It is an observation that is commonly referenced by market pundits including yours truly. Today's stock market is expensive. It is more expensive than it was during the height of the roaring '20s bull market in 1929. In fact, it is as expensive as it has ever been save the wildest days of the technology bubble at the turn of the millennium. But is today's stock market really that expensive?
Let's start with the basics. Today's stock market is expensive by historical standards. At present, the U.S. stock market as measured by the S&P 500 Index (SPY) is trading at 25.4 times trailing 12-month as reported earnings. This represents a more than 60% premium that investors are paying today versus the 15.7 times historical average over the long-term. And when viewed in the context of nearly a century and a half of stock market history, we see that stocks (IVV) have only been as expensive as they are today on a rare handful of occasions, or just six times to be exact, dating back to the 1870s.
But what of those past six instances. It should be noted that five out of these six past valuation "spikes" that occurred in 1894, 1921, 1933, 1992 and 2008 came not because the "P", or price, in the numerator of the P/E ratio was necessarily steadily rising higher but instead because the "E", or earnings, in the denominator of the P/E ratio was falling. More simply, valuations spiked during these time period because things were going so poorly from an earnings perspective, not because the stock market was booming.
To smooth out the effects of these profit recessions in viewing valuations, we can turn to the 10-Year Cyclically Adjusted Price To Earnings ratio. By this well-publicized measure that should be emphatically noted is not useful at all in predicting stock market inflection points but instead is more relevant in determining longer-term market trends including expected returns over extended future time periods, we see that stocks (DIA) at 32.4 times earnings have only been this expensive twice before in history - dubiously in 1929 and in the late 1990s. And they are nearly double the historical valuation of 16.8 times.
So by these measures, stocks (QQQ) are indeed about as expensive as they have ever been.
Premium Prices In Perspective
But viewing stocks (VOO) through these absolute and historical relative lenses does not tell the entire story. For stocks are not valued in a vacuum. Instead, their valuation at any given point in time is influenced by a variety of related factors. These include the yield an investor can receive on a lower risk investment alternative such as a high-quality, AAA-rated, long-term, 10-year bond such as U.S. Treasuries (IEF). This also includes what the prevailing inflation rate might be at any given point in time. And it includes the level of short-term interest rates as dictated by policy makers such as the U.S. Federal Reserve. All of these are key determinants in determining whether stocks are truly expensive at any given point in time even if they may be priced at a meaningful premium on an absolute basis relative to their long-term history.
With this context in mind, let's first consider stocks relative to bonds (TLT) from a valuation perspective. In order to establish a basis of comparison, let's take the price-to-earnings ratio for stocks on a trailing 12-month GAAP basis and invert it. This leaves us with what is known as an earnings yield (E/P ratio), or how much in earnings an investor has generated through their ownership of the company as a percentage of the underlying stock price. This provides us with a more comparable metric that we can compare to 10-year bond yields, which is the interest an investor has generated through the ownership of the bond as a percentage of its underlying price. And by taking the earnings yield for stocks less the yield for bonds (BND) throughout history, we can construct a historical equity risk premium, or how much extra in yield investors required at any given point in time to assume the additional price volatility of owning stocks over holding bonds (AGG) instead.
Now when making this comparison, stocks are more expensive the lower the equity risk premium. As a result, we will show this chart with an inverted scale. Thus, a higher the premium implies that stocks are less expensive and lower on the chart, while a lower premium implies that stocks are more expensive and higher on the chart. This view yields us the following:
When considered in the context of current bond interest rates, we see that while stocks today are still priced at a premium, they are actually far more reasonably priced, particularly when considered in the context of the past few decades. More on this point in a few minutes.
But what about on a longer-term valuation basis such as CAPE. How do stock valuations look by that metric when considered against current 10-year bond yields?
Once again, we see that stocks while still at a premium are much more reasonably valued relative to bond yields.
Let's continue on to compare current stock valuations to another important metric in inflation. The following are charts of what could reasonably be described as a real earnings yield, or the E/P ratio for stocks over a trailing 12-month and CAPE basis less the inflation rate.
What we see in the two charts above is that stocks are indeed priced at a measurable premium by this measure relative to history dating back to the 1870s, but are not yet back to what would be considered historical peak levels.
An important observation does stand out when viewing these inflation related charts. Up to around the mid-1950s, the relationship between stock valuations and inflation was highly volatile. But since the mid-1950s, this relationship has become much more stable and predictable. Thus, it is worthwhile to consider this relative valuation over this more recent and arguably more relevant time frame.
Here we see an even more reasonable valuation story. Stocks are not that far above fair value relative to inflation since the mid-1950s on a trailing 12-month GAAP basis, and while they are a bit more expensive on a CAPE basis, they are still far from what would be considered previous peak valuations by this measure.
We will continue with our next step in taking a look at current valuations relative to the effective Fed Funds rate from the U.S. Federal Reserve. As introduced in a recent article, we will use a combination of data including the effective Fed Funds rate from July 1954 to the present, the discount rate for the Federal Reserve Bank of New York from November 1914 to July 1969 and the commercial paper rates for New York, NY from January 1857 to December 1971 to construct a representative historical time series for this data over the long-term time period in question here.
What we find here is particularly notable. First, stocks are effectively trading at no more than fair value with a very marginal premium relative to history on a 12-month GAAP earnings versus Fed Funds interest rate basis.
And while they are a bit more expensive on a CAPE basis versus Fed Funds, they still remain at a relatively modest premium from a long-term historical perspective that is well below historical peaks.
Conclusions So Far
U.S. stocks are as expensive as they have ever been on a historical, standalone basis. But while they are also priced at a premium today when considered in the context of bond yields, inflation and the Fed Funds rate, this premium is far more reasonable from a historical perspective and in some cases are notably close to fair value.
Why Then The Fixation On Stocks Being Expensive?
OK. So if this is the case, if stocks are actually not all that expensive relative to bonds, inflation and the Fed Funds rate, why then Parnell do I constantly hear you among many others constantly harping on the fact that stocks are so expensive today? Here are some of the reasons why it remains an important focus from my perspective.
Stock valuations as measured by the P/E ratio are derived in isolation from two key variables. These are stock prices and the underlying corporate earnings that these companies generate. As a result, we have two moving parts and how they relate to each other at any given point in time that go into the determination of this important valuation number. And as we saw when we focused first on the trailing 12-month P/E ratio that was not smoothed for the business cycle, we saw that most of the highest P/E ratio readings in history came not when stocks were necessarily "expensive" because the "P" was rising but instead because the "E" was collapsing far more rapidly than the "P" was falling. In other words, it is a number that is subject to distortion, which is one of the reasons that the longer-term CAPE exists to smooth out these potential distortions at any point in time.
Simply in isolation, the P/E ratio is a number that is subject to interpretation.
With this in mind, now consider the comparisons highlighted above including the equity risk premium of earnings yield less bond yields, the real earnings yield and, the earnings yield premium over the Fed Funds rate. Now we are talking about a reading in isolation that has two moving parts and comparing it to other readings that have various moving parts of their own. As a result, the potential for distortions in the readings at any given point in time or even over an extended period of time is meaningfully greater.
Why does this matter? Consider where we are today and where we have effectively been throughout the post crisis period over the past decade. We have near record high stock valuations. We also have near record low bond yields. We also have chronically low inflation. And we are just now emerging from the most extraordinary monetary policy experiment the world has ever seen that included holding interest rates pinned to the floor at zero.
Now when you combine all of these elements together in a comparative mix like we have done in this report, things can look both stable and attractively valued. But what can be overlooked when focusing on these combination metrics is that each of the individual elements that make up the combination are at historical extremes and thus may be inherently unstable as a result - stocks at record high valuations, bonds at record low yields, historically low inflation, record low Fed Funds rates. Put more simply, when things are historically extreme or unprecedented, the natural forces of gravity typically do not pull them to become even more extreme and unprecedented. Instead, gravity typically will eventually pull all of these categories back to their mean.
- For stocks, that's a P/E ratio in the 15 to 17 range, not 25
- For bonds, that's a 10-year yield around 4.5%, not 2.4%
- For inflation, that's an annual reading near 2.2%, not below 2%
- For Fed Funds, that's a level of around 4%, not at or near 0%
If any or all of these other mean reversions with bond yields, inflation, or the Fed Funds rate play out as so many are anticipating going into 2018, all of the sudden these still somewhat reasonable but still at a premium relative valuation metrics start quickly blowing up to the top end of their respective ranges if not beyond their historical extremes. Will the historically high P/E ratio in isolation go unscathed and avoid mean reversion itself under such a scenario? Likely not.
Of course, none of this takes into consideration what might take place within the P/E ratio itself. For stocks have reached these peak valuations not because the "E" has collapsed. Instead, earnings recently reached a new all-time high on a trailing 12-month GAAP basis. So we have an all-time high "P" divided by an all-time high "E" leading us to our near all-time high "P/E". Put simply, this is a dangerous mix. Why? Because unlike past episodes where the high "P" had a lot of room to receive support from a depressed "E" that was ready to bounce back, today's high "P" needs an "E" that is already at record highs to continue vaulting even higher. Considered differently, it is much easier to jump high when your knees are bent than it is when you are already standing on your tippy toes.
Now it should be noted that the future looks bright for continued growth in the coming year. This outlook is well founded given the recent strength of earnings growth coupled with the measurable tailwind coming from the recent tax legislation that includes major corporate tax cuts. But it cannot be overlooked that the future also looked bright for earnings heading into 2000-01, 2007-08, 2012 and 2014-15, yet things did not necessarily play out as forecast from an earnings perspective in any of these years. And if it turns out that earnings end up falling short of expectations at the same time that bond yields, inflation, and/or the Fed Funds rate are mean reverting, then you are talking about both relative AND absolute valuation measures that are suddenly blowing out to record extremes across the board. Could historically high stock prices maintain such great heights under such a scenario? Extremely unlikely.
The Bottom Line
Stocks are indeed expensive on an absolute basis. But they are fairly reasonably priced on a relative basis versus bond yields, inflation and the Fed Funds rate. This is certainly positive and is constructive for further stock price gains as long as all of these conditions continue to hold.
But do not become lulled into complacency simply because these more reasonable relative valuations exist today. For each of the underlying components that make up this reasonable valuation in aggregate are in isolation at historical extremes. And if any component begins mean reverting in a meaningful way, which it should be noted is the baseline forecast for 2018 from many leading market prognosticators - higher interest rates, higher inflation, multiple rate hikes from the Fed - these currently reasonable valuations could quickly shift to historically extreme premium valuations in their own right. And it is unlikely that stocks would emerge completely unscathed from such a scenario. This is true if corporate earnings continue to rise. And it is likely to be exponentially more so the case if corporate earnings also start to fall short of expectations in the process.
Putting this all together, stay long stocks and continue to feast on the scrumptious meal that is being served by these "goldilocks" capital markets for so many years now. But do not give into complacency and overlook the underlying risks that continue to manifest themselves in today's markets. Stay long, but be prepared!
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long RSP, TLT, IEF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.