Neither Cheap Nor Expensive

2/11/2013


When Winston Churchill warned his readers that these "are the opinions on which I base my facts," he had issues weightier than stock-market commentary in mind. But his disclaimer is worth remembering as you consider the arguments of bulls and bears — even on seemingly objective questions like whether stocks are cheap or expensive relative to earnings.

P/E RATIOS FOR S&P INDEXES
Average P/E Using
---------- Trailing Earnings ----------
Average P/E Using Estimated
---------- Forward Earnings ----------
Recent
3
Years
5
Years
10
Years
Recent
3
Years
5
Years
10
Years
S&P SmallCap 600 Index
Capitalization
Weighted
19.5
19.5
19.0
20.0
16.5
15.7
15.6
16.1
Equal Weighted
19.6
20.5
20.1
20.6
16.6
16.0
16.0
16.0
S&P MidCap 400 Index
Capitalization
Weighted
17.3
17.5
16.7
17.7
15.9
14.9
14.5
15.3
Equal Weighted
17.5
17.3
16.6
17.4
15.8
15.0
14.6
15.2
S&P 500 Index (large-cap)
Capitalization
Weighted
14.5
14.5
14.9
16.4
13.4
12.6
12.8
14.4
Equal Weighted
16.3
16.5
17.8
18.1
15.1
14.3
14.1
15.0

Bulls argue the market is clearly cheap, as the S&P 500 Index trades at 14.5 times trailing earnings — more than 11% below the 10-year norm of 16.4 and lower than 75% of month-ends over the past 10 years. Bears often counter with one of the following five arguments:

1) Trailing earnings are yesterday's news, and stocks don't look as cheap relative to historical norms using expected year-ahead earnings.

Our take: This argument holds some water, as the S&P 500's discount to 10-year norms narrows to 7% based on year-ahead estimates.

2) Capitalization-weighted indexes like the S&P 500 skew the market's P/E lower, since big stocks are unusually cheap relative to the broad market.

Our take: This argument is also valid, especially on a forward-looking basis. The equal-weighted S&P 500 trades at a small premium to 10-year norms based on year-ahead earnings, as do small-cap and midcap indexes.

3) P/E ratios based on one year of earnings can be misleading, and the S&P 500 is expensive based on 10-year average earnings.

Our take: Based on the Shiller P/E, which uses average 10-year inflation-adjusted earnings, the S&P 500 trades at a multiple of 23 — above the norm of 19.5 since 1960. But 10-year average earnings are being skewed lower by huge losses in the financial sector in 2008 and 2009. While considering average 10-year earnings is a useful exercise, some bears appear guilty of using the Shiller P/E too dogmatically. Remember, share prices discount the future, and stocks won't become cheaper in 2019 simply because the depressed earnings of 2009 no longer figure in 10-year average earnings.

4) Ten years is too short a period for valuation comparisons.

Our take: This statement is undeniably true, but stocks are not particularly expensive relative to longer-term norms. The average S&P 500 stock trades at a 9% discount to the norm since January 1991. Using Shiller data but substituting trailing one-year earnings for 10-year average earnings, the S&P 500 Index trades at a 5% discount to the norm since 1960.

5) Profit margins are unsustainably high, so earnings are inflated.

Our take: Margins are undeniably high relative to long-term norms. But with wage growth sluggish because of slack in the labor market, it's not clear why margins would narrow anytime soon.

P/Es vs. 10-YEAR NORMS
Recent
10-Yr.
Norm
Recent
As %
Of Norm
% Of Mos.
With
Lower P/E
Trailing P/E ratio
S&P SmallCap 600 Index
Cap Weighted
19.5
20.0
97
47
Equal Weighted
19.6
20.6
95
41
S&P MidCap 400 Index
Cap Weighted
17.3
17.7
98
34
Equal Weighted
17.5
17.4
101
45
S&P 500 Index (large-cap)
Cap Weighted
14.5
16.4
89
25
Equal Weighted
16.3
18.1
90
19
Forward P/E ratio
S&P SmallCap 600 Index
Cap Weighted
16.5
16.1
102
56
Equal Weighted
16.6
16.0
103
67
S&P MidCap 400 Index
Cap Weighted
15.9
15.3
104
61
Equal Weighted
15.8
15.2
104
66
S&P 500 Index (large-cap)
Cap Weighted
13.4
14.4
93
34
Equal Weighted
15.1
15.0
101
45


Conclusion

Stocks are not particularly cheap or particularly expensive relative to long-term norms. But the S&P 500 Index's P/E has been meaningfully higher than current levels at all of the bull-market peaks since 1946. Relative to today's bond yields, P/E ratios are quite low.

Subscribers should maintain a mostly invested posture, emphasizing attractively valued growers. Our Buy List and Long-Term Buy List, both of which have an average trailing P/E of 13 and forward P/E of 12, have 91% to 97% in stocks.


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