Santoli: Breakdown of the bubble vs bargain debate

Published Sun, Jul 24 20169:46 PM EDT

The value of the stock market has never been higher. Does that mean stocks are very expensive? The market slouched sideways for more than a year while bonds soared in value. Might this make equities relatively cheap? Getting a fix on stock-market valuation is both simple and mysterious. There are countless methods for calculating how shares are valued and sundry theories for what they "should" be worth. Valuation is such a malleable concept that we now simultaneously have professional investors calling stocks alternately a bubble and a bargain. So here's an attempted run through the valuation maze, with a hope to emerge on the other side with a helpful perspective on what a buyer of stocks at today's prices is getting in return and might expect from the investment. The simplest, most traditional way to value stocks relative to corporate earnings is to divide share price by reported profits from the past year. On this stringent, no-nonsense basis, the market looks quite expensive. The Standard & Poor's 500 index now trades at just over 25-times official earnings, as reported under generally accepted accounting principles. Dating back to the year 1870, this multiple has averaged 16.7, according to Doug Short's valuable Advisor Perspectives blog. Several bull markets in the past have worked their way up to this P/E zone, though only the stupendous late-'90s market mania exceeded it by much, getting to 34 in 1999. This standard measure looks high largely because energy earnings essentially disappeared with the oil crash of the past several quarters. And earnings in aggregate now appear in the process of bottoming. But of course, bad things happened to corporate results at many points in history, and this doesn't change the fact that this starting point for multiples tends not to deliver very appealing long-term returns. Using the past 12 months' "operating" earnings, which exclude extraordinary accounting items deemed to be one-off deviations from results, the market's P/E comes down to around 19 times. Not at all cheap, but not quite as alarming, especially if the profit cycle has just paused and is about to resume growth in the coming months, as seems likely. Of course, Wall Street prefers to focus on how stocks trade relative to what the future is believed to hold. The usual analyst work is based on "forward" or forecast profits. This almost always flatters stocks by penciling in earnings growth by companies. With the latest run to a new high in the S & P 500, it now trades at a bit over 17-times the next four quarters' anticipated operating earnings. Goldman Sachs last week said this measure was higher than all but 11 percent of all readings since 1976. The bullish investor might well look at the fact that stocks have been more expensive one-ninth of the time over the past 40 years and conclude, "So you're saying there's a chance?" And in fact, while Goldman points out the forward P/E has already expanded by 70 percent this cycle, in the '80s and '90s bull markets the valuation grew by more than 100 percent. This is vaguely reassuring, even if it suggests that a buyer today looking for a much higher market must count on an extreme overshoot past "normal" stock values, helped by a crucial yet uncertain revival of profit growth. Nearly every discussion of financial market values today starts or ends with the extremely low bond yields prevailing across the world. Trillions in debt yields less than zero, a minority of all bonds on the planet yield more than 1 percent and the 10-year Treasury yield has barely lifted above the all-time low of 1.36 percent set this month. Aren't all financial assets, including stocks, worth more when rates are very low? Actually, it's not that simple. Yes, low rates tend to coincide with higher stock valuations, but they don't justify them, in the sense that they improve the future returns to equities when bought in low-rate periods. Clearly, investors don't like to hear this. They want to be told that stocks look pretty good compared to an asset class (bonds) that most see as egregiously overvalued. Bank of America Merrill Lynch's quantitative strategy team puts it: "As equity markets make new highs, the bulls are grasping for new (or very old) ways to justify the rally. The latest to garner attention is the Fed model, which compares the earnings yield on stocks with bond yields. There have been many iterations of the Fed model over the years, but they all come to the same conclusion today: stocks are cheap relative to bonds." The Fed Model gained favor in the '90s after strategist Ed Yardeni noted its mention in a Fed document. The idea was that if stocks' "earnings yield" (the inverse of the forward P/E ratio) exceeded the 10-year Treasury yield, equities were relatively attractive. Variations have been created to use corporate-bond yields, or to apply some "normal" equity risk factor. Yet study after study has shown that stocks' appearing undervalued on this basis has no predictive value for market performance. And, indeed, a straight P/E ratio does a better job of handicapping future market performance than this relative measure does. But there is a practical way that low bond yields drive stock valuation, and that is to divert income-seeking investors into dividend-paying stocks. With the S & P 500's 2.1 percent dividend yield representing one of the largest sources of investment income in the world, investors are buying what they deem "safe, stable" stocks with little regard for other valuation signals. This phenomenon actually holds some good news for bullish stock investors now. Because it seems this "yield trade" is a major source of the apparently rich valuation of the overall market. Source: CNBC, Goldman Sachs As the table shows, the sectors inflated by the dividend chase (consumer staples, utilities, real estate investment trusts and telecommunications) trade at a forward P/E of 20, based on Goldman's sector valuation numbers. Energy, the outlier, is at 53-times earnings. Yet the rest of the market is around 16-times expected profits. That's far more reasonable and is confirmed by other indicators of baseline valuations for economically attuned sectors. Goldman's own basket of "domestic cyclical" stocks geared to a now-firming U.S. economy is at a 15 forward multiple. The Dow Jones Transportation Average is at less than 13-times trailing earnings. This could mean the other signs of overvaluation are a bit less scary. If high multiples for stocks are largely dangerous because they reflect excessive optimism about future earnings growth, maybe the fact that no-growth stocks are fattening today's multiple is, on some level, comforting. Comforting, that is, unless the Fed after its meeting this week decides to jolt the bond market with rate-hike talk - and a raft of those "safe" companies reporting earnings remind investors that some prices are too high to pay for yield in the form of inherently volatile shares of unpredictable businesses.

Traders work on the floor of the New York Stock Exchange.

Brendan McDermid | Reuters

The value of the stock market has never been higher. Does that mean stocks are very expensive?

The market slouched sideways for more than a year while bonds soared in value. Might this make equities relatively cheap?

Getting a fix on stock-market valuation is both simple and mysterious. There are countless methods for calculating how shares are valued and sundry theories for what they "should" be worth. Valuation is such a malleable concept that we now simultaneously have professional investors calling stocks alternately a bubble and a bargain.

So here's an attempted run through the valuation maze, with a hope to emerge on the other side with a helpful perspective on what a buyer of stocks at today's prices is getting in return and might expect from the investment.