A Review Of Stock Market Valuations

This is the first of a two-part letter reviewing the current valuation of stocks. The focus is US-centric and will investigate both long-run valuation (Part 1) and shorter-term factors which may be warning signs of irrational exuberance (Part 2).

During the last 12 months, we have seen stock markets around the world, decline rapidly and then rebound. Technically the longest bull-market in history ended in March of 2020 but the recovery was so swift that many commentators are calling it merely a sharp correction, simply an aberration. Since March the US stock market, fuelled by aggressive monetary and fiscal easing, has shot to new all-time highs. Q4 of 2020 witnessed the approval of the first Covid-19 vaccines, sending markets higher still.

Equity markets are forward-looking, the economic woes of today are discounted, expectations of recovery, backed by further fiscal support, make the prospects for future earnings appear relatively rosy. In this, the first part of my, letter I want to examine the arguments for a continued rise in equity prices together with the counter-claim that a repeat of the performance of the past decade is simply inconceivable.

Every stock index is different but, for the purposes of this research, I will focus on the US rather than the rest of the world, since it is the US market which has tended, historically, to set the global tone. The chart below looks at the forward PE ratio of the US (in red) and the MSCI World – Ex-US (in blue): -

Source: Yardeni

Looking at the evolution of earnings per share and incorporating the recent forecasts for 2020 and 2021, we get a picture of a market which might just have got a little ahead of itself: -

Source: Crestmont Research

Part of the explanation for the substantial out-performance of the US has been the scale of the fiscal and monetary response of the US administration and its notionally independent central bank, yet, as the infographic below reveals, the US response whilst substantive is relatively less dramatic than that of some other countries: -

Source: McKinsey

Many commentators are concerned that the stock market (especially in the US) is over-valued, however, a more nuanced view is provided by veteran equity market practitioner, Gregory van Kipnis. Writing at the beginning of last month in AIER, he makes a number of important observations in his article - Angst Over High Price-Earnings Levels Likely Misplaced. Stating from the outset that his purpose is not to provide valuation advice but a perspective on approaches to earnings valuation, the author looks at a variety of alternative valuation methodologies before reaching his conclusion: -

Market pundits who focus on PE, PE[-12], PE[+12] have come to the conclusion that the US stock market, as measured by the S&P 500, is overvalued and due for correction. Some believe we are in a bubble and there will be a sharp correction. Others opine that from current levels we are headed for a low rate of market performance for the next 10 years. These views may turn out to be correct.

However, a more formal analysis of classic valuation theory that relates the current price level to the present value of the future stream of expected income suggests otherwise; that is, the market is more fairly valued and in keeping with its historical norms. From a statistical point of view, there is uncertainty around such a conclusion. Market returns routinely fluctuate. Two thirds of the time total returns realized in the market fluctuate by plus or minus 4.4%. Nonetheless, there is analytical support for the conclusion that from both a market efficiency point of view and from the perspective of long-term valuation theory, the market is roughly aligned with long-term norms.

The chart below shows the S&P500 cumulative compounded total return at constant rate. The blue dotted line shows theoretical ‘fair-value’ derived from the author’s Total Return Model.

Source: AIER

Van Kipnis continues: -

At the risk of seeming repetitive, it should be stressed that the market trades within a range around its long-term fair value norms. For sure prices have trended for long periods below and above the historical norm. But it cannot be dismissed lightly that those historical norms are real and give every appearance of remaining intact for the foreseeable future.

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