My favorite valuation indicator has long been the Median price to earnings ratio or P/E. The P/E Ratio is the measure of the share price relative to the annual net income earned per share outstanding. It can be measured by looking at a specific company such as Apple (“AAPL”) or by looking at a particular index like the S&P 500® Index.
The Median P/E is the one for which exactly half of all the stocks have higher ratios and half have lower. The P/E is the most commonly used stock valuation ratio. It allows investors to quickly gauge the valuation of a company based on its current reported earnings.
By focusing on the S&P 500® Index’s Median P/E, we can be assured that the valuation metric is not being skewed by individual outliers, such as may occur with one-time write-offs or other accounting maneuvers. The next chart is from Ned Davis Research (NDR), which takes the S&P 500® Index’s Median P/E Ratio based on trailing 12-month earnings.
I favor actual reported earnings over Wall Street’s forward estimates. The top red arrow suggests a point at which the S&P 500® Index (commonly referred to as “the market”) is overvalued. The blue arrow suggests fair value and the green arrow undervalued. I see this as the upside and downside ranges.
Look at the history since 1965, the only time the market moved more than 1 standard deviation was around the tech bubble period in the late 1990s and early 2000s (standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation.). Simply, it is not normal for stocks to travel too far away from its long-term valuation trend.
So, by this measure, the update is capped at 1984, fair value is suggested at 1520 (that’s when we want to get more aggressive on equities) and extremely attractive valuations are suggested at 1055.
Longtime readers will note that this range has come down over the recent months. The reason is that earnings have been coming down due in large part to serious issues in the energy sector (lower earnings).
Several months ago, I created the following chart for The Wall Street Journal. The point made was that Median P/E can tell us a lot about what the forward 10-year market returns are likely to be. Your starting point matters:
When your starting Median P/E was high (red arrows on left in chart above), your subsequent 10-year annualized returns were low (red arrows on the right). At the end of November 2015, Median P/E was 22.2. It is 21.5 as of the end of February 2016.
Look, 75% of the investable money will be self-directed by retirees and pre-retirees within four years. We are aging, folks. Can that money afford negative to low single-digit returns over the next ten years? Can pension plans, significantly underfunded, expect to return the 7%-8% bogey their actuaries have set? If they are intending to overweight to equity (absent hedges) and find income exposure (at today’s ultra-low yield), the math just doesn’t line up.
If we take all of the month-end Median P/Es since 1926 and ranked them into five groups that range from the cheapest priced to most expensively priced and looked at what happened to the equity returns ten years later, it looks like this:
We are in the highest quintile today, suggesting a probable return of 4.3%. Play defense and wait for a better opportunity to present. A 50% correction puts the S&P 500® Index at 1000 (it is at 2000 today). I’m not saying that is going to happen but, in recession, it could.
I’m going to start to get more interested in the market at 1500. I do believe in the long-term investment and innovative abilities of our publicly traded companies. I just like them much better when I’m buying them at a fair price.
The current opinions and forecasts expressed herein are solely those of Steve Blumenthal and are subject to change. They do not represent the opinions of CMG. CMGs trading strategies are quantitative and may hold a position that at any given time does not reflect Steve’s forecasts. Steve’s opinions and forecasts may not actually come to pass. Information on this site should not be used as a recommendation to buy or sell any investment product or strategy.