Anyone brave enough to scroll down to the blog’s Greek chorus will immediately encounter the familiar siren calls regarding what’ll bring the market to its knees.
T2 usually ranks high on the list. Central bank (over)stimulus is up there too. Virus mania has a permanent place of honour. But right near the top is the chorus’s other favourite bete noire: valuation. And the advice lately? Run for your lives, equities are expensive.
Indeed, in the simplest terms, markets are expensive. The trailing 12-month P/E of the S&P 500 sits at 24x, well above its historical 85-year average of about 16x. However, standalone P/E metrics are insufficient. Valuation must be viewed more broadly. When someone, particularly an anonymous know-it-all in the comment section, advises to sell everything because markets are “overpriced” consider the following:
- Valuations frequently far exceed their historical averages and P/E multiples, in and of themselves, are actually poorly correlated with future market direction. Over the past 25 years, for a variety of reasons, including more investor emphasis on growth and technology stocks, trailing P/Es have actually spent the majority of their time above that long-term historical average P/E. In other words, these days, markets are almost always ‘expensive’.
- Other important metrics, such as the PEG ratio, which is P/E divided by the earnings growth rate, aren’t overextended. The S&P 500’s PEG ratio, for example, currently sits at only about 1x. Generally speaking, a PEG ratio around 1x is reasonable. One could argue that earnings growth assumptions for the S&P 500 of 20%+ are too bullish, but the S&P 500 has experienced an earnings growth rate much greater than this for several quarters and even in the most recent quarter earnings grew at more than 40% y-o-y. But regardless, PEG, which better credits growth, gives a clearer valuation picture than P/E alone.
- Relative valuation is always more important than absolute valuation. Are other asset classes offering potential returns that are even remotely competitive to equities? In the late 1990s, for instance, the S&P 500 had nosebleed valuations above 30x P/E, but this valuation danger was compounded by the fact that the 10-year US Treasury yield was also attractively north of 6%. In other words, equity investors could switch more to bonds, lower their risk and still bag a decent rate of return. Not only are P/Es not nearly as extended this time around, but the 10-year US Treasury yield sits at only a paltry 1.4%. A compelling ‘switch trade’ certainly doesn’t exist today.
- This brings us to earnings yield, which is a useful metric for comparing the relative value of equities versus other asset classes. Earnings yield brings the value of the market’s earnings into better focus and can indicate whether the equity risk is worth it. Earnings yield divides earnings by price instead of the reverse and is usually compared to a risk-free benchmark such as the 10-year US Treasury yield mentioned above. If the earnings yield is less than the 10-year Treasury yield, a heavy weighting to equities poses a potential problem. Again, in the late 1990s, the 10-year Treasury yield was well above the S&P 500 earnings yield—a clear red flag. Today it’s very much the opposite—the earnings yield (3.9%) sits comfortably above the 10-year Treasury yield (1.4%).
- Finally, valuations must always be put into context. Last year, for instance, the S&P 500, at times, traded at more than 30x P/E, but this was only because the “E” was temporarily subdued. Concluding that markets were too expensive last year based on P/E alone, naturally, would have been a critical error. Earnings have, of course, normalized significantly in the past 12 months so this is less of an issue at present, but it’s still worth highlighting the need to always be correctly interpreting valuation data.
So, are markets expensive? Only if one takes a narrow focus. Valuation requires nuanced analysis meaning it’s best to ditch the hysterical and oversimplified conclusions that I’m sure are awaiting me in the comment section (on Christmas Day no less).
But today’s not a day to dwell on market valuation fears.
Let’s sip eggnog instead. Heavy on the rum.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.