While the world may be less nervous than it was, it’s important not to forget that the world is still in recession and profits are still going down, not up. It’s a well-worn truism, of course, that stock markets move ahead of the real economy, but it’s unclear to us whether we’ll see either a huge rebound in growth or, at some point, a sustainable surge in corporate profits. And all that is hugely important, because a world that has been stabilized but is merely limping along and where profits are far harder to come by is a world in which equities are likely to struggle over the longer term.So What’s My problem With Stock Valuations?
Why aren’t equities a screaming buy? Well, one reason of course is that multiples aren’t, in fact, that low by historical standards, because profits have fallen so much. The S&P’s trailing PE, even on operating profits, is a hardly low 18x. On an as-reported basis, it’s, ahem, 62x. Ah, comes the reply, but multiples rise in advance of a recovery and having been hammered so much, profits should rebound strongly since costs have been cut so much. Multiples, then, will be a lot more comfortable.
One way to strip this effect out is to compare current equity prices with ten-year average profits, à la Graham and Dodd, since this will tend to fall even though, as is the case now, the trailing multiple rises very strongly indeed. To put this a slightly different way, a G&D type methodology allows you to strip out the effects of the economic cycle on corporate profits. But even this doesn’t make equities very cheap.
As we’ve said before, the S&P 500 valuation has often bottomed on a G&D valuation of 10x, and in the early 1930s it bottomed at 5x. It’s now 18x. So stocks are a lot cheaper than they were, but not even by the wildest stretch could they be called arrestingly cheap.
There are 2 central flaws in most equity valuation models at the moment.
Firstly, they are distorted by the risk-free rate which they use i.e., the 10 year government bond yield rate being so historically low. Secondly, they assume that the developed world will return to its medium term “trend” growth rate relatively seamlessly when, as was the case with Japan in the 1990’s, the potential rate of growth actually may have declined. This may well now happen again due to huge fiscal deficits, higher taxes, increased household and corporate saving and greater government intervention in the financial system. Recall that the Nikkei is still 70% below its 1989 level.