Thursday, March 1, 2012

Equities are still cheap

With February data now available, I've updated these charts covering equity valuation. As the first chart shows, the 12-month trailing PE ratio for the S&P 500 is still meaningfully below its long term average. This is remarkable, since a) Treasury yields are very close to all-time lows, so equity multiples should, all other things being equal, tend to be near all-time highs, and b) corporate profits according to the NIPA are at all-time nominal highs and all-time highs relative to GDP. This all points strongly to equities being underpriced and therefore quite attractive, provided one is reasonably optimistic about the future.

The second chart compares the earnings yield on equities to the yield on BAA corporate bonds. It is rare for the equity earnings yield to be greater than corporate bond yields, since this reflects a very pessimistic assumption on the market's part. You would only pass up a 7% earnings yield on stocks in favor of a 5% yield on corporate bonds if you thought that the outlook for earnings was dismal, and you therefore wanted to lock in a 5% yield with first claim on those earnings.

Looked at another way, corporate profits, according to NIPA data, have increased over 150% since 1999, but the S&P 500 index is essentially unchanged. Message: nobody trusts these profits to last; at the very least the market is priced to a huge mean-reversion in profits. So if profits just stay flat and/or fail to collapse, the equity market is going to have to rise considerably. As it is, S&P 500 profits are up 14.7% year over year, and up at an almost 20% annual rate in the past three months. This market is still very pessimistic. If you hold any hope for the future, equities are still very cheap.

Full disclosure: I am long the equity market at the time of this writing.


Benjamin said...

Interesting set of graphs---and makes one wonder about the "government is too intrusive" mantra. Really?

I want smaller government, but corporate profits as share of GDP are surging. Good news to me, but where is this horrible governmental monster? Is that just radio talk-show host scaremongering?

Let's hope corporate profits continue upwards, for man, many a moon.

William said...

Shaeffer's Investors Intelligence Survey 2/29/2012

% Bulls - 51.1%
% Bears - 25.5%

The % Bulls has been stuck in the 50 - 51% range since 12/28/2011. Since December, the % Bears fell 4% from 29.5%. 23.4% are looking for a correction.


After the $41 Billion outflow from Equity Funds (including ETFs) in the 4th quarter, January saw inflows of $15.4 Billion into Equity Funds and inflows of $34 Billion into Taxable Bond Funds.

For February, 2012 I estimate from the weekly data that about $10.8 Billion flowed into Equity Funds.

So Investors are acting a little more Bullish than the Investors Intelligence survey indicates.

John said...

Once bitten, twice shy. Our memories aren't that bad. Too much business is conducted in the dark. It doesn't inspire confidence in the equity markets. Why buy a piece of a company that may have most of its operations overseas, and you have know idea what they do or how they run their affairs?

Unknown said...

Always sound reasoning by Scott, but think that reason (b)(regarding cheapness of equities) is not logical: "corporate profits according to the NIPA are at all-time nominal highs and all-time highs relative to GDP" should not be an argument for higher p/e ratios but the opposite: a reversion to the mean would suggest that profit margins will not continue to be so high, thus justifying below average p/e ratios.

William said...

By Warren Buffett

"Why Stocks Will ALWAYS Beat Bonds and Gold"

FORTUNE -- Investing is often described as the process of laying out money now in the expectation of receiving more money in the future.

At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period.

Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.

Scott Grannis said...

Unknown: you have missed my point, which is that relatively low PE ratios at a time when corporate profits are at all time highs necessarily implies that the market expects profits to decline in mean reverting fashion. In other words, the market is priced to a huge decline in profits, which although rational from a mean-reverting sense, is nevertheless quite pessimistic. What if profits don't decline at all in nominal terms, but do decline relative to GDP?

Nishi said...

Hi there, I noticed your blog via Google while trying to find a stock tips

theyenguy said...

Bonds, including junk bonds, traded lower communicating the failure of credit.

The ECB’s subordination of credit and massive issue of credit commenced disinvestment out of credit instruments. Credit failed today as investors sold out Bonds, BND, LAG, AGG, expressing a loss of confidence and trust in the world central banks’ monetary policies. The world is passing through peak credit. Investors, in selling debt, are commencing global debt deflation, which will soon be revealed as falling major world currencies, DBV, and falling emerging market currencies, CEW. Competitive currency devaluation will commence soon on today’s disinvestment out of credit instruments, which saw a strong sell of the longer out US debt, the Zeroes, ZROZ, the 30 Year US Government Bond, EDV, as well as the US 10 Year Note, TLT. A global deflationary credit collapse commenced today.

Junk Bonds, JNK, traded lower communicating the end of credit as it has been known. In a soon coming credit devalued world, diktat from monetary cardinals under the monetary pope, Mario Draghi, will serve as both credit and money.

Bond vigilantes called interest rates higher globally communicating that the world central banks monetary policies constitute monetization of debt. The ECB’s LTROs, as well as its subordination of sovereign debt, and the terms of the Second Greek Bailout, communicate that the ECB has unified and regionalized banking. The Euro zone now has a One Euro Bank, that being the ECB. A Euro zone coup d etat is being effected by Angela Merkel, and the EU ECB and IMF Troika, where by a monetary union now exists to complete the EU debt union. We are witnessing political capital rising to replace investment capital. An inquiring mind asks, Will a full fledged EU political union and a EU fiscal union soon be a reality? Are we witnessing the birth of a New Europe, that is a Federal Europe?

The longer out debt traded more strongly lower than the shorter duration debt. ZROZ, EDV, TLT, fell more than IEF. and BLV fell more than LQD, as the Interest Rate on the US Ten Year Note, ^TNX, rose above 2.0%.

The debt monetization call of the bond vigilantes was so strong that even Emerging Market Bonds, EMB, traded lower, despite rising emerging market currencies, CEW; and World Treasury Bonds, BWX, traded lower, despite rising major world currencies, DBV. Emerging markets sovereign debt is no longer a safe haven investment. The global government credit bubble burst today. No level of debt is sustainable by any government world wide. The global debt trade is done and over. Out of sovereign crisis, the dynamos of growth and profit of capitalism will give way to the dynamos of regional security, stability and sustainability, producing regional global governance.

Junkyard_hawg1985 said...

This is a beautiful plot of secular bull and bear markets. The single best visualization I have seen of secular bull and bear markets is from Crestmont Research. They have a great stock market matrix from 1900 to 2011 color coded by time periods with inflation adjusted data. This plot clearly shows the secular bull and bear markets. Three times since 1900 has the real 20 year return been negative over a 20 year period: 1921, 1949, and 1982. All of those years were fantastic buying opportunities. Our 20 year return currently is 4% which matches the 110 year average.

The real stock market return over the past 13 years is neagtive as of 2011. The times in the cycles where we first hit a 13 year negative return were 1974, 1941, and 1918. While each of these markets had some additional downward time, they were reasonably close to the bottom of the market.

I'm also long on the stock market.

Hans said...

The Q Ratio, still indicates the markets are over valued...

I am not a rowbot!

Tiho said...

"Message: nobody trusts these profits to last; at the very least the market is priced to a huge mean-reversion in profits."

I agree that investors believe profit margins are very high, no doubt about that. I am one of them. Having said that, how do you figure that the market is priced for a huge mean revision? How does one know what the market is priced for?

If you hold any hope for the future, equities are still very cheap.

I disagree that the market is cheap. The price to earnings ratio is cheap, but it is the E that is wrong in the P/E. When E adjusts to the downside, as profit margins mean revert... and they always mean revert... than the P/E will expense again and another equity market sell off will occur in this secular equity bear market.

While stocks are becoming much cheaper than they were in 2000, they are not yet dirt cheap to buy them for a long term buy-and-hold strategy, like they were in 1921, 1932, 1949, 1974, 1982 etc.

WimpyInvestor said...

I've noticed many bloggers using your now famous "corporate profit divided by GDP" chart to measure US corporate profit margins.

Quick question -- is this metric still applicable in the last decade where US corporate profits are increasing coming from foreign markets?

In other words, if US corporations are serving global customers, then shouldn't be denominator be changed to Global GDP?

Scott Grannis said...

Re corporate profits vs GDP: I don't think it matters much where the profits come from. A stronger global economy is good for the U.S., isn't it? The more they produce, the more they can buy from us.

And I think you could argue that since an increasing share of the profits of U.S. based corporations is coming from their overseas operation, the record-high level of profits to GDP is not something to worry about in a mean-reverting sense. These days, the key to striking it rich is to address a global audience. A company like Apple is a great example: they can sell the same product to billions of consumers around the world. This wasn't possible a decade ago. The bigger the market, the bigger the profits. The addressable market of U.S. corporations has expanded by orders of magnitude over the past few decades, so the upper limit to corporate profits has been raised by a lot. Profits don't necessarily have to come down to historic norms relative to U.S. GDP.