Note: All data refers specifically to either the S&P500 (INDEXSP:.INX) or the Wilshire 5000 (NYSE:WFVK)
Below are eight different quantitve valuation metrics for the US equity market.
First a primer:
We are sometimes asked what is the point of measuring the stock market valuations. We state our own reasons below. Additionally, Steven Romick of FPA compares the Shiller PE to the ten yr treasury yield to measure market valuations. So there is at least one great investor out there who finds it useful.
This article deals with US market valuations. Last month’s data can be found at the following link- March 4th, Stock Market looking expensive.
You can view our extensive European market valuations by clicking here.
We started this monthly market valuation series in December 2009. We were getting tired of hearing pundits claim that the market was overvalued because at the time P/E TTM was 87. Earnings were clearly low due to the worst economic crisis since the great depression. However, the question was how to value the market from a purely quantitative methodology, while ignoring all the outside noise and macro predictions of where the economy is headed. We looked for several different metrics to evaluate the market which over time have proven to be effective and decided to look at all the metrics, instead of just focusing on the last 12 months of earnings.
We were contemplating updating the series on a quarterly basis, since why is there a need to update every month? However, since the market was and in general continues to be quite volatile, we currently consider it useful to evaluate on a monthly basis. When volatility truly gets to lower levels, it will suffice to update these series on a quarterly basis.
While many value investors will totally ignore the total market valuations ratio, they can do so at their own risk. Many investors claim that the overall value of the market does not matter since there will always be cheap individual securities. This is true, but sometimes it can lead to ‘paper’ or even permanent losses. When the tech bubble burst, most value investors did quite well. However, value investors got butchered in the crash of 08, even in the most defensive stocks. We therefore think there is some merit in being at least cognizant of the total market valuation.
As always, we must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. In addition, individual stocks can be found that will outperform or underperform the market regardless of current valuations. However, as we note at the end of the article, we expect low returns for the overall market, over the next 10 years based on current valuations when the metrics revert towards their mean.
The current level of the S&P500 is 1,408, and the Dow Jones is at 13,212 — a slight increase from last month.
The point of this article is to measure the stock market based on seven different metrics. As stated above, this article does not look at the macro picture at all and try to predict where the economy is headed.
Below are different market valuation metrics as of April 1st, 2012:
The current P/E TTM is 15.2, a slight increase from last month’s 15.0:
This data comes from 0ur colleague Doug Short of dshort.com.
Based on this data the market is fairly valued. However, we do not think this is a fair way of valuing the market since it does not account for cyclical peaks or downturns. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.
Numbers from Previous Market Lows:
Shiller PE – 23.48
The current ten-year P/E is 23.66 an increase from PE of 22.88 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years.
Min: 4.78 (Dec 1920)
Max: 44.20 (Dec 1999)
Numbers from Previous Market lows:
Mar 2009 13.32
Mar 2003 21.32
Oct 1990 14.82
Aug 1982 6.64
Oct 1974 8.29
Oct 1966 18.83
Oct 1957 14.15
June 1949 9.07
April 1942 8.54
Mar 1938 12.38
Feb 1933 7.83
July 1932 5.84
Aug 1921 5.16
Dec 1917 6.41
Oct 1914 10.61
Nov 1907 10.59
Nov 1903 16.04
The Shiller PE is calculated using the four steps below:
- Look at the yearly earning of the S&P 500 for each of the past ten years.
- Adjust these earnings for inflation, using the CPI (ie: quote each earnings figure in 2011 dollars)
- Average these values (ie: add them up and divide by ten), giving us e10.
- Then take the current Price of the S&P 500 and divide by e10.
The common criticism of Shiller’s method is that it includes years like 2008 and 2009 when earnings were awful. Howeverwe would argue that it is balanced out by the bubble years of 05-07. Additionally the Shiller PE (with the exception of 1995-2000, where the stock market reached absurd valuations) has been a much better indicator of market bottoms and tops than PE TTM. Two recent examples: in March 2009, the Shiller PE was at 13, while PE TTM was close to 100. At the market top in October 2007, the Shiller PE was at a very high level of 27.31, while the PE TTM was only at 20.68.
The AAII put together the best criticism of the Shiller PE, which we have seen to date.
Below are the main points:
- Following the Graham-Dodd recommendation, Shiller uses a 10-year moving average of earnings in computing the CAPE. According to data compiled by the National Bureau of Economic Research, economic contractions have become shorter and expansions longer in recent years. Measured peak to peak, the average is five years and six months.
- In determining the CAPE (Shiller PE), reported earnings are adjusted for inflation using the Consumer Price Index, where real values reflect current-period purchasing power. However Shiller uses data going back to 1871, when inflation was measured differently than today. There is an approximate 7% difference in the annual CPI inflation rate based on methodological changes over the last couple of decades.
- Tax codes have changed considerably since 1871. You can read further discussion of this issue above.
The criticisms are fair, and we do believe Shiller takes a more cautious approach to market valuations (Shiller can be described as a bit too cautious and overshoots on valuations). While Shiller’s method is by no means perfect, we think it is still a valid and the best method of market valuation for the following reasons.
- The 10-year Shiller PE shows markets overvalued by about 43% (at time of the article) and using a 6 year (as suggest by the AAII) business cycle the market is still overvalued by 35%. This is not a large difference to completely throw out Shiller’s methodology.
- Differences in inflation may effect the Shiller PE, but they would only have a small effect, especially if you decrease the earning duration. Also they should apply to any PE (TTM, six-year P/E, or forward P/E).
- Same point with accounting changes. Accounting changes would also effect P/B or ANY metric that is used to value the market, this is not limited to Shiller PE.
- Shiller PE has proved to be a good market valuation indicator. Shiller stated on February 22nd, 2009, that based on CAPE equities were cheap for the first time in decades. That was only two weeks before one of the biggest bull market rallies in history.
Below is some further data showing how accurate the Shiller PE has been in predicting future market returns. First how has Shiller PE been in terms of predicting future returns in the past:
In conclusion to the argument about using CAPE, I would say that the Shiller PE despite slight flaws is a great metric for predicting future long term returns of the market.
Robert Shiller stated in an interview that he believes the S&P500 will be at 1430 in 2020. Shiller believes that based on his metric the market is overvalued, and will offer subpar returns over the next 10 years. However Shiller noted in another more recent interview that the market is not too overvalued, as it has been over the past year. He also noted the ultra low interest rates, which make equities much more attractive. Shiller expects real returns of several percent a year, although below the 7% real return, which the market has historically returned.
Based on ValueWalk columnist, Rob Bennett’s market return calculator, the return of the market should be 1.94% annually over the next ten years under the mostly likely scenario.
|Stock Market||Best Possible||Lucky||Most Likely||Unlucky||Worst Possible|
|10-Year Percentage Returns||7.94||4.94||1.94||-1.06||-4.06|
|20-Year Percentage Returns||7.17||5.17||3.17||1.17||-0.83|
|30-Year Percentage Returns||8.10||7.10||6.10||5.10||4.10|
|40-Year Percentage Returns||7.11||6.21||5.31||4.31||3.31|
|50-Year Percentage Returns||7.15||6.35||5.55||4.85||4.15|
|60-Year Percentage Returns||7.64||6.99||6.34||5.74||5.14|
This new calculator tells you what return you can reasonably expect at various time-periods from an investment in the S&P stock index, presuming that stocks perform in the future much as they have in the past. The results are expressed in terms of real, annualized total (that is, with dividends reinvested and without additions or subtractions to principal) returns.
Doug Short thinks the Shiller’s numbers used above are a bit inaccurate, because the number used above does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at 22.8.
Data and chart courtesy of [multpl.com]
Current P/BV 2.08
We thought the metric would be great for figuring out future market returns: Tweedy Browne and David Dreman demonstrate through extensive research, that a basket of the lowest P/B stocks over long periods of time dramatically outperforms the market. It therefore would make sense that the P/B metric would be useful for evaluating the market itself in terms of over-valuation or undervaluation.
In regards to historic data there is very little on P/B, besides the fact that the average 2.41 over the past 30 years. Book value is considered a better measure of valuation than earnings by many investors including legendary investor Martin Whitman. He states that book value is harder to fudge than earnings (although book value can easily be distorted). In addition book value is less affected by economic cycles than one year earnings are. P/BV therefore provides a longer term accurate picture of a company’s value, than a TTM P/E. I will continue my search for P/B numbers.
Current Dividend Yield 1.88
The current dividend yield of the S&P is 1.88. This number is even lower than 1.88 from last month. The number although far below its long term average, is attractive compared to the 10-year Treasury, which is currently yielding an ultra low 2.23%. Due to Federal Reserve policy and a flight , Treasury yields have gone down, however, yields went up ~24 basis points over the past month.
For attractive yield check out my recent article about Australian debt-https://www.valuewalk.com/bonds/high-yield-low-risk-look-to-australia/. Austria has started to cut interest rates, as we predicted in the article and the thesis seems to be playing out nicely.
It is hard to determine on this basis whether the market is overpriced. The dividend yield for stocks was much higher in the begging of this century than the later half. The dividend yield on the S&P fell below the yield on 10-Year treasuries for the first time in 1958, after the flight to safety when Lehman Brothers collapsed, it did so again recently, due to fears of another worldwide recession.
Many analysts in 1958 argued that the market was overpriced and the dividend yield should be higher than bond yields to compensate for stock market risk. For the next 50 years the dividend yield remained below the treasury yield and the market rallied significantly, until recently. In addition the dividend yield has been below 3% since the early 1990s. While I personally favor individual stocks with high dividend yields, the current tax code makes it far favorable for companies to retain earnings than to pay out dividends.
Finally, as we noted above the current economic environment has zero percent interest rates and low bond yields. During periods where yields are low it is logical for income oriented investors hungry for yield to be bid up the market, and dividend yields to decrease. We think it is hard to claim that the market is overbought based on the low dividend yield.
Min: 1.11% (Aug 2000)
Max: 13.84% (Jun 1932)
Numbers from Previous Market lows:
Mar 2009 3.60
Mar 2003 1.92
Oct 1990 3.88
Aug 1982 6.24
Oct 1974 5.17
Oct 1966 3.73
Oct 1957 4.29
Jun 1949 7.30
Apr 1942 8.67
Mar 1938 7.57
Feb 1933 7.84
July 1932 12.57
Aug 1921 7.44
Dec 1917 10.15
Oct 1914 5.60
Nov 1907 7.04
Nov 1903 5.57
Data and chart courtesy of [multpl.com]
Market cap to GDP is currently 98.5%, higher than the 95.7% from last month.
|Ratio = Total Market Cap / GDP||Valuation|
|Ratio < 50%||Significantly Undervalued|
|50% < Ratio < 75%||Modestly Undervalued|
|75% < Ratio < 90%||Fair Valued|
|90% < Ratio < 115%||Modestly Overvalued|
|Ratio > 115%||Significantly Overvalued|
|Where are we today (04/01/2012)?||Ratio = 98.3%, Modestly Overvalued|
For all historic data on the AAII survey back to 1987 click on the following link:http://www.aaii.com/sentimentsurvey/sent_results.
|Table 1. Historical Averages & Extremes of AAII Member Sentiment*|
|[i]*data covers period from July 24, 1987 to September 2, 2004.[/i]|
We see the historical extremes for bullish, bearish, and neutral sentiment. Bullish sentiment reached its highest levels on Jan. 6, 2000 — the height of the tech bubble — at 75.0%. Levels of extreme bullishness — if viewed as a contrarian indicator — would lead one to believe that a market decline is in the wings, and vice versa.
Bullish Neutral Bearish
March 2009 18.92% 10.81% 70.27%
March 2003 34.3% 14.30% 51.40%
Oct. 1990 13.00% 20.00% 67.00%
Nov. 1987 31.0% 41.00% 28.00%
Average 39.00% 31.00% 30.00%
Max 75.00% 62.00% 70.00%
Min 12.00% 8.00% 6.00%
GMO forecasts the returns for the next seven years for various asset class. GMO is getting increasingly bullish on severalasset classes. However most asset classes will have lower returns than their historic real rates of return as shown below. Furthermore, only high quality and foreign stocks are expected to be good performers.
Jeremy Grantham of GMO pegged fair value of the S&P500 at 950, which is ~30%, below current levels. John Hussman stated in his weekly commentary that a 25% drop in the market would not surprise him.
Furthermore, Hussman recently stated that the S&P should have real returns of close to 4.0% a year. This would be below the long term real average of 7%, but still an attractive return. However Hussman also noted that profit margins are at historic levels which is inflating earnings, therefore it is hard to expect 4% annual returns. Hussman pointed out that the Shiller PE is above 22, wich indicates strong headwinds. Finally, he stated that based on Tobins Q, the market is 66% overvalued.
John Hussman’s track record from GuruFocus.com
Performance of Hussman Strategic Growth Fund
|Year||Return (%)||S&P500 (%)||Excess Gain (%)|
1. P/E (TTM) – Undervalued15.0 fairly valued
2. P/E 10 year – overvalued 23.66 very overvalued
3. P/BV – Undervalued – 2.08
4. Dividend Yield 1.88%– Indeterminate overvalued, but very attractive compared to treasuries: 2.33%
5. Market value relative to GDP – modestly over-valued 95.7
6. Tobin’s Q – Overvalued 0.95 Very overvalued
7. AAII Sentiment – Investors are too bullish
8. GMO – Stocks are slightly over-valued
In conclusion, the market is looking overvalued again based on the metrics used. Tobin’s Q, AAII, Market Cap to GDP, GMO metrics and Shiller P/E indicate that valuations are too high.
The historical data fails to take into account current record low interest rates. We know that not many investors take issue with our inclusion of interest rates in the equation. However, we think that investors should look at the stock/bond alternative. Right now you can get SPY with dividend yields close to the 10-year Treasury yield.
However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. We believe returns over the next 10 years will be sub-par (below the 9.5% nominal average market return). We think we will likely see real annual returns in the mid single digits over the coming decade.
You can read more about our predictions in the following two articles:
Note: We have received numerous suggestions on how to improve our monthly series. I tried to incorporate these ideas in my current article. Please leave a comment if you would like to provide further suggestions.
Stay tuned until the beginning of next month for the next monthly valuation article.
Valuing Wall Street: Protecting Wealth in Turbulent Markets by Andrew Smithers. The book explains in detail how tobin’s Q is calculated.
Wall Street Revalued: Imperfect Markets and Inept Central Bankers. A more recent book by Andrew Smithers.
Irrational Exuberance by Robert Shiller. Great book by the man who calculates the P/E 10 ratio himself; Robert Shiller. The book is written in 2000, right before the tech bubble crash. Shiller correctly predicts the crash. Shiller also accurately predicted the housing bubble.