Tuesday, September 8, 2015

Equity valuation update

Here's a quick look at equity valuations using some traditional and non-traditional methods. Data as of August 31, 2015. Worst case, stocks look a bit overvalued. Best case, stocks still look attractive.

According to Bloomberg's calculations, the trailing 12-month PE ratio of the S&P 500 (17.4) is only slightly above its long-term average (16), and far lower than its 2000 peak of 30. My read of this is that equity valuations are about average—neither over- nor under-valued.

The chart above compares the earnings yield on the S&P 500 (the inverse of the PE ratio) to the yield on BAA corporate bonds. On this basis, holding stocks gives you a slightly better yield than holding the typical corporate bond. From an historical perspective, what this means is that stocks are unusually attractive relative to corporate bonds. Why? Because equity ownership gives you unlimited, long-term upside potential, whereas the best you can get from holding corporate bonds is their yield to maturity. It also implies that the equity market is still possessed of a healthy degree of pessimism. Why? Because if investors were optimistic about the prospects for corporate earnings they would much prefer to own equities than corporate bonds, since equities promise not only yields but capital gains.

The chart above compares the earnings yield on stocks to the inverse of the real yield on 5-yr TIPS. These two series tend to move together, and they are good proxies for the degree of pessimism/optimism in equity prices. For example: when optimism was high in 2000, real yields were very high (meaning TIPS prices were very low) and earnings yields were very low (meaning equity prices were very high). The world was so enthusiastic about the prospect for corporate earnings and economic growth that investors were willing to all but ignore the historically attractive and government-guaranteed 4% real yields on TIPS, in favor of the non-guaranteed 3.5% earnings yield on stocks. Today, investors seem indifferent to the almost 6% yield on stocks, versus the meager 0.3% real yield on 5-yr TIPS. Pessimism is not hard to find these days.

Investors always have a choice between owning risky stocks or risk-free 10-yr Treasuries. Currently, the earnings yield on stocks is about 350 bps higher than the yield on 10-yr Treasuries. From an historical perspective, this is a relatively rare occurence. My read on this is that investors today are not very confident that corporate profits can hold at current levels. They fear that earnings are going to decline, and so they demand an unusually high premium for holding stocks instead of Treasuries. By this measure, stocks offer attractive valuations for those who believe that earnings are unlikely to fall. 

Corporate profits tend to track the growth of nominal GDP over time. Stock prices are theoretically driven by the discounted present value of future after-tax earnings. The market cap of equities (using the S&P 500 as a proxy) should therefore tend to track the inverse of risk-free Treasury yields (because they are the appropriate discount rate). And as the chart above shows, they do. Treasury yields are very low from an historical perspective, but the market cap of equities is not out of line with historical trends, being roughly the same today as in the early 1960s.


Benjamin Cole said...

Terrific wrap-up. I think I agree---equities are about priced right. Of course, efficient market theory says equities are always about priced right.

I tend to be bullish (as a buyer) when the average p-es get closer to 10. Some REIT stocks are worth a look at these prices. If you can stand it, you should invest in equities (in bulk) but a few times in a life.

It may be the globe enters a long period of low inflation, low interest rates and low economic growth, sort of a Japanification brought about by tight central banks and demographics.

What sorts of enterprises will prosper in such a world?

marcusbalbus said...

so trite.

Anonymous said...

Hi Scott, The S&P500/GDP (or similar) is sometimes touted as 'Warren Buffets favourite indicator' as to whether stocks are overvalued or undervalued. As you show in the last chart it is rather high. However do you always look at this compared to the inverse of 10 year bond yields? Also do you see this chart mean reverting? Or could we simply see GDP increase (heaven forbid) and this would bring down the S&P500/GDP if stocks stayed at similar levels or rose slightly. Thanks.

Scott Grannis said...

Nick: Valuation analysis is part art, part science, and no measure is infallible. I think it's useful to look at a variety of things. As for stocks/GDP, there is a school of thought that says market cap should increase as interest rates fall, because future earnings are being discounted at a lower rate. Another school of thought says that interest rates are irrelevant because they are a function of future expected inflation, and if rates are high, it's because of high inflation expectations, and in turn that means that future earnings are going to be rising at faster rates—so the inflation component of future earnings and the discount rate cancel each other out. I lean towards the first school of thought. Regardless, it's clear that stocks are not being sold at fire sale levels as they were for most of the past 6 years or so. They look a bit cheap by some measures, but regardless, there is nothing that rules out further appreciation even if they are fairly valued or a bit expensive today.

Anonymous said...

Thanks Scott!

Johnny Bee Dawg said...

The percentage of stocks trading above their 50 day moving average plunged down to levels of market bottoms in 2008/2009 and 2011 a couple of weeks ago on that Monday. Stocks on this basis were awfully washed out...down near levels where the financial system has nearly come apart in the past. Except the financial system showed no signs of coming apart this time. Similar levels occurred with the percentage of stocks trading below their 150 day average. Opportunity to be greedy while others were fearful.

These percentages have started rising now.

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