2015 0602 - is the stock market cheap_ _ advisor perspectives (dshort
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 1/9
IstheStockMarketCheap?June2,2015
byDougShortofAdvisorPerspectives(dshort.com)
HereisanewupdateofapopularmarketvaluationmethodusingthemostrecentStandard&Poor's"asreported"earningsandearningsestimatesandtheindexmonthlyaverageofdailyclosesforthepastmonth.Fortheearnings,seethetablebelowcreatedfromStandard&Poor'slatestearningsspreadsheet.
TTMP/Eratio=21.3P/E10ratio=26.9
TheValuationThesis
AstandardwaytoinvestigatemarketvaluationistostudythehistoricPricetoEarnings(P/E)ratiousingreportedearningsforthetrailingtwelvemonths(TTM).Proponentsofthisapproachignoreforwardestimatesbecausetheyareoftenbasedonwishfulthinking,erroneousassumptions,andanalystbias.
TTMP/ERatio
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 2/9
The"price"partoftheP/EcalculationisavailableinrealtimeonTVandtheInternet.The"earnings"part,however,ismoredifficulttofind.TheauthoritativesourceistheStandard&Poor'swebsite,wherethelatestnumbersarepostedontheearningspage(http://www.standardandpoors.com/indices/sp500/en/us/?indexId=spusa500usdufpusl).
ThetablehereshowstheTTMearningsbasedon"asreported"earningsandacombinationof"asreported"earningsandStandard&Poor'sestimatesfor"asreported"earningsforthenextfewquarters.Thevaluesforthemonthsbetweenarelinearinterpolationsfromthequarterlynumbers.
TheaverageP/Eratiosincethe1870'shasbeenabout16.6.ButthedisconnectbetweenpriceandTTMearningsduringmuchof2009wassoextremethattheP/Eratiowasintripledigitsashighasthe120sintheSpringof2009.In1999,afewmonthsbeforethetopoftheTechBubble,theconventionalP/Eratiohit34.Itpeakedcloseto47twoyearsafterthemarkettoppedout.
Astheseexamplesillustrate,intimesofcriticalimportance,theconventionalP/Eratiooftenlagstheindextothepointofbeinguselessasavalueindicator."Whythelag?"youmaywonder."HowcantheP/Ebeatarecordhighafterthepricehasfallensofar?"Theexplanationissimple.Earningsfellfasterthanprice.Infact,thenegativeearningsof2008Q4($23.25)issomethingthathasneverhappenedbeforeinthehistoryoftheS&P500.
Let'slookatacharttoillustratetheunsuitabilityoftheTTMP/Easaconsistentindicatorofmarketvaluation.
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 3/9
(/dshort/charts/valuation/PEratiooverview.html?SPandttmPEnominal.gif)Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?SPandttmPEnominal.gif)
TheP/E10Ratio
LegendaryeconomistandvalueinvestorBenjaminGrahamnoticedthesamebizarreP/EbehaviorduringtheRoaringTwentiesandsubsequentmarketcrash.GrahamcollaboratedwithDavidDoddtodeviseamoreaccuratewaytocalculatethemarket'svalue,whichtheydiscussedintheir1934classicbook,SecurityAnalysis(http://www.amazon.com/SecurityAnalysisClassic1934GRAHAM/dp/0070244960).TheyattributedtheillogicalP/Eratiostotemporaryandsometimesextremefluctuationsinthebusinesscycle.Theirsolutionwastodividethepricebyamultiyearaverageofearningsandsuggested5,7or10years.Inrecentyears,YaleprofessorandNobellaureateRobertShiller,theauthorofIrrationalExuberance(http://www.amazon.com/IrrationalExuberanceRobertJShiller/dp/0767923634),haspopularizedtheconcepttoawideraudienceofinvestorsandhasselectedthe10yearaverageof"real"(inflationadjusted)earningsasthedenominator.ShillerreferstothisratioastheCyclicallyAdjustedPriceEarningsRatio,abbreviatedasCAPE,orthemorepreciseP/E10,whichisourpreferredabbreviation.
TheCorrelationbetweentheS&PCompositeanditsP/E10
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 4/9
Asthechartbelowillustrates,theP/E10closelytracksthereal(inflationadjusted)priceoftheS&PComposite.Infact,thedetrendedcorrelationbetweenthetwosince1881,theyearwhenthefirstdecadeofaverageearningsisavailable,is0.9977.(Note:Aperfectpositivecorrelationwouldbe1andtheabsenceofcorrelationwouldbe0).
(/dshort/charts/valuation/PEratiooverview.html?SPandPE10.gif)Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?SPandPE10.gif)
ThehistoricP/E10averageis16.6.Afterdroppingto13.3inMarch2009,theratioreboundedtoaninterimhighof23.5inFebruaryof2011andthenhoveredinthe20to21range.ThelatestratioishoveringnearitsinterimhighthehighestsinceDecember2007.Theratiointhechartaboveisdoublysmoothed(10yearaverageofearningsandmonthlyaveragesofdailyclosingpricesfortheindex).Thusthefluctuationsduringthemontharen'tespeciallyrelevant(e.g.,thedifferencebetweenthemonthlyaverageandmonthlycloseP/E10).
Ofcourse,thehistoricP/E10hasneverflatlinedontheaverage.Onthecontrary,overthelonghaulitswingsdramaticallybetweentheoverandundervaluedranges.IfwelookatthemajorpeaksandtroughsintheP/E10,weseethatthehighduringtheTechBubblewasthealltimehighabove44inDecember1999.The1929highof32.6comesinatadistantsecond.Thesecularbottomsin1921,1932,1942and1982sawP/E10ratiosinthesingledigits.
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 5/9
ThechartalsoincludesaregressiontrendlinethroughtheP/E10ratiofortheedificationofanyonewhobelievesthepriceearningsratiohasnaturallytendedhigherovertimeasmarketsevolve.Thelatestratiois42%abovetrend.
Wheredoesthecurrentvaluationputus?
Foramorepreciseviewofhowtoday'sP/E10relatestothepast,ourchartincludeshorizontalbandstodividethemonthlyvaluationsintoquintilesfivegroups,eachwith20%ofthetotal.Ratiosinthetop20%suggestahighlyovervaluedmarket,thebottom20%ahighlyundervaluedmarket.Whatcanwelearnfromthisanalysis?TheFinancialCrisisof2008triggeredanaccelerateddeclinetowardvalueterritory,withtheratiodroppingtotheuppersecondquintile(fromthebottom)inMarch2009.Thepricereboundsincethe2009lowpushedtheratiobackintothetopquintile,hoveredaroundthatboundaryandhasnowmovedhigher.
AcautionaryobservationisthatwhentheP/E10hasfallenfromthetoptothesecondquintile,ithaseventuallydeclinedtothelowestquintileandbottomedinsingledigits.Basedonthelatest10yearearningsaverage,toreachaP/E10inthehighsingledigitswouldrequireanS&P500pricedeclinebelow550.Ofcourse,ahappieralternativewouldbeforcorporateearningstocontinuetheirstrongandprolongedsurge.Ifthe2009troughwasnotaP/E10bottom,whenmightweseeitoccur?Theseseculardeclineshaverangedinlengthfromover19yearstoasfewasthree.
PercentileAnalysis
Wecanalsouseapercentileanalysistoputtoday'smarketvaluationinthehistoricalcontext.Asthechartbelowillustrates,latestP/E10ratioisapproximatelyatthe94thpercentileofthisseries.
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 6/9
DeviationfromtheMean
HereareapairofchartsillustratingthehistoricP/E10ratiofromitsmean(average)andgeometricmeanwithcalloutsforpeaksandtroughsalongwiththelatestvalues.
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 7/9
(/dshort/charts/valuation/PEratiooverview.html?PE10STDMean.gif)Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?PE10STDMean.gif)
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 8/9
(/dshort/charts/valuation/PEratiooverview.html?PE10STDGeoMean.gif)Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?PE10STDGeoMean.gif)
Relativetothemean,themarketisexpensive,withtheratioapproximately62%aboveitsarithmeticmeanand75%aboveitsgeometricmean.
ThePrevailingQuestion...
WasMarch2009thebeginningofasecularbullmarket?Perhaps,andcertainlythenewalltimehighsrepeatedlysetoverthepastseveralmonthsareconspicuoustickmarksfortheoptimists.Butthehistoryofmarketvaluationssuggestsacautiousperspective.
AdditionalNotes
WhatAretheImpactsofLowInterestRatesandInflationonMarketValuations?
Formoreonthistopic,seeourmonthlyupdate:
MarketValuation,InflationandTreasuryYields:CluesfromthePast(/dshort/commentaries/MarketValuationInflationand10YearYields.php)
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6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015
http://www.advisorperspectives.com/commentaries/20150602advisorperspectivesdshortcomisthestockmarketcheap 9/9
Wouldn'tValuationsBeMuchLowerIfWeExcludetheFinancialCrisisEarningsCrash?
Thisisanoftenaskedquestion,theassumptionbeingthattheunprecedentednegativeearningsoftheFinancialCrisisskewedtheP/E10substantiallyhigherthanwouldotherwisehavebeenthecase.Whilethatmayseemareasonableassumption,asimpleexperimentshowsthattheearningsplungedidnotdramaticallyimpacttheratio.Let'sassumethattheDecember2007TTMearningsof66.18remainedconstantforthenext29months,totallyeliminatethecollapseinearningsoftheGreatRecession.WhatimpactdoesthishaveontheP/E10?Themean(average)onlydropsfrom16.6to16.5.Thelowerboundofthetopquintiledropsfrom21.2to20.8.
WhereCanIFindtheLatestEarningsDatafortheS&P500?
FollowthesestepstoaccesstheStandard&Poor'searningsspreadsheet:
1. GototheS&P500pageontheS&PDowJonesIndices(http://us.spindices.com/)website.Hereisa:directlink(http://us.spindices.com/indices/equity/sp500)tothepage.
2. Clickthe"ADDITIONALINFO"buttonintheleftcolumn.3. ClicktheIndexEarningslinktodownloadtheExcelfile.Onceyou'vedownloadedthe
spreadsheet,scrolldowntothe"AsReportedEarnings"dataincolumnL.
ExactlyWhatIstheS&PCompositeindex?
Forreadersunfamiliarwiththeindex,seethisarticle(/dshort/updates/ValidatingtheSPComposite.php)forsomebackgroundinformation.
Remember,ifyouhaveaquestionorcomment,[email protected](mailto:[email protected]).