If you watch the talking heads on TV or read financial articles online -- or even here on Seeking Alpha -- you've probably been hearing/seeing several market pundits calling for a correction, or asking whether the market is overvalued. The U.S. market has definitely gotten off to a fast start this year (the S&P 500 was up 6.6% as of this writing), and hasn't really corrected more than 5% since last October when the S&P 500 went from 1450 to 1350 in about a month. Prior to that is was May 2012 when it corrected 9% from 1405 to 1278. For a correction greater than 10%, you must go back to late July and early August 2011 when the market dropped almost 17% in two weeks when Europe was about to disintegrate. Below is a 15-year chart of the S&P 500.
Click to enlarge image.
Source: Yahoo Finance.
They also talk about how the market is up 122% since the bottom in March 2009, and it is all being driven by accommodative Central Banks. So, yes, the market has come a long way in what will soon be four years. But remember where we came from and how bad the climate was over those four years. And, yes, central banks around the world have been providing easy money and at some point must pull in the reigns. Granted, we are still dealing with a stubbornly slow economy and the rest of the world has its own issues, but I believe we are in far better shape than in 2008 and 2009 when we were in crisis mode in the U.S. Although Europe is in a recession and has many unresolved issues, it is seemingly on a better path than just last year.
Since I am a numbers man and believe in the facts (see my earlier article here), I decided to go back and look at the historical data to see where it leads. I pulled information together to check on valuation, dividend yields, earnings, the 10-year UST Yield, and the level of the market since 1960. I went back to the end of 1960 because I was born in 1961 (but conceived in 1960) to see how the market was valued and has performed during my lifetime. Below is a summary of the data.
1960-2012 S&P 500 Historical Data
|EPS Yld||Div Yld||EY/DY||PE||EY/10yr||Mkt Gain||EPS Gain|
The above table summarizes data from the end of 1960 through 2012 for the S&P 500 and the 10-year U.S. Treasury Yield. (EY=Earnings Yield, DY=Dividend Yield, UST=10-year, P/E=trailing 12 months P/E Ratio).
Some of the key findings are listed below for the period 1961 through 2012:
- Since the end of 1960, the market (S&P 500) has basically risen about the same level as the growth in corporate earnings of the constituents over that time period. S&P 500 earnings had an annual average growth of 6.96% since 1960, while the market gained 6.35% annually on average. Adding in reinvested dividends gets you about a 9.75% annual return.
- The average P/E (price/earnings ratio) was 16.13x for the period. At the end of 2012, the trailing P/E stood at 13.92x and currently stands at 14.8x trailing earnings.
- Based on estimated S&P earnings of $113 per share for 2013, the forward P/E ratio is 13.4x (S&P at 1,519 / $113 per share).
- Since the end of 1999 when the S&P stood at 1469, it has only risen 3.4% in total to the current level of 1519.
- At the end of 1999, the P/E ratio was 28.4x trailing earnings -- way overvalued.
- Since the end of 1999, corporate earnings have grown from $51.68 to $102.47, about doubling. The P/E ratio went from 28.4x in 1999 to where it stood at the end of 2012 at 13.92x, about one-half of where is was.
- Since the end of 2008, corporate profits are up 57% to the end of 2012 while the market has risen -- wait for it -- 57%!
- The earnings yield of the S&P 500 at the end of 2012 was 7.18% compared to the 10-year UST yield of 1.91%. The EY/UST ratio is 3.759 compared to a historical average of about 1.21x. 2011 is the only other year where the ratio was above 3x at year-end.
- The standard deviation over the period for growth in earnings is 14.9% and for the market it is 16.4% -- a fairly wide range.
If I had to summarize the one key finding about what drives the market over time, it's pretty intuitive -- when it is all said and done, earnings growth drives the market. The caveat, however, is noted in the last bullet point in that they don't necessarily always go in lock-step. In fact, on a yearly basis there is quite an amount of variability and a low correlation year to year. However, in time, there is clearly a tight pattern between EPS growth and market returns.
If you only look back four years, then the market has come a long way, but so have earnings. And if you go back to the market peak in 2007 and the peak of craziness in 1999 and 2000, then the market has actually acted somewhat rational and allowed earnings and valuation to play catch-up.
The stock market experienced a lifetime of events in the last decade. As a reminder, since 1999 we've had Y2K, 9/11 and recession, the housing bubble, the financial crisis and recession, the euro debt crisis, and a host of other not-so-minor issues. During this time, corporate earnings whipsawed but eventually rebounded and strengthened especially in the last three years -- taking the market with it.
OK, where am I going with this you may be asking? Right here -- I don't believe that the market needs to correct because it is overvalued. The market is reasonably valued based on history and where earnings are today. At a current P/E of 14.8x TTM compared to a historical average of 16.13x since 1960, the market has some "wiggle" room. For the market to rise further without future repercussions, we need corporate profits to grow. It may not be a straight line, but in time the market comes back to earnings growth. And right now earnings are growing, the market is reasonably valued, and the economy is growing, albeit slowly.
What About a Correction?
Now that leaves the question of whether the market needs to take a breather because it has not corrected for a while or for some other reason. Personally, I think a breather would be healthy for the market. Not a -10% correction, but just a few months where we go sideways and consolidate the gains we have made. It seems inevitable that the market will take a break at some point, but I can't prove with numbers that the market does or doesn't need a break. That's for the technicians to debate. However, I think I laid out a historical case that the market is not overvalued based on its last 50 years of trading history -- as long as corporate earnings continue to grow. Say what you want about the quality or sustainability of earnings, the numbers are what the number are.
Sure, there are still a lot of unanswered questions out there regarding a host of issues that I won't name here. You can read about those almost every day. And it is fairly easy to put forth an argument why the market can correct 5%, 10%, or even more. I don't think valuation is one of them, unless you think we are heading back to a double-dip recession and a drop in earnings. But that's a whole other discussion!
In summary, I believe that the market (S&P 500) is mostly rational over time and is currently reasonably valued -- if not undervalued -- based on its last 50 years trading and fundamental history. The move in the last four years has only gotten us back to the level of 1999 while allowing earnings to double since then. If the market does correct or pull back but earnings continue to move higher, the numbers show that eventually the market and earnings grow together.
Note: To view the full data of 1960-2012 used for this article, go to my website and click on "Articles."