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Stock Market Valuation Ratio Trend Evolution

| | 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. Under 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 and how are they changing week by week? Using recent actual and forecasted earnings and dividend data from Standard & Poor’s, we find that:

The following chart tracks variations in valuation ratios based on 12-month trailing earnings/dividends from the end of 1988 through the end of 2019. Solid lines show the behavior of the ratios, and dotted lines of the same color show their respective averages over the past 31 years. Data are actuals. Operating E/P, as-reported (GAAP) E/P and dividend yield are all a little 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:

  • This is an in-sample view. An investor operating in real time would not know the average during the sample period.
  • 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 2009 through December 2019. The chart also shows trajectories of operating E/P based on recent Standard & Poor’s bottom-up operating earnings forecasts through December 2021 (dashed lines) as available from five forecast dates, assuming the S&P 500 Index persists near its 5/1/20 level of 2831. Notable points are:

  • The sharp jump in E/P at the beginning of the forecast interval derives from the recent COVID-19 stock market crash.
  • Earnings forecasts, and therefore operating E/P forecasts, deteriorate with each forecast iteration.
  • Based on the 5/1/2020 S&P 500 Index level, forecasted operating E/P over the next four quarters is well below its 30-year average of 5.53% as shown in the chart above.

What about as-reported E/P?

The final chart is a shorter-term view of 12-month trailing as-reported E/P for December 2009 through December 2019. The chart also shows trajectories of as-reported E/P based on recent Standard & Poor’s top-down as-reported earnings forecasts through December 2021 (dashed lines) as available from five forecast dates, assuming the S&P 500 Index persists near its 5/1/20 level of 2831. Notable points are:

  • Again, the sharp jump in yield at the beginning of the forecast interval derives from the recent COVID-19 stock market crash.
  • Earnings forecasts, and therefore as-reported E/P forecasts, deteriorate (irregularly) with each forecast iteration.
  • Based on 5/1/2020 S&P 500 Index level, forecasted as-reported E/P over the next four quarters is well below its 30-year average of 4.80% as shown in the chart above.

In summary, recent S&P 500 earnings forecasts indicate 12-month trailing earnings-price ratios well below generational “normal” over the next year, and forecasts are deteriorating.

Cautions regarding this finding include:

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