Earnings season for the fourth quarter of 2013 is winding down, with some of the last few reports for the S&P 500 coming in this week. The data so far have been good, but not good enough to bring valuations down. Profits and revenue are growing, but average guidance has been a little soft. So far, this quarter’s reports are looking a lot like the first quarter of 2013, which has investors a little concerned about high valuations that could lead to a potential downturn in the market.
What constitutes high or low values is a little tricky but, overall, the market is clearly pricing in better growth this year than guidance from this earnings season would suggest. Management teams could simply be “sandbagging,” as we have seen in the past, to increase the potential for future surprises or to head off a sharp correction in the near term.
One of the ways we think about valuations is by comparing earnings, sales or cash flow to a stock’s price. The P/E (Price to Earnings) ratio does this by dividing the price of a stock by its earnings (profits) per share. While there isn’t a clear benchmark for what makes a P/E ratio good or bad, slow growing stocks tend to have low P/E ratios and fast growing stocks tend to have high ratios.
The P/E ratios become a little more meaningful when we look at where they are today compared to where they have been in the past. The indicator can further be improved by looking at P/E ratios on average. The average P/E for the S&P 500 will be less affected by outliers than the P/E for an individual stock. In the next chart, you can see the average P/E for the S&P 500 today compared to actual levels over the last 100 years.
Compared to recent history, the average P/E is a little high this year. But is it too high? A lot depends on actual growth. If growth accelerates then the multiple can remain high, and so can stock prices. History has actually shown the P/E ratio to be a fairly poor predictor for stock market crashes, but there have been attempts to improve this ratio that have been successful to a certain extent.
A modified version of this analysis, created by 2013 Nobel Prize winner Robert Shiller, includes a 10-year look-back period and adjustments for inflation to try to overcome some of the P/E ratio’s problems. You can see an example of his modified version, called the CAPE ratio, below.
Theoretically, we agree that the CAPE ratio should do a better job of identifying periods when the stock market is overvalued. Fortunately, there is good historical data that can be used to see how well this indicator has worked in the past, but the end result is not very good.
Yes, years when the CAPE ratio is above 20 have (on average) had lower returns than years with a CAPE ratio in the single digits, but the correlation is very weak. Avoiding periods with high CAPE ratios would have cost long-term investors 27% in the S&P over the last year. Of course, even Shiller himself has said that the CAPE ratio should not be used to predict the market, suggesting that it should simply help investors think about when they are accumulating stock more or less aggressively.
Investors should think about valuation multiples as a way to decide how long they are rather than as just a binary in-or-out signal. The trend can be persistent for a long period of time. High valuations do tend to lead to extra volatility on average, but not necessarily to bear markets. Those kinds of market conditions are good for option traders who want to be more strategic about how they allocate their assets during a period of high volatility.