How Expensive Are Stocks — Really?

How Expensive Are Stocks — Really?
Investing isn’t easy. Trying to make it simpler won’t make it any easier.
Bloomberg, March 3, 2017




Here’s an interesting analysis that should not be overlooked. Charles Lieberman here at Bloomberg View looks at whether the stock market is overvalued. He concludes it is not, but it’s his analysis, based upon a dividend discount model, that I want to point out. It is a much more nuanced case for moderate stock valuations than the Wall Street Journal’s recent argument that, in the wake of oil’s collapse, stocks are cheap.

As Lieberman observes of the price-earnings ratio:

Since 1954, the S&P 500 P/E trailing multiple has averaged about 16.6. But this encompasses very high P/E periods, such as the 1950s and the 1990s and exceptionally low P/E periods, such as the 1970s.

Rather than merely use the median, why not try to find similar periods so as to make a better comparison? He concludes:

If we focus on those periods when inflation and interest rates were low, as they are today, the implied equilibrium P/E multiple is well above the historical average, but also above the prevailing multiple in today’s market.

Thus, adding in those additional variables — interest rates and inflation — provides context that might change how you value equities.

There are many ways to value stocks, none of which are perfect. We reviewed a list of 15 such measures a couple of years ago, via a report from quant strategist Savita Subramanian of Merrill Lynch. The conclusion then was that U.S. stocks were somewhat pricey, but not terribly so.

How can we determine, then, what defines these markets? A secular bull market is an extended period of time (10 to 20 years) during which investors show an increasing willingness to pay more and more for each dollar of earnings. Consider the 1982-2000 market, which began with price-earnings ratios in the single digits and ended with a P/E ratio over 30 and markets 1,000 percent higher. About three-quarters of those gains were due to multiple expansion.

A secular bear market is just the opposite: During a period of increased volatility, frequent corrections and ongoing fear, investors become increasingly less willing to pay the same amount for that dollar of earnings. Indeed, I define the bear as investors paying less and less for it.

In both bull and bear cases, the psychological component is what drives stock valuations.

Valuations are most helpful when setting what should be your expected returns. When stocks are cheap, the odds favor higher-than-average returns; when they are expensive, expect below-average returns. But even that is subject to some surprising variations.

Just like the children in Lake Wobegon, if this was easy, everybody would be an above-average investor.


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