2015 0602 - is the stock market cheap_ _ advisor perspectives (dshort

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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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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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(/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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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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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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DeviationfromtheMean

HereareapairofchartsillustratingthehistoricP/E10ratiofromitsmean(average)andgeometricmeanwithcalloutsforpeaksandtroughsalongwiththelatestvalues.

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(/dshort/charts/valuation/PEratiooverview.html?PE10STDMean.gif)Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?PE10STDMean.gif)

6/22/2015 IstheStockMarketCheap?|AdvisorPerspectives(dshort.com)|June2,2015

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(/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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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,sendittoeditor@advisorperspectives.com(mailto:editor@advisorperspectives.com).