Different Strokes for Different Folks
It takes all sorts of people to make this world go around. While it certainly leads to divisiveness at times, it also provokes thought when we hear, and more importantly listen, to opinions that are contrary to our own. While our guess is that you suspect we are describing the current political climate, we’re not. Rather, we are acknowledging the wide spectrum of views regarding stock market valuation. Based on various valuation measures, some analysts are forecasting imminent doom while others are assuring us that everything is ok. While we continue to favor the latter view, it’s always healthy to examine the contrary views that challenge our thesis. After running all of our frameworks, in particular, our valuation framework, we see the domestic stock market as reasonably valued. That doesn’t mean markets won’t pullback in the near term due to profit-taking or the political issue du jour, it just means we think the U.S. stock market’s current price is reasonable relative to history. All things being equal, this bodes well for longer-term stock market returns. There are many different ways to view valuation, and we need to acknowledge that some valuation measures are warning of overvaluation. The reason our measure, and many other measures are indicating we are okay is twofold. First, we believe there needs to be a discount mechanism applied to future earnings. When inflation is low, the present value of future earnings should be higher. We believe this allows for a higher multiple to be justified. The S&P 500 is up 25% this year but our discount rate to earnings, the 10 Year Treasury Yield, has dropped over 100bps during this same period. Secondly, we look at consensus forward earnings, not trailing earnings. Markets are forward-looking. Investors want to know what they will make, not what they could have made.
Indicators that are warning of overvaluation tend to look at absolute levels of valuation, without adjusting for interest rates or inflation. They also tend to look at trailing earnings (accounting earnings) instead of future forecasted earnings. Even though we may disagree with their thinking, it’s important to be open-minded. Traditionally, investors have found reason to dismiss warning signs that have led to prior stock market bubbles. We want to guard against that. Let’s start by taking a look at a very straightforward measure that the Bears point to. The P/E ratio of the S&P 500. While we appreciate the simplicity and believe that complexity often leads to unnecessary confusion, this measure is too simplistic for our liking. The Bears argue that based on trailing earnings, the S&P 500 is trading at a 19.3X multiple. The long term average is 15.1X. Therefore, markets are overvalued. By this reasoning, when P/E's were in the low single digits during the 70's, stocks should have been a bargain. Despite the low P/E's of the 70's, stock market returns were abysmal. Double-digit inflation made the future value of earnings far less. In fairness, P/E's did reach ridiculous levels during the dot-com bubble and before several bear markets, but those levels were far higher than what we are experiencing today.
When we look at trailing earnings relative to the 10 Year Treasury Rate, these higher absolute valuation measures seem justified.
While we might be guilty of loving the name of this next valuation measure more so than the measure itself, it's another simplistic way to think about valuation. The Misery Index is the sum of the unemployment rate and the yearly percent change in the inflation rate The Misery Index usually drops when the economy is good and rises when the economy is poor. It currently is at 5.4%. Its recent all-time low is 5.0%. While you may not realize it, you are very happy!
The forward P/E of the S&P 500 and the Misery Index are historically inversely correlated. When we are miserable (high inflation and high unemployment), we don't buy stocks and drive up the valuation multiple. When we are happy (low inflation and low unemployment), we become optimistic, driving up the P/E. The current readings of the Misery Index are historically low and suggest that the current P/E's are justified. We mentioned our love of simplicity. Perhaps the simplest valuation model of all time is called the Rule of 20. It’s performed admirably given its incredible simplicity. It simply states that you start with the number 20 then subtract the inflation rate and the current stock market P/E multiple. If the reading is above zero markets are undervalued, below zero they are overvalued. We think it is a great rule of thumb for investors to use.
Let's take a look at a slightly more complex valuation measure. The measure of overvaluation that the Bears point to with great frequency is the Shiller P/E. Yale Professor Robert Shiller has been warning throughout this bull market that stocks are extremely overvalued. He did win the Nobel Prize in economics, so let's not take this warning lightly. Professor Shiller refers to his valuation by the acronym CAPE (cyclically adjusted P/E ratio). According to CAPE, the market is grossly overvalued at a 33.1X multiple. This multiple is 85% above its long-term average of 16.1. CAPE compares the current level of stocks to the prior 10 years of cyclically adjusted earnings. While it's track record over short-periods is suspect, by smoothing out shorter-term earnings fluctuations, it has served as a decent longer-term forecaster of stocks. So why is it's current reading so extreme?
We'd argue, as would many others, that Shiller's use of trailing earnings over the last 10 years is not representative of today. A lot changes in 10 years. Corporate earnings 10 years ago were in the depths of the 2008-2009 financial crisis. Here is a look at earnings since then.
There are countless other measures of valuation, some bullish, some bearish. What we preach is the following; develop your thesis on how you believe valuation should be measured, then accept the outcome of that measure's reading. Far too often, investors have a view of the market and then shop a valuation measure that supports that view. Regardless of which valuation measure you prefer, we must all accept that valuation is not a great timing mechanism. Despite virtually all valuation variables screaming overvaluation by late 1998, it took until early 2000 for markets to finally correct. Shorter-term returns are usually the function of more technically oriented variables, global macro events, and more recently, tweets. Which are really hard to forecast. We hope everyone had a wonderful Thanksgiving, The GreenPort Team