Stocks are now down more than 10% from their recent peak–an official “correction.”
So what does that mean?
Is it a “buying opportunity”? Are stocks cheap?
Over the short-term, the market could certainly snap back. And if the carnage keeps up, Ben Bernanke might announce some huge new quantitative easing program in addition to his zero-per cent-interest-rates-forever policy. Or Congress might panic about the elections and suddenly address “Taxmageddon” and the fiscal cliff. Or Europe might suddenly bail out all its banks and kick the can down the road for a while.
And those initiatives might boost stocks.
On the other hand, stocks could now keep dropping until they enter a “bear market” (20% decline), or worse.
On that score, the bigger valuation picture is still not that encouraging, at least for long-term returns. Even after the recent pullback, stocks are still about 20% overvalued when measured on Professor Robert Shiller’s “normalized” earnings–earnings adjusted to normalize profit margins. This is is one of the only valuation measures that actually bears some correlation to long-term future returns. (PEs based on a single year of earnings can often be highly misleading).
Specifically, even after the pullback, stocks are still trading at 20X cyclically adjusted earnings. As we can see in the following chart from Professor Shiller, over the past century, stocks have averaged about 16X those earnings. So we’re still about 20% above “normal.”
Importantly, though, 20X is a lot closer to normal than the ~24X recent peak. Stocks certainly aren’t “cheap,” but they’re also not wildly overvalued anymore.
Photo: Robert Shiller
Wait, what are “normalized” earnings? Aren’t stocks now astoundingly “cheap”?
In recent months, eager to suggest that stocks are cheap, most analysts have talked about the market P/E ratio relative to next year’s projected earnings. And relative to those earnings, stocks do seem modestly “cheap” (12X, or something).
Unfortunately, measuring stock values against next year’s projected earnings has a couple of flaws. First, no one knows whether those projections will materialise. Second, and more important, those projected earnings assume that today’s record-high profit margins (see below) will persist.
Photo: St. Louis Fed
Over history, corporate profit margins have been one of the most reliably “mean-reverting” metrics in the economy. When margins get extended to super-high (today) or super low (2009) levels, they generally revert toward the mean. This radically changes the PE ratio.
Using single-year earnings often provides a very misleading impression of how “cheap” or “expensive” stocks are. When profit margins are abnormally high, as they are now, the PE seems misleadingly low. And when profit margins are abnormally low, as they were in 2009, the PE seems misleadingly high. The “normalized” PE ratio provides a much more meaningful view.
And measured on average profit margins, not today’s super-high margins, the stock market is still a bit expensive. (We discuss this in detail here).
Sadly, this doesn’t tell you anything about what the market will do next. As you can see in Professor Shiller’s chart, the market has spent decades above and below the average.
What this PE ratio does tell you is that stocks still have lots of room to fall–20%, just to get back to normal, much more than that if they “overshoot.”
And it also tells you that long-term returns are still likely to be sub-par. Through history, one of the most reliable predictors of next-10-year returns is the valuation level at the beginning of the period. Today’s valuation level is not as high as yesterday’s. But it’s still higher than average.
But we’re getting closer to “fair value.” And that’s good news for long-term investors who want a compelling long-term return. And bonds are now so expensive that stocks are highly likely to produce better returns than bonds over the next decade, even if the stock returns are sub-par.