In financial market punditry, it is not hard to find statements asserting that stock valuations are "fair" or "average." While it may be true that index level P/E valuation statistics derived from forward earnings on market-capitalization-weighted averages are giving that signal (first chart below), it's also true that stripping out some of the biases associated with this metric gives a completely different signal.
At least two problems come to mind with the standard methodology used to derive index level valuation statistics. First, forward earnings, as we all know, are based on analyst estimates that are often (or usually, as the case has been) revised lower. Second, using market capitalization to weight the P/Es results in the P/Es of the largest companies in the sample dominating the derived result. Since a few mega-cap companies represent a preponderance of the market capitalization of many indexes, this bias can be huge. Indeed, in the case of the S&P 500 the largest 50 companies represent 48% of the market capitalization of the entire index.
One method that can be used to strip away both of these biases is to measure the valuation using the realized financial history of the median company in an index. When we measure valuations in this way we see clearly that, with the exception of the MSCI Pacific Index, the median P/E is closer to the peak valuations seen in 1999-2000 and 2007 than to the 15-year average.
When we focus the study just on North American stocks and expand the valuation analysis to include price-to-sales, price-to-cash flow, and price-to-book value, we cannot find much evidence that the median stock is fairly valued at the moment. Indeed, the P/S and price-to-cash-flow metrics are at or near the highs seen over the previous 15 years.
Valuation statistics measuring the valuation level of market-capitalization-weighted averages are flawed. One way to adjust for the embedded flaws is to measure the valuation of the median company in an index using realized financial results. Using this method one finds that the median stock is far from fairly valued and in some cases is actually at the highest valuation level seen over the last fifteen years.
The implication for active investment managers is that it has become harder and harder to find stocks trading at bargain levels and that the opportunity for alpha generation from valuation expansion has lessened dramatically. This means that to be a buyer at these levels one must believe financial results will catch up with valuations.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.