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I find valuation metrics to be notoriously dreadful ways to make specific investment decisions. For instance, the PE ratio is essentially an inefficient price divided by the future guesstimates of an inherently flawed analyst community (or in the case of trailing PE we’re using a rear view mirror approach – equally distasteful for future investment decisons). On the other hand, valuation metrics can provide some insight into a macro market approach when viewing the environment from 30,000 feet. In addition, a great many investors derive their investment decisions using these metrics so ignoring them entirely in favor of ones personal beliefs is clearly flawed methodology.

Over the holiday weekend the always excellent Alan Abelson of Barrons noted the current environment’s unusually pricey status:

Moreover, at 20 times this fading year’s earnings, stocks hardly stack up as outrageously cheap. On that score, the latest calculation by Andrew Smithers, the smart Brit who runs the eponymous London-based investment firm Smithers & Co., is that U.S. equities are more than 70% overpriced, according to q, his favorite yardstick and essentially a measure based on replacement value.

Of course, Mr. Abelson is using the rear view approach in his PE calculations. The forward looking PE is just 13.3 – cheap by historical standards, however, as I mentioned above the usefulness of this indicator is easily questioned. A more diverse look sheds some light on the picture.

Few analysts break down market value and future potential returns better than John Hussman. In his latest missive Mr. Hussman says stocks are likely to return just 3.6% per year in the coming 10 years – well below the norm (click on chart to enlarge):

On the valuation front, the consensus estimate from the strongest models we track indicates that the S&P 500 is most likely priced to achieve 10-year total returns averaging about 3.6% annually. Given the inverse relationship between the Russell 2000/S&P 500 ratio and subsequent relative returns for the Russell 2000, I expect that returns will most likely be negative for small-cap stocks over the coming 4-year period, even without the assumption of renewed economic weakness.

Robert Shiller’s cyclically adjusted PE removes much of the noise in the standard PE ratio. Valuations peaked at 27.5 during the most recent bull market. This is well above the current ratio of 22.7. During the dotcom bubble the ratio hit 45.7. Since the Greenspan Put (now the Bernanke Put) became a permanent component of the modern day equity market stocks have experienced abnormally high valuations. While stocks do not appear cheap since the inception of the Put the current ratio is high by historical standards (click on chart to enlarge):

Warren Buffett has previously stated his favoritism for comparing the entire equity market valuation to GNP. As I mentioned a few weeks ago this valuation metric is mildly overvalued by 3%, but has also become increasingly stretched as the years have gone by (click on chart to enlarge):

Like the Shiller CAPE Tobin’s Q ratio has been remarkably consistent throughout history, however, appears to have lost some of its prescience in recent years. The Greenspan Put is clearly having an equally skewing impact on the ratio, which currently shows stocks stretched (chart via dshort.com click to enlarge):

Clearly, the evidence is inconclusive at best. From a historical perspective the market appears expensive, however, history has rarely experienced times such as these. Over the last 20 years we have experienced an unprecedented financialization of our economy. The Greenspan Put has morphed into the Bernanke Put and investors are happy to capitalize on an environment in which losers are not losers. This likely means we have to throw the old playbook out the window.

While these usually reliable valuation metrics show an excessively or mildly valued market there is nothing in the evidence from the last 20 years that says stretched valuations can’t become extremely stretched. Just try not to be the one left standing when the music stops. Given the Fed’s non-stop intervention it might be safe to conclude that the music is loud and unlikely to be turned down (and certainly not stopped) any time soon.

Source: Equity Valuations Are Stretched, But Does It Matter?