Is the Stock Market Expensive?

Over at The Big Picture, Barry Ritholtz makes this point.

On a trailing one-year basis, that puts the Price to Earnings Ratio (P/E) at over 19 as of today.  This does not make the market cheap.

And what about 2009? Again, the analysts are in a race to find the bottom.

The current projections are for $42.26 for 2009. That makes the forward P/E 22. That doesn’t look like value at all, when the historical average is closer to 15.

In 2001, as-reported earnings were $24.67. Operating earnings in 2002 were $27.57. Does anyone think the current recession will be milder than the last one? Or shorter?

Is the market expensive at these levels?  Does it matter? 

I will get to the first question later.  As for the second, a better question is why would an investor value the market off cyclically low earnings?

The market bottomed in 2002 on October 10 at 768.63.  Trough earnings were $24.67.  Thus, the market bottomed at 31.1x trough earnings.  Earnings in the third quarter of 2002 were actually higher at $30.04, or 25.6x trailing 12 month earnings.  So, in fact, the market trading at 22x depressed earnings today looks cheap compared to the last bear market!

The reasons why an investor would view the market as expensive and thus avoid stocks at these levels are twofold - earnings are going to go a lot lower and stocks will follow or earnings are going to stay permanently depressed.

First, there have been occasions when the market bottomed at 8x trough earnings.  Is it prudent, however, to wait for cyclically low multiples on cyclically low earnings before buying?  As I explained last month, the answer is generally no as extreme valuations are rare.  Instead, a better strategy - in my opinion - is to buy as the market approaches an extreme low valuation and sell as the market approaches an extreme high valuation.  You can never catch the bottom or the top - or at least I cannot - but buying and selling as the market approaches extreme levels is generally a profitable strategy over time.

As for earnings staying permanently depressed, well, perhaps, but I would not bet on it.  Margins have averaged about 6% over the past two decades.

Applying a normalized profit margin, is the market expensive?

I use 7% as a normalized profit margin.  This is higher than the long-term average but in the past, lower-margin hardware companies accounted for a higher proportion of technology profits than higher-margin software companies.  Today, software companies generate a higher proportion of technology profits. 

Based on this measure of normalized profit margins, stocks look cheap.

 

On other measures, the market also looks inexpensive.

The price to sales of the market is approaching multi-decade lows ...

 

... while the price to book of the market is at multi-decade lows.

 

Even though I am very long stocks, I am skeptical that we have entered into a new bull market.  However, stocks are not expensive.

EDIT - I am currently reading Anatomy of the Bear and came across this line about the 1921 bottom in stocks on page 67.

The bulls of 1921 focused on the value in shares an key technical factors which suggested that market prices would recover.  There was little discussion on the immediate earnings outlook.  While the market bottomed in August 1921 reported earnings had a further 37% to decline before they reached bottom in December 1921.  An earnings recovery significantly lagged the recovery in the stock market. [Emphasis added.]

Comments

[dacian]

There is also a chance that 5 years from now we trade at the same levels (SPX between 700-1000); so there won't be a new bull market for years. I think we just start to see the social impact of the crisis; banks won't generate new profits any time soon; geopolitical problems might arise from this mess; we don't know yet what will be the exact impact of FED's actions (uncontrolled inflation?), etc. etc. So there are many things to consider; but related to whether the market is cheap, I don't know. Corporations still deleveraging, consumer is tapped, rising unemployement (even if this is lagger), etc., I don't know if the market is cheap. Honestly, I'm a very poor analyst :)

[psychodave]

"An earnings recovery significantly lagged the recovery in the stock market"

What gives me pause these days is the driving force of any earnings recovery.

Whether it is the recovery in the 1920s, the 1980s or, best yet, the 1990s, they all seem to be caused by some sector (government, consumer, financials, etc.) taking on a lot more debt ... until the next credit bust.

[unfettered]

A suggestion to get more historical perspective would be to recreate these plots with a data series that goes back well before 1986. The data on Shiller's web site is one possible source:

www.econ.yale.edu/~shiller/data.htm

I'm partial to looking at P/S as a total market valuation metric, since sales are harder to fudge than earnings, but Shiller doesn't have sales. I've one time seen, though I can't find it now, a data series for S&P 500 sales on the S&P site that goes back to 1977. If anyone knows of a free-to-download data set for historical S&P sales, I'd greatly appreciate being pointed to it.

[alan smithee (nee kerry)]

agree with psychodave to an extent. this time around the recovery will fight through the destruction and reduction of debt but will hinge on fundamental improvements in the economy, whether productivity, improvements in the scope of industry within which the US is competitive, free trade opening up, other restructures to improve competitiveness, etc.

[alan smithee (nee kerry)]

Continuing behind psychodave again, because equity is secondary to debt, the fact that debt is much more expensive these days automatically reduces the value of stocks and damages companies where this debt is on the bs as an asset.

[phdinsuntannin]

credit availavility is the key variable explaining earnings, and there is not any, so, why you are long equities? should you have remained in TWM ... not too late I guess, look at oil, capitulation is coming, then you can buy cheap !

[alan smithee]

I think that Toro is stuck in the same place i was 4 months back. You're wrong but want to be right re the fundamentals. That said, many people think we may trend up for a couple more months. I dunno, but will try to follow the trends. Eventually, the market will come down as the US restructures. I really think the whole process could have been avoided, but wdik, I guess.

[Hendog]

Ritholtz states: "The market bottomed in 2002 on October 10 at 768.63. Trough earnings were $24.67. Thus, the market bottomed at 31.1x trough earnings. Earnings in the third quarter of 2002 were actually higher at $30.04, or 25.6x trailing 12 month earnings. So, in fact, the market trading at 22x depressed earnings today looks cheap compared to the last bear market!"

Does he actually believe that the market bottomed there??? Only the intervention by the Maestro curtailed the decline... One should go to the P/E of the Depression to make a legitimate comparision... Or better yet, use an average of all the P/E's at market bottoms so as not to miss out on the eventual bottom... As always, scale in!!

[Jason]

The market will look more attractive when the S&P 500 is around 700...