Equity Valuations Have Improved Dramatically

With the price plunge which started in early October, the P/E ratio of the S&P 500 (using Bloomberg's measure, which is based on 12-month trailing earnings from continuing operations) has fallen from a high of 23.3 last January to 16.48 currently. To put this into perspective, consider that today's P/E ratio is below the 60-year average of this measure (16.9), and it is about equal to the market's P/E ratio just prior to the onset of the Great Recession. Relative to the current yield on 10-year Treasuries (2.79%), stocks now boast an earnings yield (the inverse of the P/E ratio) which is 3.3 percentage points higher, whereas it was only 2 percentage points higher at the end of 2007, and it has averaged only 0.4% over the past 60 years. Looking ahead, the S&P 500 is priced to a mere 14.2 times 1-year forward expected earnings. In short, and during the course of a year in which the economy has grown 3%, stocks have fallen from an arguably overvalued level to now outright cheap. And the Fed hasn't even begun to tighten monetary policy (though the market certainly fears it will).

Clearly, the market has lost a tremendous amount of confidence in the staying power of earnings and the health of the economy. Otherwise, stocks today would be a screaming buy relative to just about any other risk asset. Sure, there are lots things to worry about: Trump, China, tariff wars, a US slowdown, and another government "shutdown." But there is nothing preordained about how these worries will be resolved. Lots of things can change, and meanwhile, the economy's fundamentals remain rather healthy (fabulous corporate profits, very low unemployment, rising wages, a reasonably strong dollar, unusually high consumer confidence, and very low swap spreads). It's not hard to be optimistic when the market is suddenly so pessimistic.

Chart #1

As Chart #1 shows, P/E ratios last January climbed to a high of just over 23 on the strength of corporate tax cuts (and the promise of higher after-tax earnings). Now that the tax cuts are a reality and we've seen the growth in corporate profits, it makes sense for P/E ratios to back off a bit. But to a level that is below the long-term average?

Chart #2

Chart #2 shows the difference between the earnings yield on stocks (the inverse of the P/E ratio, and the dividend yield that would accompany stocks if corporations paid out all current earnings in the form of dividends) and the risk-free yield on 10-year Treasury bonds is 3.3%. Investors currently demand an additional 330 bps of yield in order to accept the perceived additional risk of stocks vis-a-vis Treasuries. More often than not, however, the equity risk premium is far lower than it is today. During the boom times of the '80s and '90s, the equity risk premium was negative. Investors were so confident in the stock market that they were willing to give up yield in order to benefit from an expected price appreciation. Once again, investors are consumed by pessimism and fear.

Chart #3

Chart #3 shows the latest estimate of after-tax corporate profits (this accompanied last week's revision to Q3/18 GDP figures). Profits surged some 20% in the year ending last September. Similarly, 12-month trailing reported (GAAP) profits grew almost 23% in the year ending last November. And now the market seems to be thinking that all of this will go up in smoke.

Chart #4

Chart #4 shows the ratio of corporate profits to GDP (using the ratio of the two lines in Chart #3). Profits have been running at the historically unprecedented level of 10% of GDP for most of the past 9 years. Maybe this is unlikely to continue; maybe profits fall back to 8% of GDP. That would still be well above the long-term average. Why shouldn't P/E ratios also trade above their long-term average, especially considering the generally low level of interest rates?

Chart #5

Chart #5 compares the earnings yield on stocks to the yield on BAA corporate bonds (a decent proxy for all corporate bond yields). Corporate bondholders get first claim on corporate profits, with equityholders last in line. Since the yield on corporate bonds is a safer yield than the yield promised to equityholders, corporate bond yields typically trade below equity yields. The periods during which the reverse holds (i.e., when equity yields exceed bond yields) were generally dominated by fear: e.g., the late 1970s, the years following the Great Recession, and now.

Chart #6

Chart #6 compares the market's worry levels (the Vix/10-year ratio) to the level of stock prices. We're deep within another bout of anxiety, and prices have fallen some 18% from their recent all-time highs. It's not hard to imagine fear reaching even higher levels - commensurate with prior episodes of panic attacks - and prices even lower levels. But at today's levels prices are "vulnerable" to any good news. Maybe the Fed will reconsider its plan to raise rates twice next year; maybe China will deal (actually they already are offering concessions); maybe the government shutdown won't prove any more painful than before.

Some words of wisdom distilled from several famous investors: 1) The price of a stock is only important on the day you have to sell it; 2) One should delight when stocks become cheap, not despair.