Last week, the Fed shared some widely expected news: It will taper more — keeping up a policy of slowly reducing its bond-buying program with the goal to wind it down by year’s end. It has telegraphed this action repeatedly. And yet, the markets — at historic highs — sold off on the news.
Perhaps this is a good time to revisit some favorite questions: Are stocks cheap or expensive? Where are we in the economic cycle? And has the market topped?
To know whether stocks are cheap or pricey, we typically look at price-to-earnings ratio. Valuation is a tougher question than many folks realize. People forget that although we can pinpoint the price, we can only guess at future earnings. The past isn’t much help: It simply tells whether a market was pricey or cheap.
Valuation today is a function of price relative to future prospects, and that is an unknown. Sure, we have analysts’ consensus estimates as to future revenue, earnings and cash flows, but truth be told, these are at best an informed guess. A McKinsey study found that on average, analysts’ forecast were too bullish by nearly double. (The exception was at market lows, when they were too bearish). So keep that in mind whenever you think about valuations.
With that caveat, let’s look at the Standard & Poor’s 500-stock index, a broad benchmark for equity markets. It is currently trading at 16.7 times forward earnings estimates. In other words, investors are willing to pay $16.70 for every dollar of corporate profit. That’s more expensive than the average price over the past century, but it’s about a 5 percent discount to the average over the past 15 years.
Let’s put this into broader context: In 1982, we were at the end of a 16-year bear market. Price-to-earnings multiples were under 10, and stocks, which were widely reviled, were cheap. Fast forward to 1999, the tail end of an 18-year bull market. Just before the dot-com bubble burst, the S&P 500 traded at an expensive 27 times forward earnings. Today, using the same measures, stocks are more or less fairly valued — not cheap but not terribly expensive.
For cheap stocks, you have to look abroad. Using these metrics, European equities are trading at an 18 percent discount to their 15-year average. And emerging markets are even cheaper, trading at more than a 20 percent discount. Hence, if you are a value investor, you might want to think about being more heavily weighted toward equities outside the United States. Vanguard’s FTSE European ETF (VGK), for instance, is an index that gives broad European exposure. If you want to have exposure to emerging markets, consider iShares Emerging Markets Dividend ETF (DVYE).
One last note: There are many ways to assess the value of equities. The quantitative research team at Bank of America Merrill Lynch looked at 15 of the most commonly used metrics. By most of these measures, stocks were fairly priced. By one metric — Yale professor Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE ratio — stocks are especially pricey. This has become the bears’ favorite valuation measure. But beware of cherry-picking any particular metric that rationalizes your position. Indeed, over the past 20 years, the CAPE measure has pegged U.S. equities as “overvalued” 85 percent of the time.
You are better off looking at the totality of valuation measures. That suggests a U.S. market that is more expensive than international markets, but not terribly so.
So looking at valuations involves two factors: price and profits. One is known, and one is unknown. That is where the economy comes in. Gains in corporate profits depend in large part on accelerating global economic growth. This is something else that people seem to enjoy making guesses about. I am not sure why, as you have amassed a horrific and embarrassing track record at this kind of thing. Forecasting what the economy is going to do next month or next year is, to be kind, not your forte.
The economic guessers have been, for the most part, fooled by this cycle. They have mistakenly assumed that the recovery from a credit crisis would be similar to the typical postwar recession recovery. It has not worked out that way. As we discussed in July 2011, deleveraging excess debt makes for a distinct sort of recovery. In their book “This Time Is Different: Eight Centuries of Financial Folly,” Carmen Reinhart and Kenneth Rogoff show that after a major credit crisis, recoveries are typically far softer. Weaker GDP, slower growth and mediocre job creation are typical. That sums up our economic experiences since 2009 rather well, don’t you think?
That has not stopped the guessers from looking at every twitch of the data as the start of something significant. As we discussed last year, economic data are very noisy. This year, a lot of the numbers have been disappointing. Retail sales have been weak, auto sales have missed consensus estimates, and housing has been soft.
Normally, without some rational explanation, I would be concerned about that sort of data. This year, for a change, the weather is a legitimate excuse. I usually mock the retailers who complain that it is cold in Minnesota in January (Really? Who could have seen that coming!?) But this has been the winter of our discontent. I’ve lived in New York for half a century, and I do not recall ever having this many days where temperatures were in the teens and single digits. We had snow in 49 of 50 states, according to the National Climatic Data Center. At the same time, a drought struck western states, and California had its hottest winter on record.
I am willing to give the economic data the benefit of the doubt for another month or two. Were the recent data legitimately affected by the whacky winter weather, or is this the start of an economic downturn? We shall find out before the Fourth of July fireworks are upon us.
Investing is about making probabilistic decisions with limited information about an unknowable future. The variables are well known, as are the possible outcomes.
Last year saw tremendous gains in U.S. equities, with the S&P 500 up more than 30 percent. It should not surprise you to see some digestion of those gains, as earnings catch up with price. If the global economy accelerates, then U.S. stocks are cheaper than they appear, while European and emerging stocks are even cheaper. But if the economy goes the other way, you should expect to see a sizable correction in equity markets, especially in the United States.
Anyone who claims to know the future, who says they can tell you what the economy will do, what earnings will be and, therefore, where the stock market is going is lying to you. Understanding the variables and valuation should help you make better investing decisions.