by Dan Burrows | September 19, 2012 6:45 am
When it comes to investing over the longer-term — or, at the very least, say, five years — it all comes down to valuation.
It’s supposed to, anyway. Buy cheap, sell dear. Undervalued assets should outperform and overvalued assets should lag.
That’s the theory, and if you’re truly adept at sussing out undervalued assets and wait long enough, there are indeed riches to be made in practice.
Just look at Warren Buffett.
The great challenge, of course, is that valuation often is in the eye of the beholder. When looking at stocks, we can measure whether they are expensive or cheap by all manner of ratios: price-to-sales, price-to-book, price-to-cash flow … the list goes on.
But the most common measure of whether a stock or the stock market is a bargain or a rip-off is the price-to-earnings ratio. Take the price, divide it by actual trailing earnings and you get trailing P/E. Take the same price, divide by Wall Street’s earnings forecast, and you get forward P/E.
When the P/E is below some average or trend, stocks are cheap. And when it’s above, they’re expensive. Sounds simple enough, right?
So, based on P/E … are stocks cheap or expensive?
The problem with P/E is that there are a whole bunch of ways of looking at it. Trailing earnings are reported profits that actually happened, at least for accounting purposes. But that only tells you where earnings have been — not where they’re going. And the market, of course, is forward-looking.
Forward P/E’s are therefore more important — except that they are based on analysts’ average guesstimates of where profits are headed. As well all know painfully too well, analysts, as a whole, are often way off.
By trailing earnings, the S&P 500 currently sports a P/E of nearly 17, according to Birinyi Associates. Going back to 1871, the market’s average P/E is 15.5 and the median is 14.5.
(Chart courtesy of multpl.com)
By this yardstick, the market is overvalued by nearly 10%, at least.
So should you sell? Not so fast. By forward earnings, the S&P 500’s P/E is a bit over 13, or about a 20% discount to its own long-term average, suggesting stocks are a screaming buy.
(Chart courtesy of yardeni.com)
Confused? It gets even more interesting.
If you look at something called cyclically adjusted P/E, or CAPE, which smooths out the effects of the business cycle by using an average of inflation-adjusted earnings over the trailing 10 years, stocks are wickedly overpriced. The S&P 500’s CAPE stands at nearly 23. The median and the mean (going back to 1881) are both around 16.
(Chart courtesy of multpl.com)
Multiple expansion, whereby investors are willing to pay more for each dollar of earnings, could very well make the market go up even further — but, by extension, make it look like even less of a bargain. The previously shown forward P/E chart also provides examples of this. Take a look at the blue line at the top of that forward P/E chart. It shows that if the forward P/E multiple expanded to 15, the S&P 500 would be closing in on 1,700.
Also supporting the case for higher stocks is the paucity of alternatives. Cash pays essentially nothing and bonds are yielding 1% to 2%. The dividend on the S&P 500, meanwhile, still is above 2% — with a chance for price appreciation to boot!
The market always churns on some combination of fundamentals and technicals, and the great fundamental question of this rally is whether stocks are a bargain.
By cyclically adjusted and trailing measures, we can see how some value investors might be getting hinky. On the other hand, if analysts’ estimates are right, stocks look like a screaming bargain right now.
Valuation, regardless of how you measure it, does have a tendency to revert to the mean in the long run.
Of course as Keynes said, in the long run, we’re all dead.
Source URL: http://investorplace.com/2012/09/is-the-market-cheap-or-dear-yes/
Short URL: http://invstplc.com/1dcsKc3
Copyright ©2016 InvestorPlace Media, LLC. All rights reserved. 700 Indian Springs Drive, Lancaster, PA 17601.