Stock Market Valuation Ratio Trends

To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as price-earnings ratio (P/E) and price-dividend ratio. 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 low (high). Where are the ratios now? Using the S&P 500 Index level as of the close on 11/22/11 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 third quarter of 2011. Solid lines show the behavior of the ratios, and dashed lines of the same color show their respective averages over the past 22 years. All data are actuals (over 90% reported for the third quarter of 2011). Operating P/E and as-reported (GAAP) P/E are well below “normal” values, while the price-dividend ratio is a little below “normal.”

Operating P/E derives from corporate earnings sources expected by management to continue contributing to future earnings. As-reported P/E 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 P/E for September 2007 through September 2011. The chart also shows the trajectory of operating P/E for the current Standard and Poor’s bottom-up operating earnings forecast through September 2012, assuming the S&P 500 Index persists near its level of 1188 as of 11/22/11. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near 1188, 12-month trailing operating P/E will remain well below its 22-year mean of 19.3 shown in the chart above.

The final chart presents a shorter-term view of 12-month trailing as-reported P/E for September 2007 through September 2011. The chart also shows the trajectory of as-reported P/E for the current Standard and Poor’s top-down as-reported earnings forecast through September 2012, assuming the S&P 500 Index persists near its level of 1188 as of 11/22/11. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near 1188, 12-month trailing as-reported P/E will remain well below its 22-year mean of 25.9 shown in the top chart above.

In summary, current S&P earnings data forecast 12-month trailing price-earnings ratios below 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.
• P/E distributions may not be tame (Gaussian-like), and the average historical P/E may therefore not be a reliable estimate of future P/E.

For other perspectives on simple U.S. stock market valuation ratios, see Market Models.

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