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

IstheStockMarketCheap?
June2,2015
byDougShort
ofAdvisorPerspectives(dshort.com)
HereisanewupdateofapopularmarketvaluationmethodusingthemostrecentStandard&
Poor's"asreported"earningsandearningsestimatesandtheindexmonthlyaverageofdaily
closesforthepastmonth.Fortheearnings,seethetablebelowcreatedfromStandard&
Poor'slatestearningsspreadsheet.
TTMP/Eratio=21.3
P/E10ratio=26.9
TheValuationThesis

AstandardwaytoinvestigatemarketvaluationistostudythehistoricPricetoEarnings(P/E)
ratiousingreportedearningsforthetrailingtwelvemonths(TTM).Proponentsofthis
approachignoreforwardestimatesbecausetheyareoftenbasedonwishfulthinking,
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"earningsandacombination
of"asreported"earningsandStandard&Poor'sestimatesfor"asreported"earningsforthe
nextfewquarters.Thevaluesforthemonthsbetweenarelinearinterpolationsfromthe
quarterlynumbers.
TheaverageP/Eratiosincethe1870'shasbeenabout16.6.Butthedisconnectbetween
priceandTTMearningsduringmuchof2009wassoextremethattheP/Eratiowasintriple
digitsashighasthe120sintheSpringof2009.In1999,afewmonthsbeforethetopof
theTechBubble,theconventionalP/Eratiohit34.Itpeakedcloseto47twoyearsafterthe
markettoppedout.
Astheseexamplesillustrate,intimesofcriticalimportance,theconventionalP/Eratiooften
lagstheindextothepointofbeinguselessasavalueindicator."Whythelag?"youmay
wonder."HowcantheP/Ebeatarecordhighafterthepricehasfallensofar?"The
explanationissimple.Earningsfellfasterthanprice.Infact,thenegativeearningsof2008Q4
($23.25)issomethingthathasneverhappenedbeforeinthehistoryoftheS&P500.
Let'slookatacharttoillustratetheunsuitabilityoftheTTMP/Easaconsistentindicatorof
marketvaluation.

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(/dshort/charts/valuation/PEratiooverview.html?SPandttmPEnominal.gif)
Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?SPandttmPE
nominal.gif)
TheP/E10Ratio
LegendaryeconomistandvalueinvestorBenjaminGrahamnoticedthesamebizarreP/E
behaviorduringtheRoaringTwentiesandsubsequentmarketcrash.Grahamcollaborated
withDavidDoddtodeviseamoreaccuratewaytocalculatethemarket'svalue,whichthey
discussedintheir1934classicbook,SecurityAnalysis(http://www.amazon.com/Security
AnalysisClassic1934GRAHAM/dp/0070244960).TheyattributedtheillogicalP/Eratiosto
temporaryandsometimesextremefluctuationsinthebusinesscycle.Theirsolutionwasto
dividethepricebyamultiyearaverageofearningsandsuggested5,7or10years.Inrecent
years,YaleprofessorandNobellaureateRobertShiller,theauthorofIrrationalExuberance
(http://www.amazon.com/IrrationalExuberanceRobertJShiller/dp/0767923634),has
popularizedtheconcepttoawideraudienceofinvestorsandhasselectedthe10year
averageof"real"(inflationadjusted)earningsasthedenominator.Shillerreferstothisratio
astheCyclicallyAdjustedPriceEarningsRatio,abbreviatedasCAPE,orthemoreprecise
P/E10,whichisourpreferredabbreviation.
TheCorrelationbetweentheS&PCompositeanditsP/E10

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Asthechartbelowillustrates,theP/E10closelytracksthereal(inflationadjusted)priceofthe
S&PComposite.Infact,thedetrendedcorrelationbetweenthetwosince1881,theyear
whenthefirstdecadeofaverageearningsisavailable,is0.9977.(Note:Aperfectpositive
correlationwouldbe1andtheabsenceofcorrelationwouldbe0).

(/dshort/charts/valuation/PEratiooverview.html?SPandPE10.gif)
Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?SPandPE10.gif)
ThehistoricP/E10averageis16.6.Afterdroppingto13.3inMarch2009,theratiorebounded
toaninterimhighof23.5inFebruaryof2011andthenhoveredinthe20to21range.The
latestratioishoveringnearitsinterimhighthehighestsinceDecember2007.Theratioin
thechartaboveisdoublysmoothed(10yearaverageofearningsandmonthlyaveragesof
dailyclosingpricesfortheindex).Thusthefluctuationsduringthemontharen'tespecially
relevant(e.g.,thedifferencebetweenthemonthlyaverageandmonthlycloseP/E10).
Ofcourse,thehistoricP/E10hasneverflatlinedontheaverage.Onthecontrary,overthe
longhaulitswingsdramaticallybetweentheoverandundervaluedranges.Ifwelookatthe
majorpeaksandtroughsintheP/E10,weseethatthehighduringtheTechBubblewasthe
alltimehighabove44inDecember1999.The1929highof32.6comesinatadistant
second.Thesecularbottomsin1921,1932,1942and1982sawP/E10ratiosinthesingle
digits.

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ThechartalsoincludesaregressiontrendlinethroughtheP/E10ratiofortheedificationof
anyonewhobelievesthepriceearningsratiohasnaturallytendedhigherovertimeas
marketsevolve.Thelatestratiois42%abovetrend.
Wheredoesthecurrentvaluationputus?
Foramorepreciseviewofhowtoday'sP/E10relatestothepast,ourchartincludes
horizontalbandstodividethemonthlyvaluationsintoquintilesfivegroups,eachwith20%
ofthetotal.Ratiosinthetop20%suggestahighlyovervaluedmarket,thebottom20%a
highlyundervaluedmarket.Whatcanwelearnfromthisanalysis?TheFinancialCrisisof
2008triggeredanaccelerateddeclinetowardvalueterritory,withtheratiodroppingtothe
uppersecondquintile(fromthebottom)inMarch2009.Thepricereboundsincethe2009low
pushedtheratiobackintothetopquintile,hoveredaroundthatboundaryandhasnowmoved
higher.
AcautionaryobservationisthatwhentheP/E10hasfallenfromthetoptothesecond
quintile,ithaseventuallydeclinedtothelowestquintileandbottomedinsingledigits.Based
onthelatest10yearearningsaverage,toreachaP/E10inthehighsingledigitswould
requireanS&P500pricedeclinebelow550.Ofcourse,ahappieralternativewouldbefor
corporateearningstocontinuetheirstrongandprolongedsurge.Ifthe2009troughwasnota
P/E10bottom,whenmightweseeitoccur?Theseseculardeclineshaverangedinlength
fromover19yearstoasfewasthree.
PercentileAnalysis
Wecanalsouseapercentileanalysistoputtoday'smarketvaluationinthehistoricalcontext.
Asthechartbelowillustrates,latestP/E10ratioisapproximatelyatthe94thpercentileofthis
series.

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DeviationfromtheMean
HereareapairofchartsillustratingthehistoricP/E10ratiofromitsmean(average)and
geometricmeanwithcalloutsforpeaksandtroughsalongwiththelatestvalues.

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

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(/dshort/charts/valuation/PEratiooverview.html?PE10STDGeoMean.gif)
Clickforalargerimage(/dshort/charts/valuation/PEratiooverview.html?PE10STDGeo
Mean.gif)
Relativetothemean,themarketisexpensive,withtheratioapproximately62%aboveits
arithmeticmeanand75%aboveitsgeometricmean.
ThePrevailingQuestion...
WasMarch2009thebeginningofasecularbullmarket?Perhaps,andcertainlythenewall
timehighsrepeatedlysetoverthepastseveralmonthsareconspicuoustickmarksforthe
optimists.Butthehistoryofmarketvaluationssuggestsacautiousperspective.

AdditionalNotes
WhatAretheImpactsofLowInterestRatesandInflationonMarketValuations?
Formoreonthistopic,seeourmonthlyupdate:
MarketValuation,InflationandTreasuryYields:CluesfromthePast
(/dshort/commentaries/MarketValuationInflationand10YearYields.php)
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Wouldn'tValuationsBeMuchLowerIfWeExcludetheFinancialCrisisEarnings
Crash?
Thisisanoftenaskedquestion,theassumptionbeingthattheunprecedentednegative
earningsoftheFinancialCrisisskewedtheP/E10substantiallyhigherthanwouldotherwise
havebeenthecase.Whilethatmayseemareasonableassumption,asimpleexperiment
showsthattheearningsplungedidnotdramaticallyimpacttheratio.Let'sassumethatthe
December2007TTMearningsof66.18remainedconstantforthenext29months,totally
eliminatethecollapseinearningsoftheGreatRecession.Whatimpactdoesthishaveonthe
P/E10?Themean(average)onlydropsfrom16.6to16.5.Thelowerboundofthetop
quintiledropsfrom21.2to20.8.
WhereCanIFindtheLatestEarningsDatafortheS&P500?
FollowthesestepstoaccesstheStandard&Poor'searningsspreadsheet:
1. GototheS&P500pageontheS&PDowJonesIndices(http://us.spindices.com/)
website.Hereisa:directlink(http://us.spindices.com/indices/equity/sp500)tothe
page.
2. Clickthe"ADDITIONALINFO"buttonintheleftcolumn.
3. ClicktheIndexEarningslinktodownloadtheExcelfile.Onceyou'vedownloadedthe
spreadsheet,scrolldowntothe"AsReportedEarnings"dataincolumnL.
ExactlyWhatIstheS&PCompositeindex?
Forreadersunfamiliarwiththeindex,seethisarticle(/dshort/updates/ValidatingtheSP
Composite.php)forsomebackgroundinformation.
Remember,ifyouhaveaquestionorcomment,sendittoeditor@advisorperspectives.com
(mailto:editor@advisorperspectives.com).

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