There’s almost nothing more in vogue today than commenting – confidently – that the U.S. stock market is “overpriced,” “expensive,” and “overbought.”
To which the in-vogue reply is to confidently agree and then knowledgeably assert that we’re overdue for a correction at minimum and, more likely, a bear market.
Stock market prognostications are the province of soothsayers and cretins, so we won’t weigh in there exactly. But it’s worth discussing market valuation a bit since equities are where strapping Luchadores most like to place their nuts.
Now, it’s true that by some historical measures U.S. stocks appear on the pricey side of average. We’re told Schiller’s CAPE-10 approaching the upper-20s means we’re doomed. And we hear a deluge of commentary about depressed earnings growth, etc., which militate toward a correction.
Nonetheless, by some measures, stocks seem somewhat undervalued. TINA’s a good friend of lots of stock investors these days, for instance, because of the yield differential between bonds and stocks.
But whether equities are indeed overvalued or undervalued is only half the story for long-term investors and cunning Luchadores. The presence of pricey-ness in stocks doesn’t tell us much at all about what comes next – over the short term or long term.
So here’s the full story.
Riddle Me This
The “intrinsic” value of stocks is the present value of future anticipated earnings (or cash flows) accruing to shareholders. If there are greater corporate earnings to go around, then stock prices increase.
Notwithstanding all the noise surrounding stock valuation, in the aggregate, this price-to-earnings relationship is incredibly robust. About 95% of all long-run stock price variation is explained by earnings; that is, there’s an observed 0.95 correlation coefficient between earnings per share (EPS) and S&P 500 index value from 1935 through today.
The good folks over at OppenheimerFunds have made a pretty graphic that summarizes.
The chart makes a good case for the correlation, but it also divulges the essential weakness of the relationship. While it’s true that, over long stretches, the positive relationship between earnings and prices is undeniable, shorter-run periods reflect pretty serious chasms.
These short-run deltas are explained by all the noise that gets shunted into investors’ heads and causes market overreactions and other lunacy. So, the stupidity corrects over the long term. But it can be pretty painful for the less steely of us along the way.
What does the current state of price-to-earnings tell us? At first glace, it looks like prices have overextended a bit. From this first glance it appears stock prices must be due for a decline if earnings don’t increase.
To really find out, we can sort of formalize this observation by comparing market-wide PE Ratios for the current period against historical norms. A PE Ratio gives us the “multiple” of EPS reflected by each share’s price. For instance, a PE Ratio of 10 would mean that, given EPS of $1, a share of stock would trade at $10. The PE Ratio tells us how much investors are willing to pay for a given level of annual earnings.
Just as we can calculate a single issue’s EPS and PE Ratio, we can calculate the PE Ratio for the stock market as a whole. A higher multiple implies a “more expensive” stock market – one in which each bit of earnings accruing to a share commands a relatively high price. When PE Ratios get expensive, it’s often the case that, over time, those PE Ratios revert to the long-run average one way or another.
So, are we higher than usual?
Below is a gorgeous rendering done by los hombres over at multpl.com that shows S&P 500 PE Ratios from the late 1800s through ahora. What’s it tell us, exactly? A few things pop out. First, PE Ratios for the market jump around more than Bugs Bunny on crack. And second, yes, right now we’re well above the historical average.
Since way back when horse manure flooded city streets and the rotary telephone was considered “newfangled,” we’ve had a pretty solid central tendency observable in U.S. stocks’ PE Ratios. The range of 14.6 (the median) to 15.6 (the average) is where we tend to revert. Call the central value 15 for simplicity.
But hmm… that “reversion to the mean” story seems to have gotten weaker and weaker over time, doesn’t it? In fact, we haven’t really spent any appreciable amount of time below the 15 mark since before MC Hammer told us not to touch his pants.
If we begin a PE Ratio analysis on the S&P 500 from around the time the Chicago Bears last won a Super Bowl (1986) and carry it through 2016, then we get a very different reading on what’s “normal” or “central.” The median is 20, and the average is close to 23. Let’s just say that, over the last 30 years, the central value’s around 22.
The central values are higher by almost 50% in this 30-year stretch…! Um, yeah, that’s kind of a lot. And by “a lot,” I mean, like, super-duper-cray-cray a lot.
What’s that mean? Well, mathematically it means that each dollar of earnings generated by public companies is being valued more highly (by about 50%) in the present era than it has tended to be historically.
More generally it could mean that we’ve entered a “new era” of equity valuation. Or it could mean we, the investing public, have become more inclined to walk farther and farther off the overpriced cliff before looking down and only then, cartoon-style, fall to the desert floor below. There’s no definitive answer. Theories, maybe, but no answers as yet.
Now, before we get all theoretical and perhaps even theological about this, there’s one more stop on the PE Express we have to make. It’s a little town known as the Schiller CAPE-10.
Schiller’s CAPE-10 PE Ratio analysis is meant to “smooth” out the periodic volatility of company earnings. The idea is very Graham-ian in nature: Since earnings are volatile, we should look to the last 10 years’ worth to really get a good understanding of “true” earnings capabilities. In practice, this approach levels out earnings volatility due to market cycle fluctuations, and it can help reduce some of the effects of temporal lags between earnings changes and price changes.
From multpl.com (man, those guys make pretty graphs) is a rendering of the Schiller 10 PE over time. It more or less tells the same story as our earlier PE Ratio analysis. Yes, we’re pretty peaky right now. And compared to the long history of the S&P 500, very peaky. But, compared with more recent history, maybe not so much.
The essential takeaway from the Schiller 10 and from our other observations regarding PE Ratios is that, given the “high” valuations now, we’d expect lower long-run returns to equities investments in the future. That’s simply because, if we buy stocks now, we’re buying when they’re priced like the latest fashions on Fifth Avenue: not exactly on discount.
Yes, that could mean that stock prices fall so that PE Ratios revert to their central tendency values of 15 to 22.
Riddle Me That
“FL, what are you waiting for?!?” you say. “Sell those stocks before the market crashes!”
You’ve got a point. Stock prices are high. Earnings aren’t keeping pace. We know prices ultimately reflect earnings, and we’re way above the averages in terms of how highly those earnings are valued. So prices have to plummet to fix the imbalance. Right?
Stock valuation doesn’t exactly happen in a vacuum. As expensive as each dollar of earnings might appear right now, that’s not the only thing investors consider when they’re thinking about putting their dollars to work.
Let me introduce you to TINA, in case you haven’t already met. TINA is lovely, has an affinity for fuzzy animals, takes long walks on the beach and is pretty much all investors can think about when they get crisp Washingtons and Lincolns into their hot little hands.
There Is No Alternative (TINA). Why would anyone invest in stocks right now when the market is so “obviously” overheated? Well, if not stocks, then which mattress would you like to slice into?
Because here’s the deal with the chief alternative to stocks – that is, bonds: If stocks are hot and sweaty, then bonds are melting the floor.
Bond prices move inversely with yields. The basic equation is Price = 1/(1+ Yield%).
So, if you see news headlines that Treasury yields are at all-time lows, then that tells you everything you need to know about Treasury prices.
To the extent there’s downside risk with stocks, there’s at least equal downside risk with bonds, in terms of price action. If you don’t intend to hold your bonds to maturity, then any increases in interest rates will crater the price you’d be able to charge when selling the bonds to someone else.
Unless you’ve been living in a cave for the last few years, you know interest rates can’t really go down a whole lot.
And, if you buy a gummint bond now, you’ll maybe get a scintillating 2% yield…if you hold it to maturity for 30 years.
So, to many investors, There Is No Alternative but stocks.
Formally, this sort of TINA analysis is found in a comparison between stocks’ “earnings yield” (which is just the reciprocal of the PE Ratio) compared with bonds’ yields. The guys over at Yardeni Research made a cool graph comparing historical values of the two, using corporate bonds (which have higher yields than government bills).
As we see in the chart, stock yields are better than bond yields in the modern era. By a lot. Like 2x a lot.
Which means that a given level of earnings accruing to a share of stock is priced at 50% of what a given level of interest is priced at in bonds. A 50% discount.
Which is a felony-serious kind of divergence from historical norms. Like, as in, never before encountered in the modern era prior to the last few years. Super-duper-cray-cray, mathematically.
So, by this measure, stocks don’t appear overvalued. After all, one direct way to restore balance between stock earnings yields and bond yields would be for stock prices to climb. By as much as 100%. (This would reduce stocks’ earnings yields by 50%, thus closing the yield gap between stocks and bonds.)
Under this view, stocks are, well, sort of maybe kind of a little possibly, um, undervalued.
<A hush falls over the crowd.>
Or at least maybe stocks aren’t totally wildly overvalued.
<Silence. Throat clear.>
Or, at a minimum, we can say there’s a lot of money tied up in low-yielding bonds right now that might – just might – want to trade into stocks at any time, thus supporting stock prices…
<An older woman in the crowd begins to clap. And then stops at the urging of others around her.>
Look, I know the “stocks are undervalued” story isn’t very popular these days. But, just as isolated PE Ratios tell us stocks look pricey, the stock earnings yield v. bond yield comparison tells us maybe stocks are priced pretty fairly, if not a bit low.
Remember: With interest rates at near-zero values, there’s not exactly a clear historical precedent for how stock prices behave under these circumstances. We’ve never seen rates like this in the U.S. before. The closest we’ve ever been was during the depths of WWII. And it’s hard to draw a lot of parallels between then and now for real guidance.
Wrapped In An Enigma
“FL, if I could, I would beat you with a rubber hose,” you say. “Where does all this leave us? What are we supposed to do?”
So, this is the part of our story where we find ourselves armpit-deep in analysis bullshit and learn that one of our waterwings just deflated.
Because, for as fancy as all the graphs and numbers appear, and for as erudite as the history notes make us feel, they tell us very little about the future.
When the Schiller CAPE-10 is at a high value, like it is now, equities returns tend to be lower than average over the next decade – but those returns can still be better than any alternative investments offer.
Bonds will kill us with limbo-low yields and peaky prices, whether we buy with an intention of selling or holding to maturity.
How will stocks behave over the next several years? There are four distinct scenarios.
One: A correction or bear market.
According to our PE Ratio analysis, stock prices (given current earnings) could be overvalued. So they could certainly drop (assuming earnings are static), either rapidly or over a few years.
This scenario gets nastier if earnings decrease since a simultaneous decline in E and the PE Ratio multiple would mean bad things, man. Bad things. At least a 20% price decline would be expected because, even with static earnings, to go from a PE multiple of 25 to 22 implies a ~15% drop. To go all the way down to a multiple of 15 implies a, well, much bigger fall. And if E goes down too…
Dos: An earnings renaissance.
There are two parts to the PE Ratio story: Price and Earnings. If earnings go up like a SpaceX rocket, then stock prices can stay where they are or climb, even as PE Ratios “normalize.” That is, if the E denominator grows faster than the P numerator, then the entire fraction falls in value – the PE Ratio declines while stock prices stay the same or rise.
Or, more specifically, things basically stay the same. In this scenario, stock prices would kind of meander along sideways, while earnings incrementally edge upward. Prices wouldn’t collapse or shoot up and, slowly, over a long period, price/earnings ratios would slowly work back to “normal” while we all fall asleep every time the financial news comes on.
IV: We all spring for the box seats.
Or, more specifically, we continue living in a new era of stock valuation, where the amount investors are willing to pay for each dollar of earnings continues to climb. Stock prices go up, even if earnings decline a little, since the trendline of higher PE Ratio multiples is extended upward and to the right.
In this scenario, we’d see what’s known as “secular demand growth” for stocks that has less to do with equities’ PE valuation characteristics and more with TINA or something like it. We would see PE Ratios continue to climb higher and higher, and a new “normal” PE Ratio would emerge above the 15 to 22 “central” PE Ratios observed over earlier periods.
The Joke’s On Them
So, what do we do?
Stay the course, naturally.
Stocks are still the best long-term investment out there. Out of the four distinct scenarios facing stock investors, three are neutral or good for prices.
The fourth scenario implies price downside sometime (probably), but tells us nothing about when that will happen, how it will happen, or how much higher prices will go before any correction occurs.
And we’ll still get dividends regardless.
Now, for those of you still thinking stocks are way overdue for a mudslide, take another look at those PE graphs. We’re getting up there in pricey-ness, sure. But compared with the PE Everest that was the ’08-’09 crisis (when the S&P 500 PE Ratio touched 123), we’re barely hanging out in Denver (at a current PE Ratio of about 25). Stock prices relative to earnings could still double. Or triple. Or quadruple. Or even (almost) quintuple… and still not be the highest they’ve ever been.
Think about that for a second. Think about what that means. If you’re fretting a, say, 20% decline in stock prices – or, no, wait… a 30% decline in stock prices, how sure are you it’s going to happen? Are you willing to bet on that outcome when it’s just as possible that, over the same period, prices will go up, say, 50%?
I’m not expressing an opinion – and, indeed, I don’t have one – about whether either is going to occur. But, with the stock market, there’s almost always an asymmetry that favors the long position. And, in the long run, the long position is the only one that ever pays.
For the long-term investor Luchador, none of this speculation really matters, though.
We only care on an academic level because we like to understand some of this finance stuff. It’s interesting and graphs are fun. None of this is going to change our investing philosophy.
So the next time you’re cornered at a cocktail party by some dude with broccoli in his teeth and bad hair who tells you stocks are “overbought” and the only way to fly is to short the S&P and buy precious metals, please think back to this discussion. Please recall the pretty graphs. Please accidentally pour your cabernet onto his Polo. And please kindly walk away without saying a word.
Stock market forecasting is for soothsayers and cretins. And you’re not one of them.
Luchadores, what do you think of PE Ratios and Schiller’s CAPE-10? What about stock/bond yield comparisons? Do they tell you anything, or do you not care because you know to just tune out the noise?
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