Market Valuations Today
Board: Berkshire Hathaway
Even if earnings fall 25% from current levels, stocks would still sell at a P/E ratio close to their long-term average. If earnings stay at current levels forever, stocks would still be a great buy, Siegel says. "You don't need growth to justify these numbers," he says. "And if we actually earn $112 next year? Oh, god. It's a bonus. You'll see stocks up 30% or 40%."
Thinking about second-order effects, if earnings came down 25% or were perceived to be in danger of coming down that much, corporations would be cutting as many jobs as they could. That would be pretty bad for aggregate demand, which then feeds into expectations from that point forward.
Ben Graham thought about what is now called CAPE, or cyclically adjusted price / earnings, which looks at trailing ten-year P/E. By that measure, the market is not all that cheap-looking at 21x real trailing 10-year earnings. Yes, the trailing earnings yield is higher than 10-year treasury rates, but the ratio of trailing earnings yield to rates is also not very attractive relative to history, especially when you consider the danger to valuation if inflation heats up due to monetary policy actions of the last (pick here) three to 25 years.
Hussman expands on some of this.
I pay little attention to strategists, but I do pay attention to Hussman and Rob Arnott, who are both theoreticians and practitioners (and really good at both).
Arnott and Bernstein lay out in a few different papers (What Risk Premium Is Normal? among these, link below) the sources of equity market returns that lay waste to the Siegel approach. First, Arnott and Bernstein document thoroughly why the 5% "equity risk premium" (or excess return earned by equities vs. 10-year treasurys) is not correct, concluding 2.4% is more in-line with reality. That means equity investors may look forward to returns of 4.6% annually over the next ten years. Without Fed intervention, 10-year treasurys could actually trade closer to 4.8% to 5.4%, given the long-term spread of 2.82 percentage points between inflation and 19-year treasurys, the most recent GDP deflator of 2.6%, and TIPS-implied inflation expectations of 1.98% (TIPS-implied inflation expectations reflect a market which the Fed is "involved" with, which some might use the term "manipulates"). If that were the case, valuation relative to rates would be actually be pretty bad, in the bottom quartile of months from 1870 to the present, using Schiller's data.
Arnott lays out a useful formula in the above-mentioned paper for calculating expected equity returns. They depend on opening and closing dividend yield (one might use P/E), real GDP per capita growth, and a dilution factor for creative destruction and stock option dilution offset by share repurchases. Let's say $95 is an OK place to start with S&P 500 earnings. At 12.9x earnings, if we get 2.0% real GDP growth and that translates to 1.5% real GDP per capita, then you get 1.5% real dividend growth if you're not diluted by management or enhanced by share repurchases. That gets you a real return of 3.5% over ten years and a nominal return of 5.5%. That's for the market overall with no valuation change. Let's say the P/E goes to 15x at the end of ten years. That gets you a 7.0% return over that time. If payouts rise 10 percentage points from the paltry current level around 26%, you get a 5.9% 10-year return with no valuation expansion.
The bad part of all of this is interest rate risk. If the rate on 10-year treasurys rises by 100-200 bps, you get lots of money lost in treasurys and the risk of valuation compression if that comes from higher inflation expectations.
I believe one thing that could bail us all out is innovation in energy production and usage, new educational modalities, changes in food production technologies, nanotech, or a host of other advances. In other words, human ingenuity can break the deadlock on "The New Normal." Over the last 54 years, per capita GDP grew by 2.0% annually. Can we do better? Yes, but that's not a sure bet at all. Let's say we did, though. If we did 2.5% real per capita GDP growth, we had increased payouts, boards on overage bought back a net of 1.0% per year, and the ending P/E expanded to 15x, the 10-year return on the market would be 9.4% annually. That's not my forecast, but that's about what it would take to get there, according to Arnott and Bernstein's work.
This is why it pays to be in companies that have good dividend yields, good competitive positions where competition won't erode the moat, where capital management doesn't squander the moat and where management doesn't take your wealth but knows how to enhance it through buybacks, and where overall valuation is reasonable . It also helps to be in geographies where GDP per capita growth is attractive. I would also add a factor for default risk, to which bad balance sheets expose investors. If you have all those things working for you impeccably well, 11-14% equity returns are possible without valuation expansion.
I think there is margin risk in the overall market today, especially considering so much of the market caps of the major indexes are represented by cyclical industries where suppressed interest rates and easy capital markets access plus government fiscal stimulus globally have juiced up economic output. In my opinion, there are pockets of attractive valuation in companies with good capital allocation, attractive competitive positions, reasonable current valuations, and good growth exposures.