Tuesday, July 5, 2011

Equities are not overvalued

I've been pushing this theme for a long time, and the point is to show that the market is still gripped more by pessimism than by optimism. This is a market that is very reluctant to accept that things have improved and very quick to believe that conditions are going to deteriorate. For investors who believe that there will be no deterioration, rather just a continuation of the (unimpressive) status quo or perhaps some modest improvement in the future, this makes today's valuations attractive.

The top chart shows that PE ratios remain below their long-term average, using data as of June 30. The bottom chart compares the earnings yield (the ratio of per-share profits to share price) on equities to the yield on BAA corporate bonds (which is representative of a significant share of the large cap corporate universe). For the past year, earnings yields have been higher than corporate bond yields, a condition that is a relatively rare occurrence. Ordinarily, investors are willing to accept a lower yield on equity ownership than they could receive by buying a corporate bond, because equity ownership can deliver capital gains in addition to the earnings yield. That investors today seem largely indifferent to these two valuation metrics is a sign that the market doesn't see much chance, if any, of future capital gains.

To be fair, I should note that the growth of earnings has slowed considerably this year, as evidenced by the chart above. Over the past six months, profits growth has slowed to an 8.1% annualized pace. But I would also note that an earnings growth slowdown does not necessarily foreshadow a recession (e.g., 1986-87), nor does relatively slow earnings growth preclude an ongoing rise in equity prices (e.g., 1996-1999). So while the market may be correct to suspect that earnings growth could be well below the double-digit range for the foreseeable future, this is not a death knell for the economy or the stock market. After all, earnings growth has averaged 6% per year over the past 50 years.


Patrick T. said...

Great post!

The equity markets should offer some pretty decent returns over the next few years (5 and possibly more), and you get all this with a considerable margin of safety (which I rarely witnessed over the 15 years of my investing career)

Benjamin Cole said...

Long time ago, people bought stocks for the yields (dividends). Then, for the last several decades, it has been about capital gains.

Maybe it is going back to dividends (wisely, I say). That might mean some of the froth is off the market. But solid gains can still be had.

BTW, the WSJ says look for 13 percent increase in earnings.

"Combined earnings of companies in the Standard & Poor's 500-stock index are projected to rise 13.6% from a year ago for the second quarter, according to an analysis of Wall Street forecasts by Brown Brothers Harriman."

Doesn't seem like stocks are overvalued.

Barring another Long-Term Capital Management, AIG, Lehman Bros, or Greece, I still say we have a 20-year global boom in front of us.

TradingStrategyLetter - Weekly Summary said...

You have been pushing the theme and a steadfast bull. Should this market register new recovery highs you will look very clever indeed. Very impressive job!

John said...

Trading Strategy,

Last year in late August, at probably the lowest point of a brutal 17% market correction that had begun in late April, Scott made a post called '20 Bullish Charts'. Its in the archive so you may look it up if you wish. The market almost immediately began an advance that was to carry it much higher through yearend and beyond.

Some who comment here dislike his bullish, optimistic point of view but in my experience his market perspectives have been largely accurate, and in the case late last summer, spectacularly so. I always make it a point to know how he sees the equity market. If he ever turns bearish, I want to know!

TradingStrategyLetter - Weekly Summary said...

It is nice to see an 'economist' with a point of view. Especially one who makes a call and takes a position. I could care less if he is always right or wrong! He is worth the price of admission.

septizoniom said...

you should stick to economics and politics, or put your money where your mouth is and start managing money professionally.

Benjamin Cole said...

OT, but I want credit.

I say gold prices have topped out. Why?

This little blurb:

"Gold Max, a chain of cash-for-gold stores, plans to open 100 stores ranging in size from 700 to 4,000 SF in SoCal within the next year. Tustin-based Present Value Properties is the company’s exclusive broker for California."

That's it. That's the top.

Remember I called it. Gold at $1,500 is the top.

It's official.

David said...


I come to your blog to be encouraged in the face of contrary opinions like the following article from Brett Arends: Article link

However, given the pummeling we have taken in the last 3.5 years, myself included, and some of what seem to be valid points in Mr. Arends' piece, I do have some misgivings.

If you get a chance, could you offer your opinions of the 10 points that Mr. Arends addresses? Particularly numbers 5 & 6.

Thanks for all your work and words.

Scott Grannis said...

Re Arends' article. His breathless litany of woes doesn't impress me. His logic and facts are often faulty, and he is not analyzing things on the margin. Dividend yields are not the best measure of equity valuation—earnings are, and by that measure valuations are at least decent. Indeed, it's quite likely that with record corporate profits we will be seeing increased dividend payouts in the future. I don't see any evidence that only the "riskiest" stocks have risen. This has been a broad-based rally. Consumer staple stocks are well above their pre-recession highs, for example. Finally, he doesn't understand derivatives. The notional amount of outstanding financial derivatives is almost meaningless.

TradingStrategyLetter - Weekly Summary said...

Ben - not a bad thought on gold!

Buddy R Pacifico said...

Benjie states:

"That's it. That's the top.

Remember I called it. Gold at $1,500 is the top.

It's official."

Benjie, gold is now at $1529 -- leave some wiggle room when calling a top or bottom; ie., "topping out" or "bottoming out" and not a hard call.