GMO Quarterly Update (4/29/11) – At the end of the quarter, the S&P 500 stood at 1325. Over the last 10 years, the same index has produced an average of $56.6 of real earnings. Taken together, this means that the index finished the quarter with a cyclically adjusted price to earnings of 23.5 and suggests that the market is currently about 40% overvalued according to this popular and robust method … These factors taken together make it appear that we are approaching levels from which large drops in asset prices could easily occur.
David Einhorn (4/29/11) – “All news is good news” was also true for individual stocks, including a number of our shorts. We expect to take some lumps when our shorts release strong earnings and their stock prices rise accordingly. Yet, this quarter we were repeatedly confuzzled when we read company news announcements that we expected to cause falling stock prices, only to see them rise instead – and sometimes sharply at that. Nonetheless, we believe that this environment is cyclical, and that it will continue this way … until it doesn’t. Since we don’t expect to be able to call the turn, we believe our best course is to concentrate on generating better alpha.
Steve Romick, First Pacific Advisors (5/3/11 at Value Investing Congress) – A refrain oft used at FPA is that sometimes returns are generated not by what you own, but by what you don‘t. With corporate margins near highs, we fear their compression. With rates bound to increase, we wonder what might happen to P/E multiples. When shorting with inflation heading higher, we fear being nominally right, but real wrong. And, we are anxious about the longer term prospects for the U.S. dollar. Cash has therefore built by default in our portfolio; and yet, we also fear inflation eroding its value. One of our strategies is to shift our focus to larger, quality businesses, with more exposure to foreign revenue sources and the ability to grow unit volume and increase prices. This is not to say we find abundant investment opportunities … Therefore, when considering market valuation, we prefer to look at measures smoothed over time. Using 10-year average earnings as the denominator, looking at the blue line, you can see that the stock market now trades at a 23x earnings – 36% above average. This can be explained by lower than average interest rates, the red line, with the 10-year U.S. Treasury Bond at just 3.5%, 33% below average. [Authors note: similar to GMO's comment on asset prices]
Horizon Asset Management (4/14/11) – It's also worth noting, in light of the S&P price-to-book value ratio of 3.68x, that the Japanese market traded at its historical high in 1989 at 5x book value.
There is another way to look at it. Standard & Poor's itself estimates the S&P 500 earnings for 2011 at more or less $96 on a unit value basis, and the index level is now about 1,325, suggesting that the index trades at 13.8x earnings (1,325 ÷ 96 = 13.8). This is within what would be considered a historically average range of valuation – neither obviously discounted nor expensive. Yet, quite a different picture emerges if those estimated earnings are viewed from an ROE perspective. The book value of the S&P 500 is about $360. Accordingly, to earn $96 on $360 of book value would require a ROE of 26.6% for the average company, which is an extraordinary number. Remarkably, the S&P produced about a 21% ROE in 2010.
Now it's time for another frame of reference. The highest ROE ever sustained for the longest time period by any company is, of course, that of Berkshire Hathaway (BRK.A) at about 20% per annum. If the earnings estimates are to be believed, they would imply that the average S&P company is earning a return on its equity capital that is more or less consistent with the historical rate of return of Berkshire Hathaway, which is the greatest return there ever was…
Robert Schiller (this particular quote from 4/28/11 interview with WSJ) – A ten year average is a very conservative estimate of the underlying earning power of a company or of the whole economy; our P/E ratio is 23, and that’s high … It’s not great, and suggests prices might stay where they are; you get dividends though, so you’re getting between 2-3% returns … it’s not bad, it’s just not exciting.
As you can see, there is a bit of concern about the markets at these levels. As Steve Romick points out in his presentation, the hard part is sitting in cash (if you don’t like equity valuations) when you see inflation on the horizon.
Fortunately, we don't need to be right on the market; we just need to pick individual securities that can meet our expectations over the long haul. I’m confident in the long-term ability of my high quality large caps (JNJ, MSFT, BRK.B, and PEP) based on the price I paid, and will be waiting for further value opportunities to present themselves before I deploy any cash in new investments. For now, my strategy follows Mr. Romick’s advice: “Wait and hope.”
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