One chart that always seems to pop up on TV interviews is Robert Shiller's price to earnings chart from his book Irrational Exuberance. This is used to emphasize that markets are currently expensive. (Shiller’s data evaluates the average inflation-adjusted earnings from 10 year periods).
I believe that one of the conclusions that one can make, whether you use Shiller’s 10yr P/E ratio or the TTM P/E is this:
At 7x ttm EPS, the S&P 500 in the early 80's was cheap.
At 32x ttm EPS, the S&P 500 in 2000 was expensive.
And currently, the estimated P/E ratio on the S&P is 17x ttm EPS.
So the question is, is the market currently expensive and is there room for P/E expansion? Let’s take another look... underneath the market’s hood...
In my mind, when looking at historical P/E expansion it wasn't all that significant as some want us to believe. It was a function of:
1) Falling interest rates (down to zero)
2) Technological advances. (technology makes companies more efficient with their capital)
3) Productivity gains.
4) More investors. (Especially with the rise of deep discount and online brokers, there are far more investors in the market since the 80's and 90’s)
5) Demographics. (Increase in growth investors vs. balanced or income investors)
6) More scrutiny in the accounting methods used. (If they had the same accounting methods in the 80’s and 90’s as we do today, the earnings would have been much lower).
7) Companies instead of giving their earnings directly to shareholders as a dividend, they have spent the money to buy back shares. (This drives up the price per share, effectively giving every shareholder the dividend indirectly as a capital gain.)
To me, the market is not expensive. Today’s valuation is justified by the above mentioned reasons and it is not an apples to apples comparison to historical valuations…..
What's more interesting about P/E expansion is the comparison of the S&P 500 market capitalization P/E vs. the S&P 500 equal weight P/E.
The equal weighted index has outperformed the capitalization weighted index, from the market bottom of March 9th,2009, by 17%!
However, when looking at the P/E expansion of both indexes it has been identical!
My view is, if we really want to determine if the market is cheap or expensive we need to focus on the appropriate index.
We need to strip out the mega caps from the S&P 500 index and construct an equal weighted index made up of only the country's large cap stocks. (And there are many reasons why mega caps skew the numbers)...
If we do that then we will be able to conclude that the market is not only not expensive but it is actually a bargain at these prices!
The bottom line is, you need strong data to make a successful forecast…but sometimes not even strong data can be useful when making a prediction…
As the stock hit the 52-week low today, I was looking at the company’s key statistics again, and I must say….the numbers are impressive. Of course, right now, it’s all about jobs, housing and the global economy etc… So trailing P/E, forward P/E, price/book and all other key statistics are of secondary importance.
But it is still amazing how a company can grow its Qtrly Earnings 30% (yoy) and the stock be down more than 10% from the year before!