We’ve regularly observed that corporate profit margins (and economy-wide, profits as a share of GDP) have a strong tendency to “mean revert” over time – specifically, elevated profit margins are associated with unusually weak earnings growth over the following 5-year period, and depressed profit margins are associated with unusually strong earnings growth over that horizon (see last week’s comment, A False Sense of Security ). Notably, the ratio of corporate profits to GDP is presently nearly 70% above its historical norm. Of course, the most common valuation methods used by Wall Street analysts (whether they use the “Fed model” or “forward operating earnings times arbitrary P/E multiple”) rely almost exclusively on estimates of year ahead earnings. Embedded in these toy models is the quiet assumption that current profit margins will be sustained indefinitely.
By contrast, a wide range of measures that use “normalized” fundamentals of one form or another are extraordinarily stretched. Andrew Smithers recently took note of the elevated levels of cyclically adjusted P/E ratios and price to replacement cost (“q”) and observed “As of 8th March, 2012, with the S&P 500 at 1365.9 , the overvaluation by the relevant measures was 48% for non-financials and 66% for quoted shares. Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.”
At 1400 on the S&P 500, the market’s overvaluation has now reached 70% on these measures, which have a far stronger correlation with subsequent market returns than the Fed Model or other unadjusted methods using forward operating earnings. This is particularly true over horizons of 4 years or longer. As a side note, since the reliance on forward operating earnings is now an established Wall Street practice, Valuing the S&P 500 Using Forward Operating Earnings details how to improve the reliability of market valuations based on these figures.
Vanguard’s move into PE may change the landscape forever
Private equity has been growing in popularity in recent years as more and more big-name funds and institutional investors dive in. Now even indexing giant Vanguard is out to take a piece of the PE pie. During a panel at the Morningstar Investment Conference this year, Fran Kinniry of Vanguard, John Rekenthaler of Morningstar and Read More
We presently estimate a nominal total return on the S&P 500 averaging 4.1% annually over the coming decade. This modestly exceeds the yield available on a 10-year Treasury, but by a small margin that – outside the late 1990’s bubble period – has previously been seen only during the two-year period approaching the 1929 peak, between 1968-1972 (which was finally cleared by the 73-74 market plunge), and briefly in 1987, before the crash of that year.
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