I started this monthly market valuation series in December 2009. The motivation for the article was because I was getting tired of hearing that the market was overvalued because PE TTM was 87. This was ridiculous because earnings were deflated 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. I 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.
Recently, Bruce Greenwald carried out a virtual Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital. Greenwald and Lu covered multiple topics during the discussion, addressing everything from the value investor's approach to appraising businesses and what he had learned from his great friend Charlie Munger. The duo also discussed China's economy Read More
I was 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, I 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.
What a difference a month makes. In my market valuation article on June 2nd, 2011 I stated:
I find the current valuations astonishing. No I am not refering to linkedin or Groupon or the high fliers. The overall market is so overvalued considering the macro picture. I am not a macro investor, but Wall Street is. It makes no sense for the Shiller PE to be at 23 (an earnings yield of 4.3%), when the deficit is out of control, there is inflation across the board except Real estate (the one asset class QE2 was really supposed to help!), housing is in a double dip, unemployment cannot come down for years unless there is job growth of 500k a month (close to impossible). Additionally, the Euro zone is experiencing a big crisis, Japan suffered a catastrophic humanitarian and economic disaster, and countries like China are starting to get nervous about over heating in their economies.
What further demonstrates the inefficiencies in the market, is the valuation of small caps to large caps. The perma-bulls are looking for companies that have large exposure overseas, especially in emerging markets. However, the large cap companies produce far more of their revenue from overseas than small caps. Yet, large caps are far cheaper than small caps. This really defies logic.
The market declined ~4% over the past month. Since July 16th, the S&P500 has decreased over 16%. I was not predicting that the market would crash, merely stating that the market would eventually go down to more normalized levels. However as the data below demonstrates, the market still seems overvalued by some metrics.
The current level of the S&P500 is 1,131, and the Dow is at 10,913– lower than last month.
I update market valuations on a monthly basis. The point of this article is to measure the stock market based on seven different metrics. This article does not look at the macro picture and try to predict where the economy is headed.
1. P/E (TTM) – Undervalued Valued 13.3
2. P/E 10 year – Modestly overvalued 19.45
3. P/BV – Undervalued – 2.20
4. Dividend Yield – Indeterminate/ overvalued, but very attractive compared to treasuries: 2.15%
5. Market value relative to GDP – Fairly valued 78.
6. Tobins Q – Extremely overvalued 1.01
7. AAII Sentiment – Investors are too bullish
8. GMO – Stocks are slightly over-valued
In conclusion, the market is possibly at fair value based on the metrics used. The picture is more mixed as opposed to previous months, where the market was overvalued by most metrics. Tobins Q, and Shiller PE indicate that valuations are too high. AAII sentiment, dividend yield are more bullish. PE ratio is about average, but as mentioned above not a great indicator. Market cap to GDP is fairly valued.
The historical data fails to take into account current record low interest rates. I know not many investors take issue with my inclusion of interest rates in the equation. However, I think that investors should look at the stock/bond alternative. Right now you can get SPY with dividend yields close to the Ten year treasury yield.
However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. I believe returns over the next 10 years will be sub-par (below the 9.5% nominal average market return). I think we will likely see real annual returns in the low single digits over the coming decade.
You can read more about my predictions in the following two articles:
What Will The S&P 500 Return Over The Next 10 Years Part I
What Will The S&P 500 Return Over The Next 10 Years Part II
Note: I have received numerous suggestions on how to improve my 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.
Full article Can be found on Stock Market Valuation: October 1, 2011.