Year-End Valuation Update

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The traditional year-end parade of investment analysts and strategists has been painting a rosy picture for 2014. A frequent argument emphasizes that a powerful up year such as 2013 is typically followed by another positive year, albeit one with a far more moderate return. Positive momentum could, of course, produce such a result.

At the same time, honest skeptics have reason to question whether central bankers will remain willing and able to continue unprecedented stimulus and, if so, whether such aggressive policy will remain effective in supporting equity prices.

Those of us who believe that valuations ultimately determine stock prices invariably sneak a peek at numerous measures of value. After having just received a year-end collection of valuation graphs from the outstanding Ned Davis Research data gatherers, now is a perfect time to evaluate market prices relative to historic valuation criteria.

While few analysts and strategists currently categorize market prices as “cheap”, most consider them “reasonable.” Very few, however, discuss valuation measures other than price-to-earnings. Chart 1 shows the S&P 500 selling at 19.1 times its trailing GAAP earnings. To put the current level into a clear historical context, we have drawn a solid line from the present level left across the entire date spectrum.

Chart 1 (Click on chart to enlarge.)

While high, today’s 19.1 reading is obviously far below the peaks recorded so far in the twenty-first century. Observing that precedent, many commentators suggest that multiples could climb even higher before the current rally runs its course. It’s instructive to recall, however, that investors have rarely made money when purchasing stocks at or above the current PE multiple. Such purchases in the past two major market rallies preceded the two biggest stock market collapses since the 1929 crash and the Great Depression that followed.

If we consider today’s PE multiple relative to all cycles preceding the late-1990s, the current level is obviously high, typically exceeded only marginally near prior stock market peaks.

A look at other important measures illustrates that the market is, in fact, significantly overvalued. Chart 2 and Chart 3 demonstrate that price-to dividend and price-to-book value ratios never came even close to current levels before recent bubble readings.

Chart 2 (Click on chart to enlarge.)

Chart 3 (Click on chart to enlarge.)

The market crashes that began in 1929 and 1973—two of the worst of the twentieth century–each began at far less egregiously stretched multiples.

Chart 4 and Chart 5 paint the same picture with respect to price-to-sales and price-to-cash flow.

Chart 4 (Click on chart to enlarge.)

Chart 5 (Click on chart to enlarge.)
Davis 159

While these charts are current only through the third quarter and only go back to the 1950s, the message is nonetheless compelling. Almost certainly the multiples will be even higher when fourth quarter data are included.

While valuations are excellent long-term guides, they leave a lot to be desired as short-term market price forecasters. It is, of course, wise not to forget the old saying that markets can remain irrational longer than you can stay solvent.

While markets very rarely adjust instantly to any historic mean, it can be a helpful exercise to see where markets would be if they were currently at their long-term average levels. Doing a rough calculation of how much above average each valuation measure is today, it would take a 34% decline to just above 1200 for the S&P to reach its “normal” valuations. That level was first attained in late 1998 and, in the current rally, in March 2010. Prices are above that level today because valuations have risen far above normal.

We cannot know how long investor confidence will justify valuations remaining far above average. Next year we could again be celebrating a succession of stock market highs. On the other hand, there is a genuine risk that valuation measures could revert to or below long-term norms. The prime determinant probably remains central bankers’ ability to keep investors confident that they know what they’re doing and are capable of effectively carrying out their policy. The year 2013 demonstrated clearly the upside while that confidence prevailed. From today’s prices, reaching mean valuation levels would create great investor distress should that confidence wane.