Is the market cheap or expensive right now?

I'm not going to cop out and say it depends (though what methodology you use matters). I'm just going to come right out and say that it looks slightly undervalued overall.

This headline "S&P 500 Profits Cut First Time in Year by Analysts" should give some pause because I don't like it when earnings upgrades give way to downgrades while the market is struggling to make gains. That generally signals some warning signs. However, there is a fair amount of cushion regarding earnings estimates. The article states that S&P 500 earnings estimates were cut from $96 to $95 for the S&P 500. That's based on a "share" of the S&P 500 if you view the index level as a price. So then, the basic calculation is made with the S&P 500 trading at 1165 and earnings at $95 the S&P 500's PE ratio is a whopping 12.26x. Not exactly a historic high. As such, estimates could be cut a great deal and the market still would be in decent condition from a valuation perspective.

An annoying post from Mish's Global Economic Trend Analysis references the 1970s where, as market historians know, the stock market failed to advance throughout the decade. The S&P 500's PE ratio entered the decade at around 16x and left at under 7x, representing severe multiple contraction. However, if you look at long term interest rates, as we have in previous posts comparing the relative attractiveness of bonds to stocks, this makes sense. 10-year treasury rates rose from around 7% to as much as 12.75% by March of 1980 (the same month cited in that post) and then up to a high of over 15% by 1981. If you look at the comparative earnings yields and interest rates, you have stocks at 6% or so at the start of the decade with 7% on treasuries. In 1980 you have stocks at 14% (approximately) and bonds at nearly 13%. I rounded a fair amount here because I am feeling lazy, but the post I'm responding to was even lazier.

Currently, by the same comparison, stocks at a forward earnings yield of 8.15% (not the same comparison, but let's use it for now) and the ten year treasury is at 2.39%. Depending on your metric, you might use the ten year trailing PE ratio, which puts us at 21x earnings, or the one year trailing which seems to be more like 15x (depending on what is included in trailing earnings). In any case, unless interest rates start rising a great deal, which is highly unlikely, the outlook for stocks is fairly constructive at the moment.

Edit: I just remembered that we had an earlier discussion about whether or not the spread between earnings yield and interest rates is a good predictor of future returns. Generally it isn't, but the relevant comparison is whether or not it is useful for selecting between stocks and bonds which offers the best return and on that count it performs reasonably well.

Another Take on the "Bond Bubble"

Here's a somewhat more well supported take on the bond market from Angry Bear than what you'll see most places. His model suggests that bonds are properly valued at the moment and were actually somewhat cheap not that long ago. I haven't looked much into his model yet to see if there's something I disagree with in there, but given levels of GDP growth and inflation, it could well be that present bond prices aren't that overvalued.

I don't happen to buy into the thesis that bonds are a bubble in the same way that stocks were in 1999 or housing was in 2006. I think they are only modestly overvalued on an absolute basis, but they are very unattractive to stocks at the present time. Let me put it bluntly. Do you think that the total return of bonds, which will be the present yields at best considering prices are likely to drop as interest rates rise, will exceed that of stocks over the next five or ten years? Even after adjusting for the relevant risk premiums, stocks are quite a bit more attractive than bonds at the moment.

How do I value stocks anyway? Part 2

This will be relatively brief as a follow-up to the previous discussion and it will predominantly focus on a particular part of how price to earnings ratios (PEs) are used to value stocks. I will confess that I have not read a finance textbook in some time so the following is more what I have observed and what economic theory would dictate than any particular theory that is widely accepted.

When you look at a stock quote page on any website such as Bloomberg, Yahoo! Finance, Marketwatch, or whatever brokerage account you use, you will see an estimate of the company's PE ratio. More often than not, this is based on the earnings per share for the prior one year as reported on a GAAP basis. Often when you hear an analyst on TV talking about a stock that they like, they will either use this prior one year number or use analyst estimates of the next fiscal year. Either way, it is almost always a one year snapshot. The market in general is usually somewhere between 10 and 20 times earnings, though individual companies vary widely.

Now, you might be asking yourself "Why would I pay 10-20 times a year's worth of earnings for a company?". This, on its face, is a good question. It does seem a bit absurd. However, implicit in our acceptance of any given PE ratio is the assumption that the current year's earnings per share are a good point for estimating future years' earnings. Indeed, stocks, more or less, conform to the discounted future earnings (or the related dividends and cash flows) of a company over a number of years. Take a current year's earnings, grow them at 8% per year, appropriately discount them for inflation or a risk free rate of return (people do both), sum up, say, 10 years and you get a number that makes considerably more theoretical sense.

Now, some interesting implications of this can be found in real life examples. Take Bristol-Myers Squibb (BMY) for a moment. In 2000, it traded at about 25 times earnings, which was not absurd given its growth rate in the 1990s. This was true of nearly all pharmaceutical stocks. However, collectively, their pipelines dried up and their patents expired, leading to earnings stagnation. Despite having a reasonable PE often around 13-17 times current year earnings, the stock first plunged and then simply faltered. This was repeated across the pharmaceutical industry.

Many analysts routinely mentioned the low PE ratios of the pharmaceutical companies as being a cause to buy these stocks under the assumption that they were now underpriced. However, the only thing that makes a PE ratio of 15 or so reasonable is if that company is going to be growing earnings over the next decade by at least 7% a year. In the case of BMY, you can see in the lower panel of that chart that they have had no earnings growth for a long time. Hence, the stock has fallen well off its highs and continues to languish.

Of course, the same thing happens the other way too. Seemingly unreasonable PEs like Google's (GOOG) can be made reasonable by truly extraordinary growth rates. A company can trade at 60x earnings if it is about to grow 35% a year or more for five years straight.

Another implication of this concept is when a company is poised to have an explosive year due to a big one-time payment or government contract. It may have a very low PE ratio due to these artificially expanded earnings. However, it will be a rude surprise for you indeed if you buy based on that and the company's earnings return to earth a few years later 80% below that inflated level. The discounted sum of its earnings over ten years (or whatever interval you choose) will be far less than you might expect.

This actually also relates to my prior post on bad trend analysis. You have to do more homework than just extrapolating out the past five years' average growth rate over the next decade for a company. You need to do good qualitative analysis to determine whether or not that makes sense or else using a particular PE as a rationale for purchasing a stock will not be fruitful.

Q: How do I value stocks anyway? A: Umm....

One of the basic questions that is brought up time and again is: Is the stock market overvalued or undervalued? Investors are chronically asking this question and the debate between the two factions is what creates a market. Those who think their stocks have had their run will sell and those that think that those stocks can continue to run will buy and where the two meet is the price of the stock. The question for you is which side of that trade do you come down on?

I wish there was an easy answer here, but there is no easy answer. I don't subscribe to any one view of it. Efficient market theorists insist that the price of a stock is always justified because that is what the market values it at. Well.... that's nice, but kind of useless. Then, to quote Cheech Marin's character at the end of From Dusk Till Dawn, "One place's just as good as another". Put in terms of market history, buying Microstrategy (MSTR) at $3,000 a share in March of 2000 made just as much sense as buying Ford (F) at $1 in late 2008.

Dismissing this idea for a moment, how then should stocks, or the stock market at large, be valued? One idea for the overall market is by relative valuation. This is the previously mentioned earnings yield (1/PE * 100%) and compare it to long term bonds. If the earnings yield is at 5% and the 10-year Treasury Note is at 3.5%, stocks seem cheap. If the earnings yield is at 4% and the 10-year Treasury Note is at 7%, stocks are horrifically overvalued. There are some problems with this method in that it is possible that the "E", or earnings, in the PE ratio may be temporarily distorted. Also, interest rates can change in a hurry. It is not uncommon for long term rates to move 100 basis points in a six week period.

If you have taken a microeconomics class that has discussed financial markets at all, or any finance class, you have heard of the Dividend Discount Model. There are two problems with this as well. One is that many companies do not pay dividends, or do not pay particularly large dividends as a matter of policy. As a result, these companies get the shaft in this method of valuation. Also, you have to make the leap of faith that some given level of dividend growth will be sustainable. Just because a company has grown dividends at 8% each year for the past ten years does not mean that they will continue to do so. Case in point: the financials during the 2007-2008 period. If you valued those companies with the assumption that their current dividends were a good proxy of their dividends over the next five years, you would get hosed. Purely conceptually, however, this is probably the best method. It's just that it is difficult to apply to a large number of stocks.