Key Points
- Stock market valuation can be looked at through different lenses, each with their own benefits and limitations.
- Shiller’s CAPE is a good long-term tool for gauging long-term returns; but not for short-term market timing.
- Traditional P/Es show less extreme valuations; but rising interest rates should be considered.
As has nearly always been the case and remains so today, ask a market bear about valuation and he’ll likely say the market is very expensive. Yet, ask a market bull about valuation and he’ll likely say the market is reasonably valued. How can that be? Assuming by “valuation,” we’re talking about price-to-earnings (P/E) ratios, the answer is in the eye of the beholder; and/or a function of the denominator (E, or earnings) you opt to plug in. There are three popular P/E ratios:
- Forward P/E (on subsequent 12-month earnings forecasts)
- Trailing P/E (on most recent 12-month past earnings)
- Robert Shiller’s Cyclically-Adjusted P/E (CAPE)
CAPE has been coming up a lot lately—especially by those who feel the stock market is overvalued. The CAPE uses earnings from the prior 10 years and has become a widely followed valuation measure. Yale professor and Nobel Laureate Robert Shiller defines the numerator of the CAPE as the real (inflation-adjusted) price level of the S&P 500 Index, and the denominator as the moving average of the preceding 10 years of S&P 500 real reported earnings. The US Consumer Price Index (CPI) is used to adjust for inflation. The purpose of averaging 10 years of real reported earnings is to control for business cycle effects.
The CAPE is a great tool to keep in the valuation toolbox when judging the likely long-term returns for the stock market. But where it can fall short is as a shorter-term market timing tool; especially by investors following it dogmatically.
The chart below is of the CAPE—all the way back to the 19th century. Comparing today’s reading of 27 to the long-term median of 16 suggests the stock market is about 70% overvalued. This suggests the market is dangerously over-priced, but a sudden pivot to a severe bear market is by no means certain.
Source: Data and methodology courtesy of Professor Robert J. Shiller (http://www.econ.yale.edu/~shiller/data.htm), as of May 15, 2015.
Timing is everything
Even if you follow the CAPE as a valuation tool, be mindful of the simple fact that the stock market can become “overvalued” and stay that way for quite some time.
In the present bull market—now over six years old—the first month the CAPE crossed into overvalued territory (i.e., moved above its long-term median) was May 2009; just two months after the market’s bottom. Since then, the market is up nearly two-and-a-half times. Even more dramatic was the cross into overvalued territory by the CAPE in February 1991—nine years shy of the top of the great 1990s bull market.
That said, CAPE does have a strong long-term relationship to subsequent 10-year stock market returns. And, it is quite possible that the market’s returns in the next 10 years could be lower than normal due to the high values versus long-term averages.
Traditional P/Es…shorter time frames
Two other common P/E ratios used to value stocks look at a shorter time frame for earnings. In the chart below are the forward and trailing P/Es; both relative to their long-term medians. Both are a bit above their medians, suggesting stocks are mildly overvalued—I would not quibble with that either.
Source: FactSet, Standard & Poor’s, Strategas Research Partners LLC, as of May 15, 2015.
Although the S&P 500 is trading near an all-time high, it hasn’t made much headway so far this year. The elevation in the P/E has come from weak earnings growth—albeit not as weak as was expected heading into the quarter’s reporting season. In advance of the first quarter earnings season, the consensus of analysts’ expectations was for a drop of nearly 6% for the S&P 500. That has now moved to a gain of about 2%, which is a record-breaking improvement to earnings expectations. But, 2% is obviously not gangbusters, which means earnings are not doing the market’s heavy-lifting necessary when valuations get stretched.
But recent weak earnings growth needs a little dissection for clarity. Most of the weakness in the first quarter was concentrated in the energy sector—excluding energy, S&P earnings would have been up over 11% instead of the more paltry 2%; courtesy of strong earnings from the healthcare, financial and technology sectors (the latter two are sectors on which we have overweight recommendations).
Decent historical zone for P/Es re stock market gains
Clearly, history shows us that the best returns for the stock market come after P/Es decline to very low levels. And similarly, the worst returns occurred following high P/Es (i.e. north of 20).
But, when the forward P/E is in the range between 16 and 18 (the range in which we sit presently), the stock market has averaged double-digits gains on a subsequent one-year basis. This fact is not intended to be a prediction. As the saying goes, past performance is no guarantee of future returns, and this is especially true today. However, it is also true that stocks can perform well even after they become slightly overvalued versus historical averages.
Equity valuation in the context of bond yields
Finally, there is the relationship between stock prices and bond yields worth discussing. This is especially relevant given Fed Chair Janet Yellen’s recent comments that valuations in the stock market were “quite high” and that there was a risk of a “sharp jump” in long-term bond yields when the Fed raises short-term rates.
Interest rates are an important input to pricing equities—taking the present value of the future stream of earnings and discounting by the risk-free rate (typically the 10-year Treasury yield). To that, you need to add the “risk premium,” which relates to the risk of buying stocks over bonds.
If the discount rate is going down, investors will typically pay more for earnings and vice versa. With yields now moving higher, companies will require stronger earnings growth to support current stretched valuations. This is one reason I am more cautious on US stocks this year compared to past years.