Do these headlines look familiar?
Is the Stock Market Rocket Out of Fuel?
Buy Stocks, More Room to Run.
Market Way Overvalued.
8-9 Years Left in Bull Market.
You are probably getting tired of seeing headlines like these. I know I am. I took these from various financial media sites over the last 120 days.
Makes zero sense, right?
The reason? When the market is selling off the media usually wants opinions about how the market is under-valued. When it’s heading up, they want to hear that it’s over-valued. This sells ads and drives investor activity, which is good for the financial media and for Wall Street.
Not usually so good for the individual investor.
This series is about getting away from opinions and evaluating the market’s condition based on current and historical facts.
Let’s use the S&P 500 via it’s proxy ETF, “SPY”, offered by State Street Global Advisors.
Both the S&P 500 and SPY are market capitalization weighted, meaning the more the company is worth, the more it counts in the index. The same goes for its earnings. I prefer equal weighted earnings (let’s call these “EWE”) as I think they give a better picture of the broader earnings trends in the S&P 500. Without an equal weight approach, a handful of companies with monstrous earnings and market caps (think Apple and Exxon) could make things seem better or worse than they actually are. All earnings references here are EWE, and price-to-earnings (“PE”) referenced are based on EWE.
For the most recent quarter (ended December 2014) earnings were about 3.1% lower than the previous quarter with trailing twelve month earnings of $19.29. This puts today’s price (April 14, 2015) of $209.50 at 10.86x PE. Trailing twelve month earnings were still rising as of quarter end, which is good. With earnings season upon us, we’ll see if that trend continues.
Historically, the average 10 year PE for SPY has been 9.7x. At $209.50 SPY is about 12% over the average valuation of the last 10 years, but still well below the valuation peaks of 2008, when interest rates were considerably higher.
Why is this important?
Valuation and average expected return are inversely related, assuming stable earnings growth, etc.. In English, this means that if you buy when the valuation is below the historical average, all things being equal, your expected return is higher, and when you buy high in the valuation range, your expected return is lower.
To determine an expected return range for the S&P 500, my firm looks at over 50 analysis models based on hard earnings and valuation data.
Here is a condensed summary of SPY’s expected return ranges on an EWE basis:
I condensed this down into 5 central tendencies so it wouldn’t be an unreadable rainbow blob. Regardless, it gives a good idea of the range of possible price outcomes.
I have a preference for investing client dollars when the central tendencies suggest double digit average expected returns. Doesn’t guarantee we’ll get ’em, but why pay $1 today to get $1.03 next year when a little bit of patience and research might turn that $1 into $1.11 or maybe $1.15 instead?
Here is a table of the expected returns given average historical valuation and average historical earnings growth derived from 40 quarters of earnings and valuation data.
So, we now know that the S&P 500 is a bit over priced and that buying here may result in returns that barely keep up with inflation in the near to intermediate term.
What happens to returns if we buy at the average historical valuation?
How about if we buy just 10% below the historical average valuation?
It’s clear why valuation is an important issue when determining when to buy the market (or a sector, or a company) and when it may be wiser to seek better opportunities.
This type of valuation thinking is a major component behind the success of investors like Warren Buffett.
It’s important to understand that interest rates play a role in valuation: lower interest rates support higher valuation, and higher interest rates drive lower valuation. Given current interest rates, and the likelihood they will remain low by historical standards for some time, a 12% premium to average value does not constitute a bubble, nor does it mean the market is greatly over-valued.
But neither does it offer a strong opportunity to make money. When expected returns are in the low to mid single digits, my firm and I look for other sectors or indices that have probabilities of higher returns. All told, we cover nearly 20 sectors and indices. There are opportunities out there; you just have to know where and how to look.
I’ll have a look at the energy sector in the next Market Valuation Update as everyone seems interested in where that’s going.
Feel free to reach out via the contact form or my email if you have questions or post a comment. I block out time each week to answer emails from this site.
To smart investing,