This note was originally published March 28, 2011 at 15:40 in Macro
Conclusion: Based on Shiller’s CAPE P/E multiple, the market is at least one standard deviation overvalued. Further, corporate margins are at 30-year highs, which suggest it is unlikely that earnings will grow into their multiple.
When Keith and other members of our team appear on CNBC and other major media outlets to discuss the markets and investments, it gives us a keen ability to really focus on consensus’ best ideas and the associated storytelling. A key consensus reason often given to increase long exposure to the US equity market is valuation.
As a graduate of the Value Investing Program at the Columbia University, I’m all for value, but, as always, a valuation is only as good as its assumptions. Attempting to value a stock is difficult enough given all the relevant assumptions needed, but attempting to project those earnings for an entire market, like say the SP500, only magnifies the complexity and, really, likelihood of error.
Regardless of our ability to actually project the earnings for a company or market accurately, valuation multiples themselves can provide an important gauge of investor sentiment. Simply put, in extremes of serious stock investing euphoria valuations are high. In contrast, in periods when investors are extremely concerned about the outlook for equities, stock market valuations are depressed. Thus the power of the stock market crowd in aggregate will provide us some insightful contrarian indicators.
In the chart directly below, we’ve highlighted Professor Robert Shiller’s (our neighbor across the street at Yale’s School of Management) long term Cyclically Adjusted P/E chart for the SP500. Over time, the valuation of the U.S. stock market has varied widely. Based on Professor Shiller’s work, the lowest P/E multiple for the broad market was 4.8x in December 1920, while the highest P/E multiple came in December 1999 at 44.2x.
Currently, the valuation according to Shiller’s analysis is 23.6x earnings, which is well above the long run average of 16.4x. In fact, the current valuation of SP500 composite is more than one standard deviation above its long run average. So, while this is not necessarily an extreme overvaluation, the market is clearly not cheap on this basis. The chart above shows this well graphically, as valuation is just starting to breakout above its historical range.
By way of background, Professor Shiller uses what is called CAPE, or Cyclically Adjusted Price to Earnings. In terms of the numerator, or price, Shiller uses the monthly average of daily closes for the SP500. To derive the earnings data, in this instance the denominator, Professor Shiller uses the quarterly earnings data from the SP500’s website and utilizes an interpolation to provide earnings data by month. He then adjusts both the numerator and denominator for inflation using CPI from the Bureau of Labor Statistics. Finally, the inflation adjusted price is divided by an average of ten years of real monthly earnings to determine the CAPE.
Obviously, market valuation is one of many factors to consider, but certainly the stock market is not cheap. The key push back on this call out is that future earnings growth will drive the overall P/E of the market lower, so perhaps the market is not as expensive as it appears. Our key issue with the earnings growth argument is based on slower than expected GDP growth both domestically and abroad and a limited ability of corporations to expand margins.
On the second point related to corporate margins, profit margins in the United States are at near all-time highs on various calculations. In fact, as highlighted in the chart below, our calculations using BEA data show that both EBITDA and EBIT margins are at/near 30-year highs. Needless to say, the margin expansion argument is somewhat difficult to make given that backdrop and the potential for mean reversion.
In the face of near all-time high margins, a stock market that is at a stretched valuation, and sequentially slowing domestic and global growth, it is becoming increasingly difficult to make the “valuation” argument to buy equities. That said, as long as The Bernank keeps interest rates at zero, investors are at least marginally incentivized to take some equity risk, but, to be clear, it is risky.
Daryl G. Jones