hare1Here is a new update of a popular market valuation method using the
most recent Standard & Poor’s “as reported” earnings and earnings
estimates and the index monthly averages of daily closes for the past
month, which is 1,403.45. The ratios in parentheses use the monthly
close of 1,406.58. For the earnings, see the table below created from
Standard & Poor’s latest earnings spreadsheet.
● TTM P/E ratio = 15.9 (15.9)
● P/E10 ratio = 21.5 (21.6)
The Valuation Thesis
A
standard way to investigate market valuation is to study the historic
Price-to-Earnings (P/E) ratio using reported earnings for the trailing
twelve months (TTM). Proponents of this approach ignore forward
estimates because they are often based on wishful thinking, erroneous
assumptions, and analyst bias.
TTM P/E Ratio
The “price” part of the P/E calculation is available in real time on
TV and the Internet. The “earnings” part, however, is more difficult to
find. The authoritative source is the Standard & Poor’s website,
where the latest numbers are posted on the
earnings page. (See the footnote below for instructions on accessing the file).
The table here shows the TTM earnings based on “as reported” earnings
and a combination of “as reported” earnings and Standard & Poor’s
estimates for “as reported” earnings for the next few quarters. The
values for the months between are linear interpolations from the
quarterly numbers.
The average P/E ratio since the 1870′s has been about 15. But the
disconnect between price and TTM earnings during much of 2009 was so
extreme that the P/E ratio was in triple digits — as high as the 120s —
in the Spring of 2009. In 1999, a few months before the top of the Tech
Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two
years after the market topped out.
As these examples illustrate, in times of critical importance, the
conventional P/E ratio often lags the index to the point of being
useless as a value indicator. “Why the lag?” you may wonder. “How can
the P/E be at a record high after the price has fallen so far?” The
explanation is simple. Earnings fell faster than price. In fact, the
negative earnings of 2008 Q4 (
-$23.25) is something that has never happened before in the history of the S&P 500.
Let’s look at a chart to illustrate the unsuitability of the TTM P/E as a consistent indicator of market valuation.
The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the
same bizarre P/E behavior during the Roaring Twenties and subsequent
market crash. Graham collaborated with David Dodd to devise a more
accurate way to calculate the market’s value, which they discussed in
their 1934 classic book,
Security Analysis.
They attributed the illogical P/E ratios to temporary and sometimes
extreme fluctuations in the business cycle. Their solution was to divide
the price by a multi-year average of earnings and suggested 5, 7 or
10-years. In recent years, Yale professor Robert Shiller, the author of
Irrational Exuberance,
has reintroduced the concept to a wider audience of investors and has
selected the 10-year average of “real” (inflation-adjusted) earnings as
the denominator. As the accompanying chart illustrates, this ratio
closely tracks the real (inflation-adjusted) price of the S&P
Composite. The historic average is 16.4. Shiller refers to this ratio as
the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or
the more precise P/E10, which is my preferred abbreviation.
The Current P/E10
After dropping to 13.3 in March 2009, the P/E10 rebounded to an
interim high of 23.5 in February of last year and is now at 21.5. The
next chart gives us a historical context for these numbers. The ratio in
this chart is doubly smoothed (10-year average of earnings and monthly
averages of daily closing prices). Thus the fluctuations during the
month aren’t especially relevant (e.g., the difference between the
monthly average and monthly close P/E10).
Of course, the historic P/E10 has never flat-lined on the average. On
the contrary, over the long haul it swings dramatically between the
over- and under-valued ranges. If we look at the major peaks and troughs
in the P/E10, we see that the high during the Tech Bubble was the
all-time high above 44 in December 1999. The 1929 high of 32.6 comes in
at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982
saw P/E10 ratios in the single digits.
Where does the current valuation put us?
For a more precise view of how today’s P/E10 relates to the past, our
chart includes horizontal bands to divide the monthly valuations into
quintiles — five groups, each with 20% of the total. Ratios in the top
20% suggest a highly overvalued market, the bottom 20% a highly
undervalued market. What can we learn from this analysis? The Financial
Crisis of 2008 triggered an accelerated decline toward value territory,
with the ratio dropping to the upper second quintile in March 2009. The
price rebound since the 2009 low pushed the ratio back into the top
quintile, and it has since hovered around that boundary. By this
historic measure, the market is expensive, with the ratio approximately
31% above its average (arithmetic mean) of 16.5 (16.45 to two decimal
places). Last month it was 28% above.
I’ve also included a regression trendline through the P/E10 ratio for
the edification of anyone who believes the price-earnings ratio has
naturally tended higher over time as markets evolve. The latest ratio is
about 15% above trend, up from 12% last month. Critics of this more
optimistic view would point to the unprecedented P/Es of the Tech Bubble
as the explanation for this “unnatural” slope to the regression.
We can also use a percentile analysis to put today’s market valuation
in the historical context. As the chart below illustrates, latest P/E10
ratio is approximately at the 83rd percentile of the 1580 data points
in this series.
A more cautionary observation is that when the P/E10 has fallen from
the top to the second quintile, it has eventually declined to the first
quintile and bottomed in single digits. Based on the latest 10-year
earnings average, to reach a P/E10 in the high single digits would
require an S&P 500 price decline below 540. Of course, a happier
alternative would be for corporate earnings to continue their strong and
prolonged surge. If the 2009 trough was not a P/E10 bottom, when might
we see it occur? These secular declines have ranged in length from over
19 years to as few as three. The current decline is now in its 12th
year.
Or was March 2009 the beginning of a secular bull market? Perhaps,
but the history of market valuations suggests a cautious perspective.
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