Valuations Alone Not Reason Enought To Buy
Are stocks cheap? With confidence among consumers fading and investment from businesses only beginning to revive, much depends on the answer to that question. The last thing the U.S. economy needs right now is another reason for decision-makers to err on the side of caution, and another round or two of dispiriting economic data seems likely before year-end. So, unless stocks have underlying support based on valuation, a stock-market decline premised on fears of a double-dip recession could become a self-fulfilling prophecy.
The price/earnings ratio of the S&P 500 Index is the most widely cited metric of market valuation. Using trailing operating earnings, which exclude one-time items, the S&P 500 Index trades at a P/E of nearly 15 — close to the low since 1995 but in line with 50-year norms.
Based on expected year-ahead operating earnings, the P/E is about 12.5, meaning the index would gain 20% over the next year if earnings meet consensus estimates and the trailing P/E remains at 15.
P/E ratios based on the S&P 500 Index reflect the capitalization-weighted nature of the index, meaning the biggest companies have the most influence. On an equal-weighted basis, the median S&P 500 stock has a trailing P/E of 15, below the norm of 18 since year-end 1992. Among the more than 4,000 U.S.-traded stocks in our Quadrix® universe, the median P/E is 16, versus a norm of 17 since year-end 1992.
Other measures of valuation tell a similar story. On an equal-weighted basis, the median S&P 500 stock trades at roughly a 10% discount to 18-year norms based on price/cash flow and enterprise value/EBITDA ratios. For the Quadrix universe, the discount is 5% to 6% on these ratios.
Bears and bulls
Bears argue it is a mistake to value stocks based on a single year of earnings or cash flow. Robert Shiller, a professor at Yale and author of Irrational Exuberance, calculates a P/E based on average inflation-adjusted earnings over the prior 10 years. Based on this measure, the P/E of large-company stocks is 20, versus an average of 16 since 1888 and an average of 18 since 1945.
Advocates of using the Shiller P/E argue that corporate profit margins are unusually high relative to historical norms, so valuing stocks based on trailing 12-month earnings overstates the sustainable earning power of U.S. companies.
Bulls argue that using 10-year average earnings means companies get little credit for the big productivity and efficiency gains achieved over the past decade.
Moreover, argue some bulls, stock valuations need to be considered relative to bonds. Based on the spread between yields on 10-year Treasury bonds and the S&P 500 Index’s forward earnings yield (or earnings/price ratio), the index is as cheap as it has been in about 30 years.
Investment-grade U.S. companies can borrow at 4.5% and repurchase shares that provide an earnings yield of 6.7% (equivalent to a P/E of 15). Not surprisingly, this gap in relative valuations is causing companies to fund themselves with debt and avoid issuing equity.
Based on trailing earnings, the S&P 500 Index and the typical U.S. stock are slightly undervalued relative to long-term norms. Assuming year-ahead consensus earnings estimates are accurate and the trailing P/E will remain near long-term norms, the S&P 500 Index has 15% to 25% upside potential over the next year. However, if you assume current profit margins and profits are unsustainably high, stocks are not cheap.
Similarly, if you assume bond yields will remain near current levels, stocks are very cheap relative to bonds. But if the bond market is in a bubble and yields are likely to rise, the gap in relative valuations may be closed by a drop in bond prices rather than a jump in stock prices.
While we tend to side with the optimists regarding corporate earnings, we’re not convinced that stocks are cheap simply because bonds are expensive. Before committing more of our portfolios to stocks, we’d like to see better price action from the market averages.
In our view, a breakout above this year’s highs of 11,205.03 in the Dow Industrials and 4,806.01 in the Dow Transports would bode well for corporate earnings. In the meantime, we’re emphasizing attractively valued shares of quality companies and holding 25% to 30% of stock portfolios in a short-term bond fund.