guesstimates of an inherently flawed analyst community (or in the case of trailing PE we’re using a rear view mirror approach – equally distasteful for future investment decisons). On the other hand, valuation metrics can provide some insight into a macro market approach when viewing the environment from 30,000 feet. In addition, a great many investors derive their investment decisions using these metrics so ignoring them entirely in favor of ones personal beliefs is clearly flawed methodology.
Over the holiday weekend the always excellent Alan Abelson of Barrons noted the current environment’s unusually pricey status:
“Moreover, at 20 times this fading year’s earnings, stocks hardly stack up as outrageously cheap. On that score, the latest calculation by Andrew Smithers, the smart Brit who runs the eponymous London-based investment firm Smithers & Co., is that U.S. equities are more than 70% overpriced, according to q, his favorite yardstick and essentially a measure based on replacement value.”
Of course, Mr. Abelson is using the rear view approach in his PE calculations. The forward looking PE is just 13.3 – cheap by historical standards, however, as I mentioned above the usefulness of this indicator is easily questioned. A more diverse look sheds some light on the picture.
Few analysts break down market value and future potential returns better than John Hussman. In his latest missive Mr. Hussman says stocks are likely to return just 3.6% per year in the coming 10 years – well below the norm:
“On the valuation front, the consensus estimate from the strongest models we track indicates that the S&P 500 is most likely priced to achieve 10-year total returns averaging about 3.6% annually. Given the inverse relationship between the Russell 2000/S&P 500 ratio and subsequent relative returns for the Russell 2000, I expect that returns will most likely be negative for small-cap stocks over the coming 4-year period, even without the assumption of renewed economic weakness.”
Robert Shiller’s cyclically adjusted PE removes much of the noise in the standard PE ratio. Valuations peaked at 27.5 during the most recent bull market. This is well above the current ratio of 22.7. During the dotcom bubble the ratio hit 45.7. Since the Greenspan Put (now the Bernanke Put) became a permanent component of the modern day equity market stocks have experienced abnormally high valuations. While stocks do not appear cheap since the inception of the Put the current ratio is high by historical standards:
Warren Buffett has previously stated his favoritism for comparing the entire equity market valuation to GNP. As I mentioned a few weeks ago this valuation metric is mildly overvalued by 3%, but has also become increasingly stretched as the years have gone by:
Like the Shiller CAPE Tobin’s Q ratio has been remarkably consistent throughout history, however, appears to have lost some of its prescience in recent years. The Greenspan Put is clearly having an equally skewing impact on the ratio, which currently shows stocks stretched (chart via dshort.com):
Clearly, the evidence is inconclusive at best. From a historical perspective the market appears expensive, however, history has rarely experienced times such as these. Over the last 20 years we have experienced an unprecedented financialization of our economy. The Greenspan Put has morphed into the Bernanke Put and investors are happy to capitalize on an environment in which losers are not losers. This likely means we have to throw the old playbook out the window. While these usually reliable valuation metrics show an excessively or mildly valued market there is nothing in the evidence from the last 20 years that says stretched valuations can’t become extremely stretched. Just try not to be the one left standing when the music stops. Given the Fed’s non-stop intervention it might be safe to conclude that the music is loud and unlikely to be turned down (and certainly not stopped) any time soon.
if QE2 is, as you say, a’ monetary non-event’, then how does the bernanke put work? if QE2 is just asset swapping, then how does it actually support asset prices? is this just affecting investor psychology?
Fundamentally, QE does nothing except alter bank balance sheets (which, in the case of QE1 actually helped), but buying tsys is just an asset swap and BB isn’t doing it in a way that actually controls interest rates. So yes, in this case it’s psychological – it’s this pervasive idea that the govt will always protect investors….
would also add that over a 20 year, 75% market decline, japan has never become cheap by any of these valuation metrics…would almost jump to the conclusion that post a credit bubble collapse valuation is irrelevant and that fear/euphoria are the only two things that matter, with extremes of both being faded
The collapse of Japan is not yet finished.
The article perfectly illustrates the quandary I have struggled to answer for the past several months: Will the “Bernanke Put” allow valuations to reach a level where the P/E ratios are in line with historical levels (<10) that attract investors back into the market? I suspect a great many Dow Theorists will answer with "of course it will", but it is becoming more and more difficult to imagine, which seems to be the perfect "slope of hope"…
If investors lose confidence in the put, it could be a long way down…
Interesting article. Thank you.
Looking at the second and third charts, while I agree with you that the stock market could easily go from stretched to extremely stretched, the thing that strikes me is that this is not the environment for a “new” secular bull market. Extension of current rally? Easily. Flip a coin. But the beginning of a long-term bull market? Seems unlikely. Not with interest rates at historical lows *AND* SPX/GNP at 100%.
The markets can and will do whatever they want to. No rhyme or reason. Then, in hindsight, we’ll find reasons that it did what it did, in order to try and make sense of it.
The hell with valuations or true price discovery. Ben “The Buffoon” Bernanke is only interested in keeping the banks solvent…… If he really was focused on full employment and stable prices he would decrease the leverage banks could hold.
This article reminds me of the old cliche of investing vs. speculating. It almost sounds like you are making an argument that fundamentals don’t matter (or can’t be determined).
I read you as supporting an investment approach that is basically to find the right trend following algorithm. But in a market like the tech bubble, why would you try to squeeze out another 5% when a 50% drop is entirely possible? Valuation clearly showed that to be a risky market.
Boy did we turn the clock back 11 years to end of 1999 where PE and for that matter valuations did not matter?
Interesting that this q ratio tells of 70% over-valuation. I just read in the WSJ over the weekend (I think) that private equity will be putting more money to work in 2011 because so many companies are priced below 1.1 times replacement value. I’m not intimately familiar with either calculation, but I remember Mark Twain saying something about statistics…
Dividend yield is another metric I prefer to use to get some relative idea. Currently it’s around 2% for S&P500 compared to 10 year trasury yield of around 3.12. Historically, stocks perform better when the dividend yield is in the 4-5% range or 2-3% above 10 year treasury yeild.
I’m a little surprised by your analysis that valuations may not matter. They have throughout the last 100+ years so why is this time truly different? We had an unprecedented (at least in the last 70 years) stock market bubble pop in 2000 and then another bubble in the form of real estate and we’re nearing the previous highs, at least in the case of the Nasdaq. What’s fascinating is that we haven’t had a cheap (PE under 10) trailing P/E in nearly 30 years! Nor have dividend yields hit 6% in 30 years as well!
Thanks to the Fed, the stock market bubble is still alive and well. If a credit collapse isn’t enough to drive valuations closer to fair value, I don’t know what will. Perhaps the third and final stock market collapse will lead to some real reforms or, God willing, the disintegration of the Federal Reserve.
Carl Swenlin’s earnings analysis is quite sobering. For dividends to go back to 6%, as they have at virtually every major recession and subsequent stock market bottom, the implied S&P value is under 400! But thanks to Bernanke, the balloon never really popped, until it does. I should note that this earnings analysis says nothing as to timing, when the next collapse occurs is the $64M question.
http://www.decisionpoint.com/TAC/SWENLIN.html
I am not saying they don’t matter. I am just saying that they’re not likely to provide much guidance given the unusual circumstances….
They will matter if we get to a point where nothing will support new bubbles anymore. It seems to me that we have exhausted every opportunity to generate more bubbles at this point even though we are still trying because of balance sheet recession.
Fair enough TPC. You do make an interesting point about the unusual times and the Greenspan/Bernanke put. Those DecisionPoint P/E and Dividend Ratio charts put in pictures how unprecedented this era truly is. We’ve never meaningfully dipped below a 3% dividend yield in the last hundred years and all of a sudden, sub-3% becomes the norm. I mean, we have to revert back to the mean at some point, right? I refuse to believe that the trailing P/E will never go back to 10 or that dividend yields won’t rise to at least 5-6%. And when that happens, the results will be devastating. I just hope I’m still trading when that day comes!
VCC,
I think that is right. i would note that dividend yields are a bit low relative to sustainable earnings after the crisis, so somewhat faster dividend growth should correct some of that gap. Assuming a reversion to normal payout ratios increases the likely value a good bit. However, profit margins are at a cyclical high, and over time that cannot hold. Of course, truly cheap being arong 500 to 550 is better than 400, but not exactly exciting!
As for Q, I prefer the arithmetic mean to the geometric (and both can be found at dshorts site) as it is more in line with what other methods of valuation show. I also believe it generally overstates the case. However, in relative terms no other valuation metric has been more predictive of future returns.
why do you always look at Pe´s?
A PBV of 3X and ROE 30%, gives you a PE of 10
A PBV of 1X and ROE 10%, gives you the PE of 10
despite same PE you most often have two diffrent stories?
in a second step, why look at 10yrs bond yield? It peaked in 1982 and has been falling since… not a great parameter of attractiveness of equities?
At least look at 2 yrs…. its correlated to the economic outlook! It hardly didnt move lately, why? Bencause the outlook didnt change!
Instead of the charts disclosed i´d like to see simple equity risk premium ERP, calculated as following:
ROE/COE = PBV
where
COE= 2yrs + ERP
ERP = (ROE/PBV)- 2 yrs
where are we from a historical perspecitve?
Everybody who has posted anything here about valuation mean reversion is DEAD wrong. I can’t believe 4 months later people fail to grasp the relevance of Bernanke’s WaPo op-Ed. And believe you me, in no way am I patting myself on the back as it took me far too long.
However, it is a known fact now per that op-Ed that the man has EXPLICITLY told you stocks are the central pillar of Fed policy focus per the wealth effect. Thus, Bernanke has told you in advance what the end game is – STOCKS ARE A VEHICLE FOR SPECULATION and nothing more. Quit acting like they should in any way reflect anything fundamental whatsoever anymore. It is such a DOA argument.
Please, somebody, Cullen or otherwise, tell me why this time IS NOT DIFFERENT??? Somebody tell me, when in the annals of the modern post civil war era have we ever had a national economic policy structure centered ENTIRELY around propping stock prices higher?? When? If the answer is NEVER how is this time not different??
The answer is so blatantly obvious!! NEVER! Will it end in tears? F’ing hell yes it will. Just like the last two. But this is the last dance, that much you all have figured out. However, it took the BIGGEST stock market and housing bubbles in the history of man-kind to pop the last two. So, tell me, if took eight sigma events last time, don’t you think it will take something more devastating this time now that the Fed is EXPLICITLY telling you it wants higher stocks vs a long history of creating amazing bubbles when they were metely IMPLICITLY telling us the same??
Where is the terminal velocity event to pop this one? Europe? Give me a break. China? Maybe, but if China is the US it is the US circa 07 ish, not early 08. Ex some MAJOR exogenous terminal velocity event like a China collapse we have a US economy that is notably improving or at worst, muddling through in conjunction with an UNPRECEDENTED desire to extend and pretend with huge liquidity injections used to swap people into equities.
Barring that terminal velocity event that forces the madman imto submission, you would be a fool not to buy every god damn dip. To short the market or sit on the sidelines would be to turn down Kobe Bryant in the offseason as a free agent all because he is on his last leg and his current numbers are unsustainable….the man, like Bernanke is about to dto with the market, has it in him to will himself to one or two more memorable championships, and Bernanke, one last great bubble. I would sacrifice the next ten years of #1 draft picks as a franchise and pay Kobe $40M per season to have one great run at it. Bernanke is my Kobe.
You all know this time is different – lie to yourselves all you want.
Stocks have reached a permenantly high plateu, it’s a new era, Greenspan Put, blah, blah, blah. People always have to come up with a reason for why the current valuation is “correct”. But there is no such thing.
The lesson of history is that valuations go from one extreme to another. We reached an extreme high in 2000, but have yet to reach an extreme low. We won’t necessarily get another crash; we could get to lower valuations gradually. Let’s hope so…
IMO I also believe that the market is being manipulated/’gamed’ by this administration as part of the their plan to appear to be aiding the economy. These illusions of progress and effort distract us from their legislative and regulatory plans which will ultimately cripple our economy’s ability to recover on it’s own. While investors are looking for patterns, trends and history, I perceive there are a lot of investors who believe they can beat this administration at their own ‘game’ by disregarding historical economic data and adapting to the new rules this administration has replaced economics with. The stock market now more than ever seems like a game of musical chairs where some investors believe they have a stategy that will prevail when the music stops, insuring they will grab a chair; are we to believe this administration doesn’t know this? How many chairs do you think they’re leaving out there for this game?
Earnings do matter:
“the first negative quarter ever in 2009 preceded the March 2009 bottom in stocks”
http://www.elliottwave.com/freeupdates/archives/2011/01/06/Earnings-Drive-Stock-Prices-See-This-Chart-Before-You-Answer-.aspx