After a 20%-ish decline in the US stock market, it would be nice if stocks were cheap, but they aren’t. The two best valuation measures we know of–cyclically adjusted P/Es and Tobin’s Q–suggest US stocks are still well above their long-term averages.
Although these (or any) valuation measures are not particularly helpful in predicting near-term market performance, they suggest stocks remain priced for mediocre long-term returns. They also suggest that the current bear market has farther to go.
Last month, we described the cyclically adjusted earnings measure used by Yale professor Robert Shiller, London-based economist Andrew Smithers, and others. This measure compares prices to an average of corporate earnings over the previous 10 years, thus adjusting for the effects of the business cycle. Profit margins are mean-reverting–high in good times, low in bad times–so comparing the market’s value to only one year can be misleading. Cyclically adjusted PEs do assume that the future will be similar to the past–which some analysts are always rightfully sceptical of–but they are far more predictive than straight PEs.
Cambridge Associates, an institutional consulting firm, looked at the US market at the end of July using cyclically adjusted PEs and came to the same conclusion we did: It’s expensive (and that was before the recent rally). The good news, as we noted last month, is that the market is less overvalued than it used to be:
U.S. equities are overvalued. Despite the 20% decline in stock prices since October 2007, headline
P/E ratios continue to tick higher as reported EPS fall faster than stock prices. The trailing P/E ratio
for the S&P 500 has risen from 17.7 at the end of June 2007 (when EPS peaked) to 22.2 at the end of June 2008, as earnings have slumped by close to 30% since last June, while the S&P is down 15% over the same period. At a P/E ratio of 22 times preliminary second quarter trailing GAAP earnings of $57.66, the S&P remains 1 standard deviation above its post-1900 mean of 16.
Normalized valuation measures [cyclically adjusted], however, show that while the S&P remains overvalued, valuations are rapidly improving, with a P/E ratio based on 10-year average real earnings at 21.5, or 0.8 standard deviation above the long-term average of 16, down sharply from 1.5 deviations back in September 2007. Indeed, at 21, the “Shiller” P/E ratio is at its lowest level since 2003. ROE-adjusted P/E ratios (based on the MSCI U.S. Index3), show U.S. equities trading at 20.5, or 0.5 standard deviation above a long-term mean of 16.
What does all this mean? That US stocks are still priced to deliver far lower long-term returns than most investors are probably counting on: low- to mid-single digits, versus the “10% a year” that is baked into most retirement calculators.
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