Is the US Market Expensive?
I find it amazing how so many people can look at the same data and come to completely different conclusions. Well perhaps amazing is a stretch, but certainly amusing. Take a simple support line on a chart. Different technical analysts draw different support and resistance lines on the same chart because they focus on different things. While there is usually more than one right way to do something, there is often a better way. I wanted to say best, but that’s to black and white for me. Sticking with those support lines for a minute, I wonder why so many people draw them starting from the left, the furtherest point away in time. Surely the closest inflection point to now, the right most, should be given the most weight, with lines drawn backwards in time from there. But that’s really a discussion for another day, I simply wanted to set the scene by illustrating if market participants can’t agree on something as simple as a line on a chart, how the heck are they ever going to agree on whether the market is expensive or not! In short, of course there not agreement and that disagreement is what makes auction markets.
However, just as with support lines, there are better ways to assess whether the market is expensive and not such good ways. First off, looking at any one number in isolation is fool hardy. I’m talking about anyone quoting the point in time market P/E as a basis for whether the market is cheap or not. The ‘P’ is what it is, but the all important ‘E’ is a moving beast and is best looked at as average over time. Multpl.com kindly provides a S&P 500 P/E 10 chart based on Robert Shiller’s data which they update daily. Today’s chart is below, showing the PE 10 sitting a 23.8.
Benjamin Graham introduced the idea of viewing slices of time rather than points in time, well actually it was probably some Greek philosopher, but Graham bought it to the investing public.
While the current P/E10 is historically high it is still only one metric, is backwards looking and includes a couple bad years that will soon fall off the end, yeah those stinkers of 2001 and 2002 really were around ten years ago. However the P/E 10 is what it is and at 23.8 it’s high, so we may as well have a look at what Robert Shiller’s Cyclically Adjusted Price Earnings Ratio P/E10 or CAPE for short shows the historic forward returns to be based on various P/E 10 levels. Hey do we even need to look? No we don’t, the answer is obvious, but we may as well take a look now that I’ve bought it up. As the average CAPE was just over 16 I examined the data in buckets of under and over 16, over 20 for those who like round numbers and over 23 to reflect the current level. First up is a scatter chart shows the higher the CAPE the lower returns and the fewer extremely good returns.
Scatter charts can be a bit overwhelming so I’ve also summarised the data by average returns.
It seems pretty clear that if you want good returns you should be looking to invest when the P/E 10 is under 16, but hey at least on average the current reading of over 23 gets you better one and two years returns than CAPE’s over 16 and over 20. Without digging into the data I’m prepared to guess that simply shows the parabolic nature of market peaks. Yes the current reading is a real downer for anyone with a 3-5 year time horizon, but cheer up you’re likely to get a positive annual .25% return for the next 10 years.
It’s late and I haven’t even got to the starting point of this post, which was this great post by Vitaliy Katsenelson. VK used the following great chart to highlight that the E in earnings is as I’ve been saying a complex beast, although it is based on simple concepts like profitability. He highlights that the current profit margin, like the current P/E 10 is at an unsustainable level and does a wonderful job of refuting many of reasons cheap market theorists currently put forward for margins won’t revert. Why is that the same people who use simplistic snap shots in time like the current P/E ratio often sit in the it’s different this time camp? Could it be that there brains are wired to fool them? Or perhaps they’re simply looking at a shorter time horizon which makes the market look cheap and from their perspective it may well be.
Putting it all together I think the above shows what is pretty obvious anyway. The US in an economic recovery, a cyclical bull market, with peak margins due to cost cutting, an abundance of near free money and current rebounding revenue making the market appear cheap when viewed through the simplistic moment in time P/E filter. While a cursory scratch at the surface highlights that forward returns may be good for a year or two, the market is priced too high for strong multi-year returns. Yes great stocks will outperform and yes great value and growth stories exist in all markets. If you’ve got a track record of picking them and outperforming in all market conditions then keep up the great investing. Other investors should be paying attention to the in-flight safety demonstration and checking where their nearest exist is.
If the US market appears cheap when viewed through your moment in time P/E filter, then perhaps it’s time to change your filter.
Related posts:
Dean,
Do you think VK’s definition of Profit Margin as US Corporate Profit / US GDP is really appropriate?
Simply looking at the S&P data for the S&P500, I get a trailing S&P500 profit margin (based on GAAP Sales and GAAP Profit) of ~8% (8.16% if you use their projected Q4 ’10 data and TTM weight for both S and E).
Looking at US ratios for global companies I think shouldn’t be done. I agree that margins are high, but I don’t trust the way VK presents the data… seems like actually tracking individual company margins shows a truer result. Maybe showing a Global Equity / Global GDP ratio would say something, but I think for the US, this kind of ratio makes no sense as it introduces obvious sku in the direction of overvaluation…
My 2 cents.
Ben
Ben, thanks a lot for your comment, challenging questions like yours is one of the main reasons I post my thoughts here. I need to think about this and look at the past data for S&P500 profit margin calculated your way, which I agree is more sensible. Having followed VK for a while I imagine historic GAAP sales and profit calculated your way will not show such as pronounced a peak as his data.
Data aside I’m not finding many bargains at the moment, which leads me to have a market is not cheap bias, rather than face facts that I’m just not looking very hard
. The only way I can see this market is cheap over a five plus year time frame is to think the America’s problems are behind it and a long period of sustained growth are ahead. What sort of odds would you place on that? Do you think the market is cheap/expensive or are you indifferent? I think the highest probability is we’ll soon come across that can again, you know, the one that was kicked down the road.
Australian investors looking to invest in the US may wish to consider Ben’s firm Remick Capital. His returns and philosophy are excellent and with low AUM he has a long way to go before hitting any size wall. Of course that is not advice and you should do your own research.
Dean, I tend to agree that the market is expensive. I also tend to be a bit indifferent to that fact as I like to try to focus on individual names. I do try to put a little work into this profit margin / mean reversion angle though, because at extremes, I think the market will overwhelm all individual stock picking skill. I don’t think we are as out of whack as VK’s numbers would imply, but 20-30% rich for the total market may not be too far off.
I’ve been playing around with the profit margin data over the years… and while it is intuitively satisfying, I’ve never felt compelled to buy Japan based on the inverse logic (low margins reverting to ‘normal’) and so it’s tough for me to think of selling some good US stocks due to high margins.
It is something I think about off an on though.
Thanks for the discussion.
Ben
Ben, in a quick look for data this morning I found William Hester at Hussman Funds uses your method. His post from November 2006 is an excellent read http://www.hussmanfunds.com/rsi/profitmargins.htm . This post by John Hussman is also worth a read http://www.hussmanfunds.com/wmc/wmc050808.htm
Work to do, I’ll do more digging later.
“Putting it all together I think the above shows what is pretty obvious anyway. The US in an economic recovery, a cyclical bull market, with peak margins due to cost cutting, an abundance of near free money and current rebounding revenue making the market appear cheap when viewed through the simplistic moment in time P/E filter. While a cursory scratch at the surface highlights that forward returns may be good for a year or two, the market is priced too high for strong multi-year returns. Yes great stocks will outperform and yes great value and growth stories exist in all markets. If you’ve got a track record of picking them and outperforming in all market conditions then keep up the great investing. Other investors should be paying attention to the in-flight safety demonstration and checking where their nearest exist is.”
Well done Dean, no forecast will ever be accurate but investors would be far better of focusing on the probable as opposed to the possible! For an individual investor making this decision is pretty straight forward….. implementing it on behalf of investors (as an asset manager or adviser) is however a tall order, esspecially if the near term positive results play out as you (and I) suspect.
Oh and a side note, despite many attempts I have been unable to find this data for an Australian assesment…. have you had any luck here Dean??
Hi BB, I have a never ending side project of trying to accumulate Australian market data, it is a frustrating project as so much is readily and freely available for the US market. What data are you after?
This page of Damodaran’s may be of interest to you http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html
Unfortunately I don’t have a link, but I’m pretty sure that Jeremy Grantham has said that margins are above average. I think he works out the fair value by assuming average profit margins and average 10 year PE. I think his fair value estimate for the S&P is around 900.
Dean Unrelated question – Do you have any articles / thoughts on the Australian house prices?
Hi Dave
Thanks for your comment, I have the utmost respect for Grantham and his dream team.
On Australian house prices I sit firmly in the Keen Camp, that’s is residential RE is overvalued and will fall or at best stagnant for a number of years. I first posted about it May 2009, which in hindsight was a tad early, but exactly when bubbles will pop is impossible to know.
I commented yesterday on another post “Here’s one more idea that could topple this commodity based house of cards. When the AUD starts to fall, inflation will quickly rise as it has only been kept in check by the strength of the AUD. Inflation rate rise will bring interest rate rise which will make Australia’s over priced real estate suddenly un-affordable (as if it is affordable just because rates aren’t currently high), -> mass exodus from RE, massive popping of wealth bubble all the while AUD will continue falling.”
Leith van Onselen at the The Unconventional Economist has posted a lot of great stats on Australian Housing.
I was speaking to a bank worker the other day and he commented that he’d just been in an email war with their economists about housing prices. The economists said demand is too strong to allow prices to fall. When this bubble pops they’ll all be saying no-one saw it coming.
Business Insider Article
Shiller’s PE misrepresents S&P 500 valuation
The current Shiller PE of 24x is 50% above its 1900-2010 average of 16x. While we would normally take concern with a valuation measure 50% above its long- term average, we encourage investors to ignore this one. We believe Shiller’s $55 inflation-adjusted 10yr trailing avg. EPS is not a fair representation of normalized EPS for 2010 and prefer our $90 Equity Time Value Adjusted (ETVA) 10 yr. avg. EPS. The current ETVA PE of 14.7x is almost a multiple point lower than the 50yr
average of 15.6x and is well supportive of our 1400 year-end target.
Shiller’s PE understates normalized EPS
Shiller’s PE cannot be fairly compared across time because it neglects substantial shifts in dividend payout ratios over the last 110 years. Anytime the dividend payout ratio is not 100% EPS should rise with inflation plus the return on reinvested earnings. This is called an Equity Time Value Adjustment (ETVA). Shiller’s EPS does not fairly represent normal EPS because it assumes EPS only
grows by inflation, which given a decade of high EPS retention, is flawed.
Read more: http://www.businessinsider.com/robert-shiller-pe-ratio-2011-4#ixzz1JBHgcYdf
Some of the comments are particularly good on this article.
Hi Dean, I covered the bullish/bearish sentiment along with CAPE in a recent post on MacroBusiness.com.au
http://macrobusiness.com.au/2011/04/bulls-in-charge/
Thoughts? Profit margins seem to be super high, how much further can US businesses cut to the bone, with employee layoffs and productivity gains and the lower USD?
Great site btw. Hope to see more.
Cheers
The Prince
aka Chris
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