Every stock of every company exists within a larger ecosystem: The stock market.
Jeremy Siegel explained the pros and cons of the most commonly used metrics for market metrics in chapter 11 of “Stocks for the Long Run.”
He began with a measure that held sway for decades, only to be dashed on the rocks of economic circumstances: “The Evil Omen.” This was the name given to periods when the interest on long-term government bonds rose significantly above the dividend yield on equities. The so-called “Evil Omen” had been present before the crashes of 1891, 1907 and 1929; these plunges occurred when bond yields came within 1% of the dividend yield on stocks.
The idea that dividend yields should be higher than long-term interest rates had been a staple belief, based on the reasonable assumption that stocks were riskier and, thus, should yield more. As stock prices moved higher in the short term, dividend yields naturally dipped and investors took that as a sign to sell, thus driving down stock prices.
However, there was no bear market in 1958 or following years despite long-term bonds yielding nearly as much or more than stocks. Instead, stock prices just kept going up. Siegel noted that investors who responded to the “great yield reversal” were out of luck—it would be another 50 years before dividend yields again exceeded bond yields. The author emphasized, “This example illustrates that valuation yardsticks are valid only as long as underlying economic and financial conditions do not change.”
Price-earnings ratio
The most familiar of metrics for assessing the market is the price-earnings ratio. Calculations for the market are the same as those used for stocks: “The P/E ratio of the market is the ratio of the aggregate earnings of the market to the aggregate value of the market. The P/E ratio measures how much an investor is willing to pay for a dollar’s worth of current earnings.”
Siegel created the following chart to show the variation in the price-earning ratio (along with the cyclically adjusted price-earninigs ratio) between 1871 and 2012:
He added that using the median value of the price-earnings ratio reduces the impact of the spikes and, thus, provides a better guide to historical valuations. For the full 141 years covered, the median, trailing price-earnings ratio was 14.50 and the forward price-earnings ratio was 15.09.
Earnings yield
The reciprocal of the price-earnings ratio is the earnings yield, which Siegel called analogous to the dividend yield of stocks; in this case, it refers to the earnings generated for each dollar of stock market value. Mathematically, an earnings yield of about 15 is the equivalent of an earnings yield of 6.67% (100/15 = 6.67). This value is close to the long-run, real return on stocks and, according to Siegel, this is not a coincidence: “Stocks, in contrast to bonds, whose coupons and principal remain unchanged during inflation, are claims on real assets, and real assets will rise in value with an increase in the general level of prices.”
The CAPE ratio
This measure dates back to 1996, when Robert Shiller and John Campbell made a preliminary presentation to the Federal Reserve, and to 1998 when they published the article: “Valuation Ratios and the Long-Run Stock Market Outlook.” CAPE refers to the cyclically adjusted price-earnings ratio, using 10-year blocks of a broad-based index of stock market prices. Its aim was to smooth out temporary fluctuations of profits caused by business cycles.
It has been reasonably predictive about market prices, but “on closer analysis,” Siegel thought it might be too bearish—when based on S&P 500 reported earnings. However, if NIPA (National Income and Product Accounts) data for adjusted real corporate profits or S&P operating earnings are substituted for the S&P reported earnings, the bearish bias is reduced or eliminated. Siegel provided this chart to show the results:
The Fed model
This metric was developed by researchers at the Federal Reserve, and their documentation showed a strong relationship between earnings yields on stocks and yields on 30-year government bonds. It found that the stock market could be regarded as “overvalued” when the earnings yield was lower than the 30-year bond yield, and undervalued when the earnings yield moved above the bond yield.
The concept is similar to the earlier belief in the relationship between dividends and bond yields, discussed above. However, the researchers recognized that only a fraction of earnings are paid out as dividends, thus their theory should be more robust.
Still, the model has not received much attention because of a problem it shared with the dividend yield versus bond yield model: It did not account for inflation. Siegel noted: “Government bonds have ironclad guarantees to pay a specified number of dollars over time but bear the risk of inflation. Stocks, on the other hand, are real assets whose prices will rise with inflation, but they bear the risk of the uncertainty of earnings.” When the market weighted these two risks as approximately equal, the Fed model worked.
But it stops working when inflation is low or there is a potential for deflation. Therefore, since the 2008 financial crisis, it has not received much attention.
Corporate profits and GDP
This model considers the relationship between aggregate corporate profits and gross domestic product. Siegel reported some market analysts had been concerned about the falling share of profits as a component of national income. However, “closer examination of the data put those fears to rest.”
First, between 1929 and 2012, many brokerages, investment banks and other firms became publicly traded, which “has boosted the corporate share of profits but not the total share of profits to all capital, corporate and non-corporate.”
Second, an increasing fraction of corporate profits has been coming from non-American sources. In 2011, for example, more than 46% of sales by S&P 500 companies originated in international markets. Rising sales by multinational corporations led to a rising share of corporate profits versus U.S. GDP.
Book value, market value and Tobin’s Q
Although book value is often used a yardstick for valuation, Siegel calls it “severely limited.” He applies that description because book value uses historical prices and does not take into account changes in the values of assets or liabilities. In his assessment, book value becomes less and less useful over time as a measure of current value.
James Tobin set out to correct this distortion, and so adjusted book value for inflation to arrive at “replacement cost.” He designated the ratio of market value to replacement cost with letter “Q” and argued this ratio should be unity if the stock market was correctly valued. Critics of the Q theory claim there is no good secondary market for capital equipment and structures, so it is difficult, if not impossible, to value them beyond the stock market.
Profit margins
This reflects the ratio of corporate profits to revenues and is illustrated in this Siegel chart:
While profit margins were quite high at the time this book was published in 2014, Siegel wrote there were several reasons other than overvaluation. They included low leverage, which increases margins by reducing interest expenses, an increase in the amount of profit originating from foreign sales and a growing technology sector, which historically generated high margins.
Interestingly, Siegel noted at that time that profit margins might be expected to rise even more if the U.S. government lowered its corporate tax rates, an event that went into effect in the past year.
Future valuation ratios may go up even more
Regardless of the yardstick used, Siegel thought there was a strong possibility that real returns on equity would go up in the future. While the historical average real return on equity has ranged between 6% and 7%, he sees several factors in the economy and financial markets that may increase this range in the future:
- Transaction costs are falling. One study showed the one-way cost to buy or sell a stock fell from more than 1% in 1975 to less than 0.18% in 2002. High transaction costs, Siegel noted, led to less diversification and more risk.
- Fixed-income investments have been delivering lower real returns, which means more investors have turned to stocks.
- Equity-risk premium: According to Siegel, “If indeed the equity premium were fully recognized, the demand for stock would rise and P/E ratios would increase from historical levels.”
Finally, he argued, “there are persuasive reasons why the valuation of the market may in the future rise above the historical average. This will lead to lower long-term returns on stocks but higher returns during the transition to a higher valuation. Whether that transition takes place or not, stocks remain the most attractive asset class for long-term investors.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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