Wednesday, September 6, 2017

A better PE ratio

This post is an update to a 4-yr old post titled "Equity valuation exercises." Back then I observed that stocks were fairly valued according to a standard measure of PE ratios (prices divided by 12-mo trailing earnings per share from continuing operations). But they looked to be quite undervalued if measured against the most recent quarterly annualized measure of after-tax, adjusted corporate profits that is produced in the National Income and Product Accounts (NIPA).

Art Laffer long ago taught me the value of using NIPA profits. This measure of profits is based on information supplied to the IRS, and it is then adjusted for capital consumption allowances and inventory valuation. It's been calculated the same way since 1947, and we can be reasonably sure it doesn't artificially inflate profits (who would overstate their profits to the IRS?); Laffer calls it simply "true economic profits." Using this measure, which is calculated quarterly, also gives us a more timely measure of profits, compared to using a 12-mo average of profits.

Here is a chart of PE ratios for the S&P 500 using trailing earnings per share, which suggests that stocks today are moderately overvalued:

And here is a chart of PE ratios for the S&P 500 using NIPA profits (I've normalized the result so that the long-term average is the same as the average for the standard measure of PE ratios), which suggests stocks are only modestly overvalued:

Both methods produce similar results, but the NIPA method suggests that PE ratios are only about 13% above average, whereas the standard method suggests PE ratios are about 28% above average.

For the curious, here is a chart that compares NIPA profits to 12-mo trailing earnings per share (the latest NIPA profits, released last week, are as of Q2/17, while EPS are as of August 2017):

In my 4-yr old post linked above, I discuss some of the reasons for the divergence in these two measures of profits that began around 1990 (e.g., changing accounting standards and changing taxation regimes). Those problems don't affect the NIPA measure of profits, which is why I tend to prefer them.

The two charts above compare NIPA profits to nominal GDP. Note how strong profits have been since the recession of 2001. Since the end of 2001, NIPA profits have almost doubled (+185%), while nominal GDP has increased by only 80%.

Over the years I've argued that this is at least in part due to globalization. Large and successful US corporations have been able to generate a much higher level of profits by selling into the rapidly expanding global market. Global GDP has increased 125% since 2001.

All things here considered, it's not surprising that stocks have done so well of late, and that PE ratios are moderately above their long-term average.


The Cliff Claven of Finance said...

The EPS increase is mainly from stock buybacks, not high margin foreign sales.
Compare the much slower sales growth with EPS growth to see a huge difference.

The Bloomberg PE is some adjusted version not based on Standard & Poor's as-reported earnings.

Stock prices should also be compared with sales (much less volatile than earnings),
book value, Tobin's Q, and many other things, such as % of GDP (Buffett's favorite)

The S&P 500 average Price Sales Ratio is near the highest ever.

The S&P 500 median Price Sales Ratio is 50% above the previous record.

Stock market cap as a percentage of GDP is the second highest ever.

Using only ONE ratio (P/E) is bad financial analysis.

Using adjusted earnings data that lowers the PE (Bloomberg) is bad analysis too.

Anyone who studies stock market history knows stock valuations today
are among the highest in history.

There are no historical examples of stock averages having a good ten-year return
after buying stocks at such high valuations
(that's including reinvested dividends
and excluding management fees and commissions).

There are two examples since 2000 of 50% declines from high stock valuations.
Stop-loss orders are your friend.

Scott Grannis said...

Cliff: You need to check your facts. I suggest Ed Yardeni's excellent and timely collection of charts on buybacks, dividends and earnings here:

Operating earnings of the S&P 500 have increased from about $350 B per year at the end of 2001 to about $1 trillion by the end of 2016. That is an increase that exceeds the growth in NIPA profits that I cited. Total earnings have been very strong.

Last year, total S&P 500 buybacks were about $530 B, which is only 2% of the market cap of US stocks.

It's difficult to argue, based on these numbers, that buybacks have distorted valuations or that they have exaggerated the growth of earnings per share in any meaningful fashion.

The EPS data that I have used from Bloomberg are "earnings from continuing operations," which is the same data that Yardeni uses. This is superior to as-reported earnings.

This post was never intended to be an exhaustive review of market valuation metrics.

I am in the company of many long-time students of stock market history who would be reluctant to say categorically that stock valuations are among the highest in history. By some metrics maybe, by others not even close.

The prospective return on stocks over the next 10 years is very unlikely to equal or exceed the return over the past 8 years, and I think you would agree with me on that. But that does not necessarily make stocks a bad investment today. The relevant question to ask is whether prospective returns on stocks will exceed the risk-free returns available today (e.g., 2% per year on 10-yr Treasuries) by an amount sufficient to compensate for their extra volatility.

The market cap of stocks is a function of the discounted future value of after-tax profits. Given that discount rates today are about the lowest we have seen in the past 100 years, it is not surprising that market cap as a % of GDP (currently 12.6%) is close to a record high. I note that the record high was 15% in 2000, when 10-yr yields were 6%. THAT was a good example of an overvalued market.

Benjamin Cole said...

Corporate profits, absolutely and relatively, are at record highs, and much higher than in the Ronald Reagan days, remembered fondly by a few. This is good news.

Are stocks overvalued? Scott Grannis seems to nail it. Fully-priced perhaps. Maybe richly-priced. But then where to put capital? Bond yields low, and property also fully priced. If you want to be a passive investor, you have lots of company.

Ben Bernanke posited there are global capital gluts. I am inclined to agree, as huge capital pools are being formed by non-market players, such as sovereign wealth funds, public pension plans, required insurance, or forced savings in China. There is also about $32 trillion in offshore bank accounts. Capital is everywhere---no good deal goes un-financed in 2017, and many dubious deals are financed.

It may be central bankers globally have to reconsider the nature of their art. A world with constant surfeits of capital but weak demand---what is the right policy?

Perhaps helicopter drops are the answer, or the close cousin, QE and budget deficits. In the U.S., a Supreme Court ruling that property zoning is unconstitutional would help.

I do not believe in the "new normal" of lowered growth and productivity. I believe demand is being suffocated by too-tight money and other structural impediments, such as sovereign wealth funds.

Worth watching: Trump has a chance to re-make Fed leadership. Trump is Trump, so you can sensibly bet against him, but maybe, just maybe, the real-estate developer in Trump will see to it some pro-growth guys get on the Fed, instead of the usual chicken-inflation-littles.

If so, we could see an economic boom in the U.S.

Let it rip!

The Cliff Claven of Finance said...

No reason to use a variety of different stock valuation indicators.

Just use one, the P/E Ratio

But that's too high, so let's "adjust" earnings to make them
higher -- no reason to use GAAP "as reported" earnings
when "adjustments" can make the earnings higher.

Or use "operating earnings"

Or use wild guess "forward earnings"

Better yet "Adjusted Forward Operating Earnings"

Forget about GAAP -- that's for old fogies!

If "adjustments" move the P/E Ratio lower than using GAAP earnings,
that will help justify a perma-bull always be 100% invested belief.

"Adjustments" mean ignoring bad news / expenses / taxes simply because
you don't feel like seeing it (confirmation bias?).

Below is a link to Warren Buffett's favorite stock valuation metric
that also shows how well it predicts 10-year forward returns
(good valuation indicators are those that work well to predict 10-year forward returns):

Earnings are already high, from much higher than (the long-term) average profit margins,
that are likely to revert to the mean some day,
so there is no need for "adjusting" earnings higher (ignoring bad news)

Johnny Bee Dawg said...

Last 20 year S&P total return was 7% per year.
The median 20 year return since the 1920s has been 11.6% per year.

Last 10 year total return was 7.6%
The median 10 year return since the 1920s has been 9.9% per year.

Its not like we have been making outsized returns, and now have to reduce to the mean.
In fact, its the opposite.

Over 80% of stocks were trading above their 50 day moving average in January.
That number cooled off to just 35% just this month, and has started heading back up.

Imagine if the current administration continues to rip away the overreach of the last one.
Imagine if investors stop fearing their own government's assault on capital and success.
Imagine if the idiotic, economy-punishing government tax and health care policies get reformed.

The productive element of America feels optimistic for the first time in years.
Feels like stocks should be moving higher to make up for the last decade of economic lethargy.
There's a lot of ground to make up.

Anonymous said...

In reference to your post before this one regarding increased consumer and small business confidence, and the potential for the reduced demand for money increasing inflation:

Historically, how fast has/could core inflation increase/accelerate?


rich said...

to Johnny the Dawg

I like your optimism for the US.

I am currently 37% invested / 63% cash so I make some money from good news.

Maybe I'm too old to be that optimistic.

I do want Trump to succeed, and our economy to boom.

But I doubt if 51% will support Trump for major legislation.

I want you to consider the current low potential for future US GDP growth and consider that GDP growth correlates well with S&P 500 earnings growth:

S&P 500 earnings growth (includes inflation) averaged +6% a year from 1947 to 2000.

But just +4% a year since 2000, and only +1.7% a year in the past decade.

The current labor force annual growth rate (+0.3%) and productivity growth (+0.6%)

That adds up to a potential future GDP growth rate of only +0.9%
... which is not reflected in today's S&P 500 stock prices.

Using a ratio similar to a "PEG Ratio" for an individual stock:

US stocks have never been more expensive relative to the prospects for future weak GDP growth.

The "S&P 500 PEG" is 60% above the historical average.

(Note: Since 2010 nearly half of US economic growth was driven by a declining unemployment rate, which is unlikely to decline much more).

You cherry-pick start and end dates to make "your" S&P 500 return numbers look better.

1997 was a great time to buy stocks and 2017 is a great time to sell, IMO.

Picking those great start and end points biases your results.

A fair analysis would start at a prior S&P 500 peak, such as the 2000 peak.

From that 2000 peak to the peak in 2017, the total annual return was 4.7% excluding commissions and management fees (all dividends had to be reinvested immediately to get that 4.7% a year).

The purpose of my peak to peak analysis is to show that if you own stocks at a valuation peak, the return over the next decade has never been good.

A valuation peak should not be is determined by ONE indicator, using "adjusted" earnings.

And remember that from the 2000 peak to 2017 peak, there were two 50% declines through which you had to hold all your stocks without having a heart attack. (buy and hold)

This is what I wrote in my September-October 2017 economics newsletter that I'm finishing today:

Maintain a very high percentage of cash because of high stock valuations (I have 63% cash):

- The S&P 500 average Price / Sales Revenue Ratio is at the highest level on record, except for at the March 2000 peak of the technology stock bubble.

The 2000 peak was concentrated in the "top 10%" of stocks -- at the current 2017 peak, stocks in the "bottom 90%" are more overvalued than at the 2000 peak, but not the "top 10%" (ranked by market capitalization)

- The S&P 500 median Price / Sales Revenue Ratio is about 50% higher than the previous record.

- The Shiller P/E, looking at average earnings in the past 10 years, is at 30.5x, and has only been higher in 1929 and in 2000.

- A recent Conference Board survey found only 20% of Americans believe stocks will fall in the next 12 months
-- the lowest percentage since mid-2007.

- A surprising 50% of stocks on the New York Stock Exchange were trading below their 200-day moving average at the end of August 2017.

- The Stock Market Capitalization to GDP Ratio is the highest since just before the 2000 bear market.

- From current stock valuation levels, the expected rate of return over the next decade is low.

Unknown said...

'Below is a link to Warren Buffett's favorite stock valuation metric
that also shows how well it predicts 10-year forward returns
(good valuation indicators are those that work well to predict 10-year forward returns):

Earnings are already high, from much higher than (the long-term) average profit margins,
that are likely to revert to the mean some day,
so there is no need for "adjusting" earnings higher (ignoring bad news)"

It's comical to try and link a WB article from 1999 to his thoughts today. He NEVER mentions that statistical anomaly anymore. In fact, he is heavily invested and looking for dips to buy.

Profit margins have ZERO correlation with future stock returns! The weather has a higher correlation.

Perhaps the market is finished rising and eventually corrects 25% or so, maybe? One thing is certain that until a "bubble forms", LEI begins to decline and operating earnings turn South, there will be no major equity decline.

All those other measures of equity valuations are interesting but markets get crushed on bubbles and/or major economic disruptions. LEI is not pointing that way today and until it does, stay invested 80%.

Johnny Bee Dawg said...

I just started my numbers from today. Didnt "cherry pick", because I'm talking about investing from today. Stock returns have been low for the past 10 and 20 year periods, vs history. That isn't true at past market peaks.

I got criticized on here in a comment a couple of weeks ago for starting measurements at the peak of March, 2000 because that made past stock returns look even worse than the 10 and 20 years I just used. Lol.

My point is that looking backward, stock returns over meaningful periods have been worse than past averages. Not extra good like at past peaks. There's record cash piled up on the sidelines. Commentary is almost all bearish, GDP is $2 or $3 trillion below trend, and America has tons of horribly stupid policies that voters are ready to reform. And we have a good President who's ready to swing the pendulum back toward We The People. Americans have overwhelmingly rejected DEMs...PUBs have the most elected seats nationwide since the 1920s.

Future looks bright to me, unless the PUB leadership Swamp has him killed, and ends the voters' agenda they voted for. If The Swamp beats Trump, then we will suck hind teat for the foreseeable future. Swamp doesn't want to give back all that Big Government power they just amassed to the likes of a bunch of deplorables who take the risks, create the growth and pay the bills. Gut the Swamp, and GDP will soar and drag markets with it. It's about time.

Tom L said...

Thanks Scott - great analysis as usual. What did you think of today's Apple announcement? Thanks again.

Scott Grannis said...

Re Apple's announcement today. I've watched every one of Apple's new product announcements going back as far as I can remember. This one struck me as the most feature-filled and impressive of them all. I know right now I will be ordering several Apple TVs and a new Apple Watch this Friday. I currently use an iPhone 7 instead of a 7 Plus, mainly because I don't like the larger size of the Plus, and I've upgraded my iPhones every year without fail. But there's a good chance I'll wait until next month to order the iPhone X, instead of upgrading to an 8 this Friday. My wife will upgrade to an 8. The X looks just too fantastic to pass up: new and better cameras, face recognition, a much better and bigger screen (housed in a form factor slightly smaller than the 7 Plus), plus machine learning capabilities, all for just $200 more than an 8.

The stand alone cellular capability of the new Watch surprised me—I didn't think it would be possible.

Scott Grannis said...

Re a possible acceleration of core inflation. My sense of the historical record and what is likely tells me that core CPI inflation could increase from the current 1.5% to 3% or possibly 4% over a period of about 3 years. As an example, core CPI rose from 1% in late 2003 to 3% in late 2007.

Thinking Hard said...

Scott- Thoughts on the dollar?

Adam said...

MS is also warning on possibility of rising inflation, according to their predictions it could be Q1/Q2 next year.

The problem with good growth, ironically, is that it often means tighter policy. But softness in core inflation, a trend our economists expect through year-end, is providing central banks with a window to keep policy relatively accommodative. This won’t last forever, and our forecasts predict a pretty material pick-up in inflation in the G3 economies (U.S, eurozone and Japan) beginning around March 2018. But for now, we have solid global growth and some of the easiest financial conditions in history.

Benjamin Cole said...


"This month, trailing 12 month inflation remained at about 1.7%. Core inflation less shelter remained low: 0.1% for the month and 0.5% for the year. Rent inflation this month spiked, which is mainly what is keeping core inflation above 1%.

On the news, it looks like the odds of a Fed rate hike in December jumped by about 15%, (currently 55%?"---Kevin Erdmann

We have some minor inflation in the U.S. mostly tied to rising residential rents. This is driven by property zoning, and artificial heavy-handed government socialist constraints on new development.

The Fed raising rates may actually make rising rents worse by cutting off some new residential construction.

There seems to be zero interest in reforming property zoning, which does place the Fed in a box.

Will inflation get up to 3% to 4%?

Could be. Or we could see deflation in the next recession.

Jim said...

Two kinds of forecasters: those that don't know and those who don't know they don't know. (Galbraith)
I've gotten quite a kick out of reading some of these.