I started this monthly market valuation series in December 2009. The motivation for the article was that I was getting tired of hearing that the market was overvalued because P/E 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.
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 2, 2011 I stated:
I find the current valuations astonishing. No, I am not referring to LinkedIn (NYSE:LNKD) 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 5.5% over the past month. Since July 16, 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.
I collaborate with two colleagues of mine for some of the data in this article, Doug Short of Dshort, and Josh of Multipl. All are great sites, and I encourage readers to check them out.
As always, I 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 I note at the end of the article I expect low returns for the overall market, over the next 10 years based on current valuations when the metrics revert towards their mean.
To see my previous market valuation article from last month click here
Below are different market valuation metrics as of Oct. 1, 2011:
The current P/E TTM is 13.3, which is a large decrease than the TTM P/E of 15.6 from last month.
This data comes from my colleague Doug Short of dshort.com.
Based on this data the market is fairly valued. However, I 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:
The current ten-year P/E is 19.45; this is lower than the PE of 21.04 from the previous month. 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 http://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 I 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, I 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 business cycle the market is still overvalued by 35% at time of writing. still shows it overvalued by about 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 recently 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 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.
|Stock Market||Best Possible||Lucky||Most Likely||Unlucky||Worst Possible|
|10-Year Percentage Returns||9.31||6.31||3.31||0.31||-2.69|
|20-Year Percentage Returns||8.14||6.14||4.14||2.14||0.14|
|30-Year Percentage Returns||8.60||7.60||6.60||5.60||4.60|
|40-Year Percentage Returns||7.41||6.51||5.61||4.61||3.61|
|50-Year Percentage Returns||7.40||6.60||5.80||5.10||4.40|
|60-Year Percentage Returns||7.69||7.04||6.39||5.79||5.19|
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
My colleague 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 calculates P/E 10 at 22.7.
Data and chart courtesy of [multpl.com]
Current P/BV 2.20
I 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 over long periods of time dramatically outperforms the market. 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.
Horizon Asset management http://www.hamincny.com/docs/Horizon_Commentary_1stQuarter_2011.pdf used the same numbers for P/B provided by Standard and Poors and come up with a whopping 3.68% (for April), according to the same numbers that I used I came up with closer to 2.30%, and so did many other people include Barron’s. Since, the vast majority seem to conclude similar numbers to mine I will go with that figure over Horizon’s. The number that I used, I obtained using data from Barron’s, and updated using the latest change in the price of SPY. I am not sure where Horizon got their data from; no one else has measured book value at such a high rate.
Unfortunately, there is very little data regarding P/B. I have been able to find close to no historic data on the metric. Additionally, my number was always an outlier which made me suspect my numbers might be wrong. I even had a PHD student contact me to ask if there was any data available on price/book, I answered that I have not found any. If you are reading this or anyone else, and have the data I would be grateful if you sent it to me.
The average price over book value of the S&P over the past 30 years has been 2.41. Book value is considered a better measure of valuation than earnings by many investors including legendary investor 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. I will continue my search for P/B numbers.
Current Dividend Yield 2.15
The current dividend yield of the S&P is 2.15. This number is higher than 2.00 from last month. The number although below its average, is not so low considering compared to the 10-year Treasury currently is yielding an ultra low 1.92%. Recently as another flight to safety has occurred, Treasury yields have gone down, and the stock market has declined, pushing up the dividend yield.
For attractive yield check out my recent article about Australian debt-http://www.valuewalk.com/bonds/high-yield-low-risk-look-to-australia/.
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 I 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. I think it is hard to claim 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 78.5%, which is significantly lower than the 85.2% level from last month.
|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 (10/02/2011)?||Ratio = 78.5%, Fairly 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
Note from dshort: I normally post this commentary at the first of the month in conjunction with the other valuation indicators I track. However, today the Federal Reserve Flow of Funds Statistical Release was published, which includes the underlying data for calculating the Q Ratio. The accompanying charts have been updated accordingly.
Current Tobin’s Q 1.01 compared to 1.09 from last month.
As can be seen from the above charts, the market is significantly over-valued based on tobins Q. The market would have to fall 40 or 50% to be fairly valued.
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 significantly 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 Doug and I did to get the current number. This method has proven extremely accurate for calculating Tobins Q on any given day.
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 Doug and I did to get the current number. This method has proven extremely accurate for calculating Tobin's Q on any given day.
The current level of 1.01 compares with the Tobin's Q’s average over several decades of data of approximately .72. This would indicate that the market is extremely 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.)
Average historic Tobin's Q .72 (source: Stocks for the Long Run by Jeremy Siegel)
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.
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 9/28/2011http://www.aaii.com/sentimentsurvey:
Individual investors are very bearish, which is a contrarian sign that it could be a good buying opportunity.
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]|
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 most asset classes. However most asset classes will have lower returns than their historic real rates of return as shown below. Jeremy Grantham of GMO pegged fair value of the S&P500 at 950, which is ~16%, below current levels.
GMO 7 Year Forecast
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. Tobin's 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. Tobin's Q and Shiller P/E indicate that valuations are too high. AAII sentiment, dividend yield indicate more bullish future returns. P/E 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 10-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.