Inflation and interest rate-based valuation measurements suggest the market remains inexpensive.
But more traditional P/E ratios and other unique models suggest the market is expensive.
Ultimately, what matters more for the market is the direction, not the level, of valuations.
I’ve written many times about equity market valuation being both in
the eye of the beholder and a function of the chosen indicator. Even the
most common valuation metric—the price/earnings (P/E) ratio—has many
derivations. The table in this report is a summary of most of the
common (and somewhat less common) valuation metrics, and a subjective
assessment of whether they are sending an inexpensive or expensive
message about the stock market presently.
The punchline is that
valuation is presently a very mixed bag—with a few indicators saying the
market is quite cheap, while others saying it’s quite expensive. This
muddied picture continues to be one reason for our continued “neutral”
rating on U.S. stocks (meaning investors should remain at their
long-term equity allocations).
The five valuation measurements falling into the inexpensive or fairly valued category are:
Rule of 20:
Stocks are considered fairly valued when the sum of the S&P 500
forward P/E ratio and the year-over-year change in the consumer price
index (CPI) is equal to 20 (or inexpensive when it’s below 20).
This model compares the S&P 500’s earnings yield (which is the
inverse of the P/E—or E/P) to the yield on long-term U.S. government
bonds. Negative readings suggest favoring stocks over bonds.
Equity Risk Premiums:
These subtract either the forward 10-year U.S. Treasury bond yield or
the forward Baa corporate bond yield from the forward S&P 500’s
earnings yield (E/P). Positive readings suggest stocks are undervalued
relative to bonds.
Dividend Yield: Compares the
current dividend yield on the S&P 500 with both historic averages
and the 10-year U.S. Treasury yield. At near-equivalent yields, the
market is seen as fairly valued.
The seven valuation measurements falling into the expensive category are:
Probably the most common measurement, it divides the current S&P
500 price by 12-month forward expected operating earnings. It’s
presently slightly above its ~20-year median of 15.9.
Also a common measurement, it divides the current S&P 500 price by
12-month trailing operating earnings. It’s presently comfortably above
its ~25-year median of 17.8.
5-Year Normalized P/E:
This model uses four years of historic earnings, two quarters of
forward earnings, and takes the midpoint between reported and operating
earnings (it’s a take on Shiller’s CAPE, but with a shorter time span,
and with an adjusted earnings calculation). It’s presently comfortably
above its ~70-year median of 18.1.
Shiller’s Cyclically-Adjusted P/E (CAPE):
This model uses an inflation-adjusted price for the S&P 500 and
divides by reported earnings over the prior 10 years. It’s presently
comfortably above its ~135-year median of 16.
Divides the current S&P 500 price by the book value of its
components. It’s presently slightly above its ~38-year norm of 2.4.
Developed by Nobel Laureate James Tobin, it’s a fairly simple concept,
but laborious to calculate (calculations are done by the U.S. government
and the ratio’s readings are provided by the Fed). It’s often called
the Q Ratio and is the total price of the U.S. stock market divided by
the replacement cost of all its companies. A high Q (greater than .85)
Considered Warren Buffett’s “favorite valuation indicator,” the model is
the ratio of total U.S. market capitalization to gross national product
(GNP). It’s presently well above its ~65-year mean of 69%.
Three of the valuation metrics above—one of which falls
into the inexpensive category and two of which fall into the expensive
category—deserve mention for important caveats to consider: Fed Model,
Shiller’s CAPE and Market Cap/GNP.
Cornerstone Macro highlighted the problem with the Fed Model in a recent
report on valuation. “For much of history, before the early 2000s, bond
yields and earnings yields were within close range; making such a
comparison an important branch in the asset-allocation decision tree.
Since 2002, the gap has widened to historic highs, and has exposed the
shortfalls of the model.”
“In mid-2002, the yield on the 10-year
government bond fell below the yield on the S&P 500. It has never
crossed back since then. Thus, the Fed Model has told asset allocators
for 12 straight years now to prefer stocks over bonds. That’s quite a
long time to buy and hold stocks … especially while bonds have rallied
so much over that time. This is one where you sometimes should fight the
Shiller’s CAPE: In a version of
this valuation analysis I published last May, I dissected the CAPE and
the caveats which are crucial to consider. I’ve linked to that report
here: Devil Inside: Dissecting the Most Popular Valuation Metrics
As for Warren Buffett’s favorite valuation indicator, some caveats are
also worth mentioning. As noted by Cornerstone, “this metric has huge
weaknesses, such as not recognizing structural changes in a country’s
financial system, productivity, tax policy, demographics, etc. … the
list is long on why this metric isn’t useful for comparison over time.”
You could probably find two market analysts on opposite
ends of the spectrum from bullish to bearish; and they’d probably cite
valuation as one of their reasons. It’s confusing for investors, who
would probably love a simple and foolproof approach to valuing the stock
market. There are myriad factors which affect valuation levels and
their direction; including economic growth, inflation, Fed policy and
Finally, and importantly, what’s perhaps more
important than the level of valuations, is the direction they’re
heading, regardless of the metric being used. In general, valuations
have been expanding across most metrics and in the near-term, the
conditions remain ripe for that trend to continue; at least until
earnings can “catch back up” to valuations.
-- Liz Ann Sonders, Schwab Investing Insights, November 30, 2015