Stocks Are Not Cheap

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Although not very precise short-term tools, valuations are the best long-term determinants of stock market direction.  Valuations become particularly helpful forecasters when they reach either positive or negative extremes.

Throughout the past very difficult year for the equity markets, analysts have repeatedly predicted rising stock prices.  The most common justification, despite the worsening European debt crisis, has been that stocks are cheap.  In other words, they argue that valuations are extremely low.  As we turn the calendar to 2012, let us take a closer look at the valuation argument.

By far the most commonly quoted measure of value is the price-to-earnings multiple (P/E).  According to Standard & Poor’s, which is the source of all of the data in this post, using Generally Accepted Accounting Principles (GAAP), the trailing 12-month P/E ratio of the S&P 500 at year-end was 14.0.  That is below the 17.0 average going back to 1926, but it is far from cheap.  Before equity valuations went into the stratosphere beginning in the mid-1990s, the long-term P/E average was between 14 and 15.  When S&P 500 earnings went negative briefly in 2009, the effect was to artificially lift the eight and a half decade long P/E average.  That unique episode distorts history.

Reading the financial press or watching financial television, you have likely heard P/Es reported below 14.  Because forecasters work hard to bolster their case, they employ other measures than trailing 12-month GAAP earnings, which used to be the industry standard.  Now more analysts choose to use operating earnings, which eliminate non-recurring items.  Some cynics refer to operating earnings as “everything but the bad stuff.”  Another common method of reducing the P/E is to use forecasted earnings, rather than trailing 12-month results, which have always been the standard.  Because analysts tend to be perpetual optimists, actual earnings over the decades typically fall short of forecasts.  All that notwithstanding, stocks trading at 14 times earnings are only slightly undervalued compared to median P/Es since 1926.

Analysts run into far more inconvenient truths, however, when they examine other commonly employed measures of value.  But for the valuation extremes for most of the period since the mid-1990s, price-to-dividends, price-to-book value, price-to-sales and price-to-cash flow look expensive, not cheap, when compared to their valuation readings going back over many decades.

Another way to measure the value of stocks is to see how high investors have bid prices of all domestic stocks relative to the size of the U.S economy.  Ned Davis Research computes the value of domestic stocks at 96% of current GDP.  While that is below the extreme readings of the past decade and a half, it is above all preceding periods.  By comparison, even the most extreme reading before the crash of 1929 was only 87%.

Because it is common to weight recent experience more heavily than that from more distant years, it is understandable that today’s analysts view current valuations as cheap.  They are, in fact, far cheaper than are those that have characterized the past decade and a half.  The fatal flaw in such reasoning, however, is that those valuations, unique in U.S. history, distort sound analysis.  We know in retrospect that stocks bought at those extreme valuations have produced, at best, virtually flat returns.  Most equities purchased at those extremes have produced losses.  To describe stocks today as cheap relative to such unprecedented levels is to damn them with faint praise.  If we properly disregard such extreme valuations, investors should realize that, apart from P/E, which is slightly below average, all commonly used valuation measures are closer to their all-time highs than to levels from which major advances have been launched.  Stocks are not cheap.