The debate du jour amid stocks reaching new highs during a 10% gain in the first quarter is: What’s Next? Are stocks overpriced, fairly priced or perchance, undervalued? Schwab chief investment strategist Liz Ann Sonders recently surmised the answer is in the eye of the beholder as there is a valuation metric to support any of those three possibilities.
Sonders dismisses the overvalued argument that acolytes of the Shiller Cyclically Adjusted Price Earnings ratio (CAPE) are pressing these days. This metric uses the 10-year average of real (inflation adjusted) earnings and the real price of the S&P 500. The long-term average for this metric is 16. As you can see, it’s way past that level today.
Sonders believes the 10-year time frame, meant to smooth out earnings volatility, misses the mark: “The problem with using a 10-year period for earnings is that the average business cycle only lasts about six years. More recently, recessions have become shorter and expansions longer…As a result, CAPE tends to overestimate "true" average earnings during a contraction and underestimate "true" average earnings during an expansion. She also has some niggles with the underlying data used to compute CAPE.
At the other extreme, using 12-month PE’s suggests the market is slightly undervalued. Sonders notes that the median for trailing 12-month PE for the S&P 500 is 18.1 dating back to 1990. We’re under that right now.
Same is true for forward PE, but Sonders throws a tad of cold water on that metric, noting the “notoriously bad forecasting ability of the analyst community.”
Sonders is a fan of a less common valuation metric, Steve Leuthold’s calc that takes a look at five years of earnings; that’s more in line with the average 6-year business cycle. The five years of data includes 4.5 years of actual earnings and two quarters of estimated (forward) earnings. While the Shiller CAPE ratio uses only reported earnings (meaning non-recurring problems remain a factor for the full 10 years) Leuthold uses the midpoint between operating and reported earnings.
Right now the Leuthold 5-year normalized PE is flashing slightly overvalued. But if you drill down a level and take a look at the metric during periods of low inflation like today, it shifts from slightly pricey to fairly valued.
The one valuation metric Sonders addresses that is screaming stocks are undervalued is earnings yield. The so-called Fed Model contends that when the S&P 500 earnings yield (the inverse of PE) is above the rate of risk-free money, stocks are the better value. Drawing from a recent note from Oaktree’s Howard Marks, Sonders notes that stocks look cheap. The S&P 500’s earnings yield of around 6.25% is about 5.75 percentage points above short-term Treasury yields. The average spread over the past 70 years is 3.25 percentage points. Sonders’ takeaway: “The yield comparison is highly favorable for stocks today and is actually the best it's been in the past century.”
True. But it’s worth parsing that statement a bit. It’s not saying stocks are cheap. Merely that stocks are the better value relative to bonds. Yet that is purely a function of Federal Reserve policy that has pushed bond yields to record lows. It’s hard not to look like a much better value against manufactured interest rate suppression.
Cliff Asness, of AQR hedge funds did his best to debunk the utility of earnings yield in a detailed paper titled Fight the Fed Model. Asness posited that when pundits cite the Fed model as a signal that stocks are cheap, “might they actually sometimes mean stocks are overvalued, but less so than bonds.” It’s worth nothing Asness wrote that back in 2002, six years before the financial crisis ushered in the Federal Reserve’s ZIRP policy that is still in place.
His conclusion was that straightforward PE is the better gauge for parsing market valuations. And the best you can come up with -- no matter what PE you use -- is that stocks are either fairly valued or slightly overvalued right now. Undervalued is only a relative term.
That doesn’t mean that the end is nigh. As Sonders smartly points out, the Shiller CAPE ratio went from undervalued (below 16) to overvalued in May 2009. If you got bearish on stocks at that point you’d have missed the last 90% or so of a rebound that has yet to lose steam.
Just don’t use earnings yield as your sole marker for getting extra bullish right now. It would be nice to ignore all this big-picture stuff and focus on individual stocks and their prospects. Exceptional companies like Apple (AAPL) and Google (GOOG) may out-perform the S&P 500 handily over time, but many of the solid, dividend-paying stocks most investors choose -- think Johnson & Johnson (JNJ), Kimberly Clark (KMB) and Coca-Cola (KO) -- will more closely track market averages.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at email@example.com.
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