One of the keys to looking at the stock market as a whole is valuations. For a given stream of earnings, how much you pay can make the difference between success and failure. Much like buying a car, getting a great deal goes a long way toward being happy with the results.
The problem is that no one really knows how to value the market. I’ve written about different valuation metrics for the stock market before, with a focus on price/earnings ratios, or just how much people are paying for that stream of earnings. I favor the P/E10 (now known as the Shiller P/E), which is based on average earnings for the past 10 years, as it washes out the effect of business cycles, as opposed to the trailing 12-month P/E. In my studies, the P/E10 also provides more predictive power than the regular P/E, although not a lot.
I recently reviewed a Vanguard study that examined the different valuation measures in more detail. The idea behind the study was to look at the history of the valuation metrics and see which ones actually worked and over which time frames. The study seems comprehensive and well done, and the results are consistent with work I have done myself.
Cutting to the chase, the only metrics that worked were based on P/E ratios, and then only at multiyear time horizons. Returns over periods of one year were essentially unpredictable, suggesting that market timing systems—at least using the methods tested—aren’t going to work. For the P/E ratio indicators, the P/E10 and the regular P/E were the most reliable, with the P/E10 having a slight edge. Neither, though, explained more than half of returns.
Looking at these two metrics for the current market, we find contrasting results. On a P/E10 basis, the market is quite overvalued. On a P/E basis, the market is reasonably valued. Which one is right?
The argument against the P/E10 is that the 10-year period in question includes two recessions, one of which was by far the worst in the postwar era. The 10-year average, the argument goes, is inappropriately depressed and simply not representative of a more normal environment.
The counterargument is that the 10-year period also includes the real estate bubble years, when consumer spending was artificially supported, as well as the current era of financial easing, with artificially low interest rates contributing about 30 percent of current earnings. The balance is not clear.
The argument for the P/E is that current earnings are representative of normal levels. With profit margins at all-time highs and earnings supported by low interest rates, that doesn’t seem clear either.
Overall, I tend to conclude that the P/E10 suggests caution. Both current earnings and valuations have multiple positive factors already baked in, and it’s not clear to me how further good news can materially affect earnings, particularly once interest rates start to normalize. Disappointments could negatively affect either—or both. I think the risks are more to the downside, although the P/E suggests that’s not necessarily the case.
Ned Davis Research (NDR) offers another positive note. One potentially distorting factor in market valuation levels is the amount of cash companies are holding. Moreover, with interest rates so low, the interest from this cash contributes much less to the bottom line. To correct for this, NDR backed out cash from the valuations and recalculated the P/E ratios over the past several decades.
The results show that, net of cash, the current P/E ratio for the S&P 500 is 13.1, well below the long-term average of 15.4. Moreover, in the third quarter of 2011, adjusted for cash, the P/E ratio fell to 8.2, its lowest point since 1982. One of the arguments against a sustained bull market has been that prices never really corrected to the appropriate low levels; according to this metric, however, they did.
I am suspicious of new metrics that appear to justify valuation levels that otherwise look high—price to revenue in the dot-com boom, for example—but I have to say this makes a lot of sense and adjusts for one of the key differences this time around.
While I remain cautious, I believe that the trend will remain upward for the immediate future. The next test will probably come in the fall, when the expectations of accelerating economic growth begin to prove out—or not.