The Envestnet Edge, July/August 2016
Valuations: It’s all relative
As stocks climb to new highs, investors question whether today’s equity valuations are realistic. Rather than measuring valuation against a historical P/E benchmark, we suggest examining equity valuations relative to the current prices and yields of other assets given today’s low-inflation environment.
In this relatively static period in the markets, and after a strong run for stocks, we are in the midst of yet another perennial debate about the rationality of markets and valuations. On the one side, we have the usual chorus of gloom, ranging from Jeffrey Gundlach, of bond-behemoth DoubleLine, urging us to sell everything, to multiple market mavens proclaiming wonder and bemusement that stocks continue to grind higher and rates continue to bleed lower. On the other, we have those who suggest that with negative yields popping up globally, we can still go way lower, and that although equities, in turn, may be pricey historically, they are hardly on a run-away bull path.
So what’s an investor to do?
The yin and the yang
Lest you want to stop reading, here’s a spoiler alert: The second perspective has more to recommend it than the first. Prices that we pay for any asset should never be considered either in a vacuum or purely relative to what people have paid for it in the past. We don’t buy a home today and consider it pricey or cheap relative to home prices over the course of the past hundred years. At most, we might look at prices over the past five to ten years. So why should we take either a hundred- or a fifty-year average of equity prices and P/E ratios, or of bond yields, and then use it as a benchmark to assess whether those prices are either reasonable or irrational today?
We should pay much less attention to arguments that the S&P 500 might be overvalued because it is trading at the upper end of a historical average (it is at 2,182.87 as of 8/5/2016). As Figure 1 shows, although the long-term average valuation of the S&P 500 might be 14.97, stocks have actually traded at that average only a few times over the past few decades. Far more often stocks trade either well above or well below their average.
More important still is that valuations should not be considered in relation to prior valuations. Instead, valuation of any asset should be considered relative to other current valuations of other available assets. That means that if an investor has a dollar to invest, the first question should be, “What is available to invest in?” followed by, “How much does each asset cost relative to its risk and expected rate of return?” Calculating risk and expected return are, of course, best guesses about uncertain future outcomes—which is why investors may rely too heavily on past valuation patterns. At least, those patterns are certain.
The question of where to invest must also be considered in conjunction with what investment vehicles are available. For example, an investor with $50,000 to invest most likely will not have access to esoteric, exclusive private equity deals, or to much real estate, or to a host of alternative investment vehicles, all of which have the potential to generate higher returns.
Purely in terms of stocks and bonds (which almost any investor can access), the next question should be, “What are they priced relative to each other?” The current matrix indicates that the safest bonds will yield almost nothing in real, inflation-adjusted terms, whereas equities could well yield quite something (with some attendant risk that they may lose quite something).
Inflation in the United States, according to the latest report, is a tad over 2%. Compare that to the barely 1.5% yield on the 10-year notes, or the yield on other highly rated sovereign bonds, such as Germany and Japan, which will return anywhere from 0 to 1%. If yields continue to fall, that will, of course, lead to some nice price appreciation for those bondholders. The reverse is also true: If yields rise, current bondholders will see losses. But in real terms, bonds earn nothing, although they may also lose nothing, and may provide some income.
As Figure 3 shows, there is indeed a historical relationship between bond yields and equity valuations. To wit, the less bonds yield, the more investors are willing to pay for equities. Once upon a time not so long ago, investors used the so-called Fed model to assess the relative attractiveness of stocks and bonds. The model compared the earnings yield (an inverse P/E) to the bond yield. For much of the past fifteen years, except for 2009, that model has shown equities to be “cheap” relative to investment-grade bonds. No surprise, it shows the same today, with the earnings yield of the S&P 500 about 3.2%, or double that of the 10-year note.
That isn’t to say that equities are a screaming buy. As the second quarter announcement period wraps up, earnings have declined for the S&P 500 for five consecutive quarters, the worst such period since 2008-2009. However, for the first time in a year, revenue has grown, barely, by 0.1%, and the rate of earnings decline in the energy space has not only slowed but also may soon show some expansion. Overall, US economic and global growth is hardly exciting, which adds yet another “meh” mark to the prospects for corporate earnings and revenue.
Nonetheless, there are still trillions of investable dollars being put to work on a regular basis, and each of those dollars has to be allocated somewhere. That is what matters most—rather than where yields or valuations fall on a graph of averages over the past decades.
Where to go
Many investors confess to feeling flummoxed at the dearth of good options for those dollars. It is easy to look at almost any available asset class and feel uncomfortable: stocks overvalued relative to future earnings prospects; bonds yielding little or nothing with the prospect of steep price losses if rates rise; real estate not bubbly but not cheap, sustained only because rates are so low; alternative investments entering the Nth year of underperformance; gold having a nice run, but still a big nada for the past years.
Yet that flummoxed perspective speaks as much to the current sour, uncertain sentiment as it does to current prices. Last year was quite disappointing for most investors, and diversified portfolios struggled to make anything more than zero in 2015. 2016, even with a shaky start to the year and the Brexit scare, has been much better, with diversified portfolios up about 5% through mid-year. That figure suggests that investors are breathing a bit easier, but most of the discussion has tended toward valuation concern and yield worry.
There is always some unquantifiable amount of risk in financial markets—no forecast or analysis will allay that. But in a stable state, we have equities (both domestic and global) that represent companies that, for the most part, are highly profitable and throwing off some dividends that frequently amount to more than the yield on investment grade and sovereign bonds. We also have a global yield and rate environment that, at best, is about equivalent to inflation. In that scenario, it should be difficult to get overly concerned about valuations. That hasn’t stopped people from being overly concerned. But it ought to.
High stock prices are again serving as an impetus for investors to question equity valuations, especially when measured against historical P/E averages. But looking through a rear-view lens reveals that stocks actually traded in the historical range only rarely, and that a more realistic prism looks at current prices compared to the risk and expected rate of return of all available investments. In that context (and despite declining earnings over the past five quarters), stocks of highly profitable and stable companies have an earnings yield that is more than twice the yield of the risk-free 10-year Treasury note, and well above today’s inflation rate. A dearth of good investment options, plus the trillions of investment dollars that must continue to be allocated, can be a further support for prices.
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