One thing has become obvious during the endless debate in recent months about whether stock markets were overvalued: There’s more than one way to look at stock valuation.
The answer to the valuation question differs depending on whether you’re looking at forward 12-month price-to-earnings or trailing 12-month P/E. Or maybe you’re talking about Robert Shiller’s cyclically adjusted P/E (CAPE) measure. Perhaps you prefer price-to-book-value? Or price-to-cash-flow?
But there’s more to the valuation debate than just which measure to choose, argues Oppenheimer & Co. Inc. chief investment strategist Brian Belski. He says investors may need to rethink what is “normal” for stock valuations – as well as what it means to be outside of the norm.
Exploring the CAPE
The CAPE valuation for the S&P 500 – a current darling of analysts, which uses inflation-adjusted, 10-year average earnings per share in order to smooth out anomalies in the earnings cycle – sat at 21 at the start of last week, well above its historical average of 18. That fact has led many market strategists to argue that U.S. stocks were considerably overvalued – leaving the market ripe for a 10- to 15-per-cent correction. One might even argue that this overvaluation lends some fundamental credence to the panic selling the U.S. market saw last week.
But Mr. Belski says this interpretation ignores the historical relationship the S&P 500 has had with CAPE. Typically, the two move along similar paths; when one is above its historical trend, the other is, too. But while the CAPE is above its historical norms, the S&P 500 hasn’t yet recovered to its long-term historical trend line after the 2008-09 plunge. This suggests stock prices have some catching up to do.
“There have only been two times since World War II when CAPE was this far above average with the S&P 500 price levels below average,” he wrote in a report last week. When it happened in 1995, the S&P 500 rose 27 per cent in the following 12 months; when it occurred in 2003, the index gained 16 per cent in the next 12 months.
A new normal
But even looking at good old-fashioned P/E, stocks aren’t overvalued at all if you consider two key influences on stock-market valuations: Inflation and interest rates.
In times when rates and inflation have been higher, P/Es have typically fallen in response. But when rates and inflation are near historical lows – as they are now – higher P/Es are typical. Mr. Belski’s analysis shows that current P/Es look quite reasonable, given inflation and interest-rate levels.
Still not satisfied? Well then, Mr. Belski has devised a “valuation composite,” which combines six equally weighted valuation measures (trailing P/E, forward P/E, price-to-book, price-to-free cash flow, price-to-sales and P/E-to-growth, or PEG). What does it show? That U.S. stock valuations are in line with long-term norms.
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