Are stocks undervalued? That is the question that was recently posed by Mark Hulbert at MarketWatch, he is also the publisher of Hulbert’s Financial Digest.
“Let’s start with the P/E for the S&P 500 index when calculated using trailing 12-month “as-reported earnings” (through June 30). It currently is 14.0, which is about 10% below the long-term average for this ratio back to 1871 — which is 15.5, according to data supplied by Yale University finance professor Robert Shiller.”
One thing that I appreciate about Mark is that he uses trailing “as reported” earnings numbers which is the only method by which P/E ratios are ever viewed. When analysts began to use operating earnings, forward estimates or any variation thereof, they are not comparing apples to apples. When long term valuation measures are discussed it is always based on the trailing twelve month numbers. This is the basis from which we we will work today.
The markets move in very broad long term cycles as shown in the chart. These “secular” cycles on average last about 15-18 years in total from beginning to end. The driving factor behind these long term secular cycles is valuations. When valuations are low at the beginning of a period as they were in 1898, 1922, 1950 and 1982 the market experienced a bull market of significant proportions as valuations rose over time – this is called “multiple expansion”. During the opposite periods, as markets experienced “multiple contraction”, returns for investors were extremely low on a “buy and hold” basis.
It is important to have a grasp, as well as a respect, for these secular cycles as it predicates how invested dollars should be allocated. There is much more going on during these secular periods which contribute to the overall advance or malaise in the markets and exposure to risk based assets during the wrong secular period can be detrimental to investors with shorter term retirement horizons. Therefore, it is critical to understand that the directional trend and level of interest rates, inflation and dividends all contribute to the global return of assets during any period.
The chart shows the relationship between inflation and valuations. During secular bear market periods inflation began the period very low levels but rising inflationary pressures ate away at corporate profitability resulting in lower profitabiliy and ultimately lower valuations. The opposite occurred during bull market periods, as in the 1982-2000 period, where falling inflationary pressures increased the profitability of companies which justified investors paying higher multiples for companies. Of course, this all worked out well until it didn’t. P/E ratios are horrible indicators as far as market predictors go. Valuations, can and regularly are stretched well beyond their normal boundaries before finding their peaks and valleys. We call this the “rubber band” effect.
If you stretch a rubber band as far as you can in one direction; when it is released it travels an equal distance in the opposite direction. This effect makes finding true value in the markets very difficult since markets do not stick to a “fair” valuation level. This is the biggest fallacy promoted by the media today when they state that when stocks are currently trading at “fair value” then they are a “good buy”. Something is never a “good buy” when you are paying fair value for the asset. A “good buy” is when you buy something at a significant discount to fair value.
Take a look at the chart again. Stocks NEVER, and I repeat NEVER, start a secular bull market period from the long term “fair market” value of 15x the trailing 12 months earnings. You will notice that EVERY major bull market in history began from levels of a significant discount to fair value of between 40% (9x earnings) and 66% (5x earnings).
More importantly, the current levels of valuation are levels that have been more associated with peaks in bull markets rather than an undervalued entry point in a bear market. Mark points out: “To be sure, P/E ratios are quite volatile…For this reason, many researchers have followed the lead of Shiller and Harvard professor John Campbell and focused on a modified P/E ratio whose denominator is average inflation-adjusted earnings over the trailing 10 years. This modified ratio is sometimes called CAPE (for Cyclically Adjusted Price Earnings ratio). The CAPE has a markedly better forecasting record than the simple P/E.
The current CAPE, according to Professor Shiller’s data, is 20.1.That’s 22% higher than this modified ratio’s long-term average (back to 1881) of 16.4. However, in comparison to just the last 50 years, the current CAPE is just 3% overvalued. Once again, this is a low enough number such that, if you believe that the last 50 years are the proper period to use to judge current valuations, we can conclude that the market is neither over- nor undervalued.”
WIth interest rates low, inflation low and valuations still high and falling (multiple contraction) all of the evidence continues to point that the secular bear market that begin in 2000 is still quite alive and well. How much longer will this particular bear market last? History says somewhere between 5 and 8 more years. Of course, that is just a guess. The best way to tell that this bear market period has ended will be to look for valuations on stocks on a trailing basis to be 9 or below, inflation and interest rates to be substantially higher and dividend yields on stocks to be pushing 5%.
While there are plenty of main stream economists and analysts that continue to push outdated models and theories to entice individuals into overpaying for investments; the bottom line is that the market is NOT cheap by any real measure that counts. The time will come when stocks are truly a cheap investment and the long term risk of ownership has been extracted from the markets, however, today is not that day.