Valuations Reasonable, Not Cheap
Bears argue that expansion of price/earnings ratios accounts for all of the market’s rally since March, as U.S. corporate earnings have continued to fall. In fact, even though a record 79% of S&P 500 Index components exceeded consensus profit estimates for the third quarter, total per-share earnings for the index were down about 14%.
Bulls counter that the early stages of a bull market are nearly always led by expanding P/E ratios, as stock prices typically bottom before earnings growth resumes. While market watchers can spin such arguments any number of ways, our work leads to four concrete conclusions:
First, it is not worth listening to anybody who tells you the market is expensive because the S&P 500 Index trades at 71 times trailing earnings. Earnings for the capitalization-weighted S&P 500 have been depressed by huge losses among a relatively small subset of companies, especially in the financial sector. Based on current-year consensus estimates for operating earnings, the S&P 500 Index trades at a P/E of 17 — modestly above 20-year norms.
Second, unless you are limited to index funds, the valuation of the S&P 500 is not the most important indicator. As an investor, the most important question is whether you can build a diversified portfolio with attractively valued stocks. On this question, the answers are more encouraging. Excluding stocks with P/Es above 75 or below 0, one-half of S&P 500 stocks trade at trailing P/Es below 15.3 — below the norm of 18 since 1992.
Third, growth considerations are crucial when evaluating P/E ratios. Among S&P 500 components, the median estimate for five-year earnings growth has dropped to 10.0%, down from 12.3% at year-end 2007. As a result, the median PEG ratio (P/E to expected long-term growth) for S&P 500 members is 1.6 — above the nearly six-year norm of 1.4.
Fourth, the expansion in P/E ratios has been concentrated in speculative stocks. Based on our Relative Risk scores, which segment stocks by share-price volatility, average trailing P/Es on low-risk stocks have climbed to 18 from 14 in March. Meanwhile, average P/Es on high-risk stocks have more than doubled to 22.
Stocks are no longer cheap. But the typical U.S. stock is not particularly expensive relative to historical norms, and higher-quality and lower-risk stocks trade at attractive relative valuations. Partly because we are not convinced that profit-growth estimates for 2010 and beyond are reasonable — and partly because the Dow Theory has yet to provide a bull-market signal — we are holding 20% to 25% of equity portfolios in a short-term bond fund.