Monday, September 24, 2012

Is the U.S. Stock Market Expensive or Cheap?

The most important determinant of long-term returns from the stock market indisputably has been valuation.  When entering the stock market at times of cheap valuations, subsequent long-term returns have been the highest.  And vice versa.  But valuation is useless in the short-term, as momentum tends to drive stock prices higher than one would think even after they have become historically overvalued.  And prices have fallen lower over short periods despite historic undervaluations.  But over time, valuations have reverted to their long-term norms, or means.

But it's not as simple as that.  Valuation is not always straightforward.  Valuations compared to various historic periods can appear quite different, depending on which time period is being measured.  

And the basis of valuation can make a difference.  On a book value or price/sales basis, historic valuation comparisons seem straightforward and quite reliable.  On these measures, stock prices today are historically high.

Valuations based on earnings measures, however, are more challenging.  Most professional investors use forecasted operating earnings.  This is a dubious practice, as the practice overstates earnings and understates p/e ratios.  A better approach is to take actual earnings that are based on Generally Accepted Accounting Principles (GAAP earnings) and to use earnings over the prior ten years, not a forecast for the next twelve months.

There are two primary ways of using 10-year GAAP earnings, both of which are intended to remove the effect of the business cycle on valuations.  The first is to use cyclically-adjusted, or "normalized" earnings, which are essentially the long-term trend of earnings.  On this basis, the current p/e on the S & P 500 is 20 times.  Using market history back to the 1920's, this is comparable to valuations at historic market peaks, before the 1987 crash and in the 1960's, before  a 16-year period of basically no gain in stock prices.

But going back only to 1990, 20x times is comparatively low, with only early 2009 at 12x significantly cheaper than today.  Confusing, isn't it?

The other major way of using 10-year earnings is to use average earnings and to deflate them for the level of inflation.  On this basis going back to the late 1800's, the current 10-year inflation-adjusted p/e (also known as the "Shiller p/e" after economist Robert Shiller)  is 21x.  This is near historic peaks of 23x, with market troughs typically near 8x.

Using these alternative p/e measures, today's stock market is historically quite high.  So new investments from today's starting point would likely have poor returns on a valuation basis.

Steve Lehman

S & P 500:  1458

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