The Big Picture

April 15, 2011

I was asked recently for our official opinion on the topic of stock market valuations. My answer, in short, was, yes. Yes, the topic of stock valuation can become complicated and/or heated. Yes, stocks are clearly overvalued by some measures. Yes, stocks are only moderately priced by other measures. And finally, yes, they are even undervalued by others still. Thus, Im of the opinion that this topic tends to be used by those analysts looking to either make headlines or to justify their positions.

As I mentioned recently, I have two colleagues that tend to lean toward the dark side (meaning that they like to trade from the short side of the game whenever possible). So, in a not-so scientific study, I decided to ask them their opinion on market valuations.

It probably wont surprise you to learn that these two members of the permabear camp believe that stocks are overvalued at the present time. And to clarify, these two members of the glass-is-nearly-empty club dont just think stocks are a little overvalued. No, these guys say that the market is WAY too high and due to, wait for it crash at any moment! (What, you were expecting a cheery outlook from these two?)

While neither of my friends in the bear camp pointed me to the article, I was directed to a piece written by Mark Hulbert of the Hulbert Financial Digest suggesting that stock valuations currently reside in rarified air if viewed from what Yales Robert Shiller calls the CAPE (cyclically adjusted price earnings) ratio.

Hulbert writes, There have been only four other occasions over the last century when equity valuations were as high as they are now, according to a variant of the price-earnings ratio that has a wide following in academic circles. Stocks on each of those four occasions would soon suffer big declines.

Hulbert goes on to say that the four prior occasions that the CAPE has been at the current level include the late 1920s, the mid-1960s (prior to the 1965-1982 secular bear), the late 1990s, and October 2007.

In an attempted caveat, Hulbert says, To be sure, a conclusion based on a sample containing just four events cannot be conclusive from a statistical point of view. Still, it will be hard to argue that the current stock market is undervalued or even fairly valued.

However, armed with more than one approach to valuation, one might respond with, Au contraire, Monsieur Hulbert.

I have penned several pieces on the subject of market valuations over the past year or so and as such I wont bore you with the gory details of each and every indicator. But in cutting to the chase, it is plain to see that there is more than one side to this argument.

For example, if one uses the median P/E ration of actual GAAP (Generally Accepted Accounting Principles) earnings over the preceding twelve months, it is clear that stocks are fairly valued at the present time. And if youd like to broaden things out and use the ratio of total market cap to corporate profits again, things look fairly valued.

For those of you that prefer the so-called Fed Model, which puts the level of interest rates into the mix, you could provide proof that stocks remain undervalued at current prices.

So, which is it, you ask overvalued, fairly valued, or undervalued? In my humble opinion, the answer lies in the eyes of the beholder. But perhaps the most important thing to understand about the use of valuations in your analysis of the state of the markets is that the ranges of valuation indicators change over time.

If you were to print off the charts of a dozen valuation indicators, you will likely find that the high-to-low range of the indicators changes dramatically as secular cycles come and go. For example, what was overvalued in 1965 and/or 1987 is currently more toward the low end of the range that began sometime in the mid-to-late 1990s.

Because of this, it is important to recognize that the level Mr. Hulbert refers to in his article has been consistently exceeded since the mid-1990s (at least in our version of the Four-Quarter Total Earnings Smoothed over Ten Years) and is now a fair amount below where it was from 2003-2008 and WAY below the level seen in 2000.

So, if I was trying to convince you that stocks were cheap at this point in time (which, I am not) I would merely point to the current level as being one-half of where it was in 2000 and still below the levels seen in 2008. Id then bring it home with the argument that stocks simply cannot be overvalued when studying the data over the past 18+ years.

The main point here is that it is VERY easy to see what you want to see when looking at valuation indicators. And it is for this reason that we dont put much emphasis on any of them in our work. In short, it appears that interpreting valuation measures is more art than science and may be best suited for proving the point you want to prove.

All the best,

David D. Moenning

Disclosure - Mr. Moenning owns positions in securities mentioned: None

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