Note: All data refers specifically to the S&P500 (SPY) or the Wilshire 5,000 (VTI)
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 marketvaluation, we clarified why I started this monthly piece 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.
You can view extensive European market valuations (including country valuations) here.
We started this monthly market valuation series in December 2009. We were getting tired of hearing that the market was overvalued because P/E TTM was 87. Earnings were clearly lowered by the worst economic crash 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 only updating the valuations on a quarterly basis, since why is there a need every month? However, since the market was and in general continues to be quite volatile, we 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.
The current level of the S&P500 is 1,278, and the Dow is at 12,119 — a large drop over the past month. Concerns over the situation in Europe, especially Spain, has led to panic and indiscriminate selling. As the situation in Europe seems to be a spiral, which David Einhorn has described, investors are particularly scared. The Euro-zone makes up 25% of global GDP. Now we will focus on the quantitative metrics and ignore the noise from Europe and DC.
The point of this article is to measure the stock market based on eight different metrics.
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 are getting more optimistic about the long term return for the market based on the most recent numbers.
The current P/E TTM is 14.7, a slight decrease, and below its historic average:
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 is 20.53
The current ten-year P/E is 20.53, a significant decrease from PE of over 23 from just a few weeks ago. More on this below:
This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years.
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 at . 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 I 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. It should be noted, that treasury yields have declined further since that statement, and are now at low of 1.45%.
|Stock Market||Best Possible||Lucky||Most Likely||Unlucky||Worst Possible|
|10-Year Percentage Returns||8.89||5.89||2.89||-0.11||-3.11|
|20-Year Percentage Returns||7.84||5.84||3.84||1.84||-0.16|
|30-Year Percentage Returns||8.45||7.45||6.45||5.45||4.45|
|40-Year Percentage Returns||7.32||6.42||5.52||4.52||3.52|
|50-Year Percentage Returns||7.32||6.52||5.72||5.02||4.32|
|60-Year Percentage Returns||7.68||7.03||6.38||5.78||5.18|
Based on our columnist, Rob Bennett’s market return calculator, the return of the market should be 2.89% annually over the next ten years under the mostly likely scenario.
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.
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
Doug Short thinks the Shiller’s numbers are a bit inaccurate because the number used above does not include the past several months of earnings, nor revisions. Doug almost always comes up with a number close to Multipl, but right now there is a wide difference. Shiller PE is at a high level of 21.9, compared to 14.7 as mentioned above:
Data and chart courtesy of [multpl.com]
Current P/BV 1.89
We thought the metric would be great for figuring out market returns because as Tweedy Browne and David Dreman demonstrate through extensive research, a basket of the lowest P/B stocks dramatically outperform baskets of higher P/B stocks (and the market overall). 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 regard toric data there is very little on P/B, besides the average of 2.41 over the past 30 years. Book value is considered a better measure of valuation than earnings by many investors including 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. The market looks very cheap based on the current level of 1.89%.
Current Dividend Yield 2.14
The current dividend yield of the S&P is 2.14. The number although far below its long term average, is very attractive compared to the 10-year Treasury, which is currently yielding an ultra low 1.47%. Recently as another flight to ‘safety’ has occurred, Treasury yields have gone down, and the stock market has declined, pushing up the dividend yield. Some investors do not like to compare yields on bonds to equities since they are different asset classes. However, we think it is important for demonstration purposes.
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 88.9%, a large drop from the mid 90s, just a few weeks ago.
|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 (06/03/2012)?||Ratio = 88.9%, Fair valued|
According to Barron’s the ratio got as low as 40% in the late 1940s, when investors feared another depression, and in the inflationary 1970s.In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publicly traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that ”The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment”. He further went on to say ”If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire”.
We can see that, during the past four decades, the TMC/GNP ratio has varied significantly. The lowest point was about 35% in the previous deep recession of 1982, while the highest point was 148% during the tech bubble in 2000. The market went from extremely undervalued in 1982 to extremely overvalued in 2000.
According to Barron’s the ratio got as low as 40% in the late 1940s, when investors feared another depression, and in the inflationary 1970s.
Min 35% in 1982
Max 148% in 2000.
Data and charts courtesy of Gurufocus.com
Current Tobin’s Q 0.87
As can be seen from the above charts, the market is over-valued based on tobins Q. The market would have to fall 23 or 33% to be fairly valued. However, this is the lowest level of tobins Q we have seen in many months.
What is Tobins Q?
Here is a brief explanation from http://www.investopedia.com:
A ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets:
Investopedia explains Q Ratio (Tobin’s Q Ratio)
For example, a low Q (between 0 and 1) means that the cost to replace a firm’s assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm’s stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued. This measure of stock valuation is the driving factor behind investment decisions in Tobin’s model.
As can be seen from the above charts, the market is over-valued based on tobins Q. The data comes from Doug Short. This is the most accurate data that is available. It is impossible for the data to be 100% precise because the Federal Reserve releases data related to Tobin’s Q on a quarterly basis. The best that can be done is to extrapolate the data and try to provide the most accurate data possible based on the change in the Willshire 5000. This is what we and Doud did to get the current number. This method has proven extremely accurate for calculating Tobins Q on any given day.
The current level of 0.87 compares with the Tobin’s Q’s average over several decades of data of approximately .72. This would indicate that the market is modestly overvalued.
In the past Tobin’s Q has been a good indicator of future market movements. In 1920 the number was at a low of .30; the next nine years included phenomenal gains for the market. In 2000 Tobin’s Q almost reached a record high of nearly 2, and the market declined subsequently about 50% by 2003.
Historic Tobins Q:
Previous market bottoms. Data courtesy of Doug of dshort.com:
Market High 1929: 1.06 (This is not the highest number ever reached, just the number reached before the 1929 crash.)
Sometimes market sentiment is the best way to measure future returns. Usually when the retail investor is bullish it is a contrarian sign to be fearful, and when they are bearish it is a sign to be bullish. The sentiment has proven remarkably accurate, the numbers below from previous market bottoms confirm this fact. For example in 2009, 70% of investors were bearish. The broad stock market is up ~100% since then.
One reader pointed out the following interesting point about Tobins Q:
The idea behind Tobin’s Q is interesting but a modern complexity relates to the amount of money spent on R&D. It seems clear to me that the investment in many products is in proprietary technology and not in manufacturing facilities. Look at Amgen, Apple, Intel or Microsoft. Fabless Semi’s for instance. Most valuation techniques would give you a way to adjust accounting values for the R&D. I really think Tobin’s Q would be more valuable if the amount of research that had been accomplished in the last decade could be included. It may then provide a better valuation measure for modern times. A good rule of thumb may taken from Intel and how it bottoms at 2 x book. Maybe the value of its R&D is 2 x book or for for the market, 2 x Tobin’s Q. I don’t think Tobin’s Q adjusts for research although I haven’t read the techniques in a while.
According to the AAII, “the AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”
AAII sentiment survey data from 5/30/2012http://www.aaii.com/sentimentsurvey:
Individual investors are too bearish and less bullish than the long term average, which is a contrarian indicator of a cheap stock market.
Sentiment Survey Past Results
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 several asset 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 predicted that the S&P should have real returns of close to 4.4% 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 5% annual returns. He also noted that the Shiller PE is above 22 and indicates strong headwinds.
John Hussman’s track record from GuruFocus.com:
Performance of Hussman Strategic Growth Fund
|Year||Return (%)||S&P500 (%)||Excess Gain (%)|
1. P/E (TTM) – Undervalued 14.7
2. P/E 10 year – overvalued 20.9 overvalued
3. P/BV – Undervalued – 1.89
4. Dividend Yield 2.14%– Indeterminate overvalued, but very attractive compared to treasuries: 1.47%
5. Market value relative to GDP – modestly over-valued 88.7%
6. Tobin’s Q – Overvalued 0.87 Slightly overvalued
7. AAII Sentiment – Investors are too bearish
8. GMO – Stocks are slightly over-valued
In conclusion, the market is beginning to look cheap. This is the first time we have indicated this in a long time. Shiller PE is still high as is Tobins Q, but Tobins Q is at the lowest level in recent memory.
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 investors can get SPY with a dividend yield above 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 deent (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.
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.