Stock Market Valuation Ratio Trends
March 21, 2014 • Posted in Fundamental Valuation
To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as earnings-price ratio (E/P) and dividend yield. Operating under a belief that such ratios are mean-reverting, most imminently due to movement of stock prices, these experts expect high (low) future stock market returns when these ratios are high (low). Where are the ratios now? Using the S&P 500 Index level as of the close on 3/20/14 and the most recent actual and forecasted earnings and dividend data from Standard & Poor’s, we find that:
The following chart shows variations in valuation ratios based on 12-month trailing earnings/dividends from the end of 1989 through the the fourth quarter of 2013. Solid lines show the behavior of the ratios, and dashed lines of the same color show their respective averages over the past 24 years. All data are actuals. Operating E/P and as-reported (GAAP) E/P are above “normal” values, while the dividend yield is slightly below “normal.”
Operating E/P derives from corporate earnings sources expected by management to continue contributing to future earnings. As-reported E/P includes contributions to earnings from discontinued operations and anomalous (as judged by management) conditions. Operating earnings are arguably more forward-looking and optimistic. As-reported earnings are arguably more manipulation-free and realistic (sustainable).
Note that stock buybacks began augmenting/displacing dividends in the mid-1980s.
The next chart is a shorter-term view of 12-month trailing operating E/P for December 2008 through December 2013. The chart also shows the trajectory of operating E/P for the current Standard and Poor’s bottom-up operating earnings forecast through March 2015, assuming the S&P 500 Index persists near its level of 1872 as of the close on 3/20/14. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near this level, 12-month trailing operating E/P will remain well above its 24-year average of 5.5% shown in the chart above.
The final chart presents a shorter-term view of 12-month trailing as-reported E/P for December 2008 through December 2013. The chart also shows the trajectory of as-reported E/P for the current Standard and Poor’s top-down as-reported earnings forecast through March 2015, assuming the S&P 500 Index persists near its level of 1872 as of the close on 3/20/14. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near this level, 12-month trailing as-reported E/P will remain well above its 24-year average of 4.7% shown in the top chart above.
In summary, current S&P earnings forecasts indicate 12-month trailing earnings-price ratios well above generational “normal” over the next year.
Cautions regarding this conclusion include:
- Analysis of past operating earnings forecasts (see “Quarterly Aggregate Earnings Estimate Evolutions”) shows that forecast errors can be substantial.
- The sample period may not be long enough to generate an average representative of a broad range of economic/market conditions.
- E/P distributions may not be tame (Gaussian-like), and the average historical E/P may therefore not be a reliable estimate of future E/P.
For other perspectives on simple U.S. stock market valuation ratios, see Market Models.