IS THE MARKET FAIRLY VALUED?
I’ve long argued that most valuation metrics are fraught with pitfalls that the average investor too often falls for. What is often described as “value” is too often a bloated price divided by some analyst’s guesstimate. The myth of “value” and the dream of becoming the next Warren Buffett (see the many myths of Warren Buffett here) has resulted in untold stock market losses over the decades and/or misconceptions of adding “value” to a portfolio that most likely doesn’t outperform a correlating index fund after taxes and fees. Nonetheless, the PE ratio and other faulty valuation metrics remain one of the primary sources of investment strategists, stock pickers and market researchers.
While I am no fan of valuation metrics, I do happen to be a student and believer of mean reversion. In an effort to attach a “value” to this market I’ve used an old Jeremy Grantham tool to see where we are today. Grantham is a big believer in the cycle of corporate profits and specifically profit margins. As regular readers know, one of the primary reasons why we have been bullish ahead of the past 5 earnings seasons was due to the expansion in corporate margins and very low analyst expectations. Analysts became extremely negative in Q4 2008 and severely underestimated the pace at which companies were able to cut costs and support the bottom line. This stabilization in corporate margins set the table for the massive rally in stocks as profits continued to expand at a far faster pace than anyone expected.
Corporate margins are extremely cyclical. As companies expand their businesses and revenues grow they are able to better manage their costs, hire personnel, etc. But if the economy weakens for any number of reasons revenues will contract, costs will remain high and margins will ultimately contract. Businesses are then forced to cut costs in order to salvage profits. In other words, margins are constantly expanding and contracting with the business cycle around the mean.
Over the last 50 years corporate profit margins (corporate profits/GDP) have averaged 9.5%. If we multiply GDP by the average margin growth we can create a long-term trend of what corporate profits should look like. We can then compare actual corporate profits to this result in an effort to see whether corporate profits are overheated or not. The results follow:
The latest reading shows that the market is slightly overvalued (by 5.5%) based on the sustainability of corporate profits. Unfortunately, mean reversion tends to overshoot in both directions so while the market is technically overvalued according to this metric it’s important to understand and respect the fact that margins are likely to continue expanding as the economy stabilizes. This could result in even greater market overvaluation (as we saw in 2006 & 2007).
Of course, this is no silver bullet in terms of valuation metrics, but does provide us with a realistic perspective of where profits are and whether the market is currently overheated or not in terms of profit sustainability. In addition, it takes the analyst’s guesstimates and irrational market price action out of the equation. So while this by no means says that the market is due to correct or crash it does confirm one thing – the boom/bust cycle that the Fed has created is alive and well and we could very well be in the midst of another extreme overshoot to the upside in terms of profits and the sustainability of margins. And when margins begin to contract the market will surely bust again. Wax on. Wax off.
Good post. It would be good to see the vertical axis on % scale over/under trend as well as ex-financials since their huge asset value fluctuations skew the picture. Hussman also has similar observations, but concludes ~30+% overvaluation at the moment. Of course, the trick where are we in the cycle …
Are you referring to pre-tax corporate profits? After-tax earnings have averaged about 4.5% to 7% over the past 50 years.
Page 21:
http://research.stlouisfed.org/publications/net/20100301/net_20100323.pdf
http://www.jeffreyluke.com/Financial/images/Buffett_Chart.gif
From:
http://www.jeffreyluke.com/Financial/Mr_Buffett_on_the_Stock_Market.html
One metric I have found useful in gauging whether the stock market is relatively high or low is the annual percentage change of the ratio of the S&P500 to Nominal GDP. These data, plus chart, are available for free on Economagic.com. The ratio is presently above +15%, which examining the rates of change from 1950 on, appears to be at a level consistent with market top formation.
good post. one comment: your 9.5% ratio is the mean for 50 years. i would be interested to know whether in the last 20 years, with the development and implementation of powerful enterprise software and the internet, the ratio has increased (due to productivity gains etc). i have the same issue with PE10 analysis that schiller does with a historical mean that goes back to the 19th century.
This is a common misconception. As industry has become more efficient we have actually seen lower inflation and prices have not been passed thru to consumers. Margins, therefore, over the last 50 years, have not changed all that much.
right, i did some (spotty) research and came to the same conclusion…thanks mathguy
No prob. The best example is WalMart who has such an efficient business model that it actually allows them to compete at a higher level by providing lower prices. In essence, they undercut the competition by operating with equal margins at a lower price point.
Gee, I wonder if the market will finish green today? Hmmmm????
the one time it gets to be a certainty,it will not.
when everyone thinks its got nowhere but up to go, it falls to basement.
How about taking account of the corporate profits driven by the one time cost cuttings (inventory and work force reduction, etc) in 2009?
Will 2010 profits sans cost cutting above 2009?
I don’t think so and add extreme optimism by the analysts ratcheting up the 2010 estimates and we have room for many earning misses this year.
Another metric which has tracked the SPX, GDP and Corporate profits very well is M2
Makes sense as the more money/credit washing about generated from our ‘fractional banking system’ means people have more money to spend on the goods which drive corporate sales
All four (SPX, GDP, Profits, m2) have grown almost exactly by 6.5-7% since the early 1980s
The ratio, however, of SPX/M2 has flucuated a bit, notably falling in the 1980s when interest rates were so high that people put a smaller muliple on the market and rising alot in 2000 when we were in the .com (PE 25x) mania.
My problem, longer term, is that I cannot see how M2 grows 7% going forward???
It can only grow in 2 ways in our fractional reserve banking system;
1- Organically — ie, Over time deposits grow as people save and people earn money on their bank deposits, allowing banks more room to lend more and create more credit keeping their capital ratios in tact as the deposit base is growing (kind of what happened 1980-2000)
2- With zero saving and zero interest rates, desposits are not growing, so banks can now only grow credit by leveraging up their balance sheet (what happened from 2000 – 2009). Helped along the way with securitisation/monolines etc making the system look as if it wasnt actually leveraging itself up as balance sheets grew
So, now we have zero interest rates, meaning the deposit base is not going to grow alot unless we all start saving alot more.
The bank capital game is up and means they will find it harder to fool the system going forward by hiding leverage somewhere else
All in all, credit growth will stay weak for a long time as bank capital ratios become more ‘honest’ and interest rates stay low, capping the amount of money growth out there to generate earnings growth…
Obviously one needs to ‘trade’ the market themes at any point in time to make money and there is no point fighting strong currents that can last for a long time…
but lets all be honest…
The real reason the SPX has grown 7% since 1980, is because m2 grew by the same amount. There is no more ‘genius’ to the stock market longer term than that…it is just a bet that we will mamage to keep the 7% m2/credit growth machine going forever even though interest rates, wage growth etc collapsed to much lower levels over a decade ago!
1. Eyeballing that chart, it seems to indicate the market was fairly valued in the summer of 2008…..
2. Jeremy Grantham puts fair value for the S&P at below 900, so I don’t see how this can be based on Grantham’s approach.
Hi Ben,
Good comment. This requires clarification. This chart is somewhat hard to read because of its duration. A 5 year chart might have worked better. The data actually shows that the market was overvalued until Q3 2008. You wouldn’t have said the market was undervalued until January of 2009 because the full data wasn’t available until then.
That said, I don’t think this is a good market timing instrument, but does give some perspective.
As for Grantham, this is based purely on his idea of mean reversion. I have no idea how he arrives at a fair value of 900 and this is not intended to reflect or mimic his valuation approach.
What’s the Standard Deviation on this chart? How about correlation (just curious) using a .95 coefficient?
I’m wondering, how has this chart been affected by the change of accounting rules in early 2009? I know you’re probably looking at profits but how about all the paper losses?
Would operating profits really be a fair measure of economic and earnings growth? All of those writedowns were one time events that impacted one segment of the economy. Using the operating earnings from 2008 skews the real picture substantially.
Were they one-time events?
I guess by that, I mean, were companies not (to all intents and purposes) over-stating operating profits in previous years and then writing them down when they were forced to…
Thus while it clearly skews 08 to the downside, perhaps the years leading up to it were systematically skewed (by a smaller degree) to the upside…
Bingo…except I think the skew to the upside while obviously not as large as the downside skew, are quite significant.
Grantham’s approach involves the normalization of earnings, profit margins, P/E multiples, etc, by smoothing and mean-reversion.
7-year annualized real return for S&P 500 Index (simple methodology using a form of the Gordon Equation):
Dividend yield = 2.0
Real EPS growth = 2.0
P/E change: 20.5x falling to 17x = -2.6
Expected return (7yr real) = 2.0 + 2.0 – 2.6 = 1.4
Also, that was prior to market moving up to 1,170. Including inflation of say 3.0%, investors should not expect anything more than mid single digit nominal returns over the next decade from these levels.
Normalized profit margins are around 6%. Graham puts a PE of 16 on that and arrives at 875 as fair value for the S&P.
See Hester article on Hussman site:
http://www.hussmanfunds.com/rsi/forwardearningsmargins.htm