April Newsletter: Taking Stock of Valuations

Posted by Alex Frey (@alexhfrey )

Stock markets have been noticeably more volatile lately -- but why?

Last month, we examined some possible underlying causes of the recent turbluence in the stock market, focusing on the state of the overall economy. We determined that while there are certainly macroeconomic concerns around the level of debt in the developed world, recent market skittishness was likely not caused by any economic event or change. 

This month we examine market valuations, looking at whether the market is grossly overvalued relative to fundamental earnings.

We last examined market valuations about a year ago. At that time, we concluded that valuations were high by historical standards, but we thought the higher valuations might be justified by low interest rates. We were a bit pessimistic, but we didn’t suggest selling out. As you probably know, we don’t believe in trying to time the market, so we would never suggest selling out completely in any case.

So, what has happened in the past year? As most of you already know, both U.S. and foreign stock markets have surged upwards. Figure 1 summarizes the last 10 years of market history. It shows what has happened to U.S. stocks, as represented by the Vanguard Total Stock Market ETF (stock ticker VTI), non-U.S. developed country stocks, as represented by the Vanguard FSTE Developed Markets ETF (stock ticker VEA), and emerging market stocks as represented by the Vanguard FSTE Emerging Markets EFT (stock ticker VWO). For most of the last 10 years, U.S. stocks were moving upwards and foreign stocks were stagnant, but for the past two years both domestic and foreign markets have been moving up rather sharply. In 2017, the emerging markets fund (VWO) gained 31.4%, the developed markets (excluding U.S.) fund (VEA) gained 26.4%, and the U.S. fund (VTI) gained 21.2%. So, the foreign markets were the best performers in the past year, but all markets did very well.

img1.png Figure 1: The performance of U.S. and foreign stock markets for the last 10 years. Note coordinated upwards movement in the last two years. The data is from Vanguard.

So, does this mean that valuations are even higher? Yes, but not as much so as you might think. Profits and sales have also moved up. Let’s start by looking at the price to earnings (PE) ratio. This is the most common and most time-honored measure of how expensive stocks are. Figure 2 shows how the PE ratio for the S&P 500 index, an index of large U.S. stocks, has varied over time. The two very high spikes represent the low earnings during the recessions of 2001 and 2008-2009. If those spikes are ignored, the current PE ratio is quite high, but not necessarily in bubble territory. The cyclically adjusted PE (CAPE) ratio averages earnings over a 10-year period and may give a better picture of stock prices. The CAPE ratio for the S&P 500 index is shown in Figure 3. In this case, the picture is somewhat concerning. The CAPE ratio is still well below its late 90s peak, but it is otherwise higher than it has been since WWII.

img2.png Figure 2: The price/earnings ratio for the S&P 500 index. The data is from Robert Shiller’s online data.

img3.png Figure 3: The CAPE ratio for the S&P 500 index. The data was taken from Robert Shiller’s online data.

Of course, there are some reasons why one might expect higher PE ratios now than in the past. First, there was an accounting change in 1990 that required companies to write down the value of degraded assets. This can have a negative effect on earnings, especially during recessions, and it may have contributed to the very low earnings in 2008 and 2009. These are still included in the CAPE ratio. Also, dividend payout ratios tend to be lower now than they were in the past. This means that companies are investing more in the business (or in stock buybacks), so earnings should grow faster. Finally, there is the issue of low interest rates that is almost certainly helping to increase stock prices, but we will discuss this more shortly.

So, let’s consider some other valuation measures. At one time, Warren Buffet talked about the ratio of stock market capitalization to gross national product (GDP) and suggested that this was a good measure of how expensive the market is. Figure 4 shows how the current ratio compares with the historical record, and it appears that the current value is an all time high. This measure has been criticized because U.S. corporations derive some of their revenue and profit from foreign sources, but GDP considers only domestic income. In an age of globalization, where businesses have greater foreign sales, one might expect that the ratio of market capitalization to GDP would increase.

img4.png Figure 4: The ratio of U.S. stock market capitalization to GDP. The data was taken from the Federal Reserve Economic Data (FRED), but the data was extended to January 2018 using Moody’s Analytics data and Shiller online data.

A somewhat similar measure is the ratio of market value to corporate sales. One way of computing this is to use the FRED data series called “Nonfinancial Corporate Business; Corporate Equities; Liability, Level” as the measure of market capitalization and the FRED data series called “Gross value added of nonfinancial corporate business” as a measure of sales. Figure 5 shows the historical trends with this measure. By this measure, stocks are at an all time high. In the same spirit, we also looked at the ratio of equity values to sales for the S&P 500 index. In this case we took the data from reference 1. Again, the current value appears to be near an all time high.

img5.png Figure 5: The ratio of equity value to gross valued added (a proxy for sales) for U.S. stocks. The data was taken from FRED using the data series mentioned in the text.


Figure 6: Ratio of S&P 500 market capitalization to revenues. Data is from Yardeni.com (see reference 1). 

The high ratio of equity to sales is in part a reflection of the fact that companies today generate more profits per dollar of sales then they have at just about any times in the past. Figure 7 shows how the corporate profit margin has changed with time. Current values are near an all time high. One might expect that competitive pressures would cause profit margins to revert to the lower historical values, as higher profits get competed away eventually. If so, corporate profits and equity values could be adversely affected. On the other hand, the general picture in figure is of increasing profit margins, and there no indication that a significant reversal in imminent.

img7.png Figure 7. Profit as a fraction of gross value added (a proxy for revenues). Data is from FRED.

The last measure we will look at it is Tobin’s Q, which was suggested as a market price indicator by James Tobin, a Nobel prize winning American economist. Tobin’s Q is the ratio of stock market value to the net worth (or book value) of the corporations. Figure 8 shows how Tobin’s Q for U.S. stocks has varied with time. The current value is well below the late 90s peak, but it’s higher than at any other time.

img8.png Figure 8: Tobin’s Q. The data was taken from FRED.

Each of these valuation measures has limitations in isolation. However from looking at all of them, it's clear that the overall picture that emerges from the charts above is that the market is currently very expensive. 

Before selling everything, we should probably ask why might that be? What is not included in these charts is the effect of low interest rates. Although the Federal Reserve has been raising the federal funds rate, which applies to short term inter-bank loans, both short and long-term rates are still low by historical standards. The 10-year treasury rate fell below 2% in 2011. It had been that low only once before, and that was in the early 40s. Since then it has oscillated between 1.6% and 3.0%, a very low range based on history. Obviously, low interest rates make stocks look more attractive. The value of future earnings is greater if they are discounted at a lower interest rate, and psychologically, low interest rates may drive investors away from bonds and towards stocks. Given the high valuations in the U.S. stock market, we think higher interest rates could rather quickly create problems for stock prices, and this is certainly a plausible cause of the recent volatility – interest rates have approached and even briefly exceeded 3%.

So the question is, is the era of low interest rates ending? In past newsletters, we have suggested that the current low interest rates are only partly due to central bank (the Federal Reserve in the U.S.) action. We think globalization is partly responsible because it has made low cost labor available, and this has held down inflation. Also, a very high savings rate in China has made capital readily available. But, the growth of budget deficits and a revival of inflation in the U.S. could change this picture. This is where the “great experiment” that we discussed last month comes into play. If the U.S. tax cuts stimulate productivity improving investments, and if they draw discouraged workers back into the labor force, we might avoid inflation and significantly higher interest rates. In that case, the present high stock market valuations might persist for a while. We don’t know how this will play out, but we think investors should realize the dangers and keep a highly diversified portfolio. Having some exposure to foreign stocks, bonds, and commodities, in addition to U.S. stocks, is advisable.

In this regard, we will mention once again that foreign stocks are currently much cheaper than U.S. stocks based on common valuation methods. Table 1 shows the dividend yield and PE ratio for the three funds discussed above. VWO and VEA are much cheaper than VTI.

Table 1: Dividend and PE Ratio. Data is from Vanguard and Morningstar.

Fund Dividend yield, % PE ratio
VWO (emerging markets) 2.41 15.6
VEA (Non-U.S. developed markets) 3.00 14.2
VTI (U.S. markets) 1.74 21.8

One final comment regarding the “great experiment”: There was a news story very recently that we found interesting. It noted that the civilian labor force participation rate for ages 25 to 54 is increasing. Figure 9 shows the data. The upward trend started in 2015, but there has been a very recent uptick. This could indicate that some of the discouraged workers are being drawn back into the workforce, and this could alleviate inflationary pressures. The outcome of the “great experiment” is still very much uncertain (and we are still somewhat pessimistic), but this data gives a glimmer of hope.

img9.png Figure 9: Civilian labor force participation rate for ages 25 to 54. Data is from FRED.

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By Alex Frey