Why Do Some Investors Perceive This Market As Cheap?
By Barry Ritholtz - April 6th, 2010, 12:00PM
Regular readers know I am not a fan of Forward P/E ratios as they are too easily gamed — plus, they always seem to miss a major turn or reversal. They also tend to justify a bad investment posture, i.e., Perma-Bullish.
Regardless, if you are scratching your head wondering why anyone is buying into stocks at these levels, this chart explains why some investors perceive the market as cheap (all data thru Q1 2010):
S&P 500 Operating Earnings, Forward P/E Ratio
click for larger chart
Source: Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.
Tweet
Facebook
Reddit
Digg this!
April 6th, 2010 at 12:39 pm
Because the perception out there is that the Feds will always do anything and everything to prop up all assets ALL the time, so just buy every piece of junk paper you can or be “priced out forever”. P/E ratios? Please.
April 6th, 2010 at 12:39 pm
At least 75% of the mythical “anyone” , is Goldman Sucks, and a few other IBs and mutuals that have agreed to put a bid under everything to prop the market.
A quick look at the volume of trades these few firms are responsible for illustrate that the rest is made up of a few mutual funds.
There is no broad support for this ‘cheap market’. One sideglancing blow and look out.
The pros of a few supporting the market are that 10) they have no need to panic, they can buy and sell for a few cents one way or the other to each other, 2) they have the citizens of the unUnited States as underwriters and co-signers if things go disastrously wrong for hat is their payoff for keeping Ben and Timmay in their jobs to accomplish whatever it is that rulers of the world behind the curtain who are handing Timmay and Ben their marching orders.
April 6th, 2010 at 12:40 pm
Beat you by a few seconds, flip.
April 6th, 2010 at 1:17 pm
@Mannwich
Maybe the thinking here is getting too ‘clonal’? And therefore a big move to 13-25,000 is afoot?
April 6th, 2010 at 1:19 pm
Where does the average of 16.7 for the operating P/E-ratio in the lower left panel come from? I suspect this number is total bogus. I have a time series for the P/E-ratios, based on reported earnings, available going from 1936 to 2008, which I pulled from the S&P-website once. The average P/E-ratio over the whole time span is about 16. If I calculate the average P/E-ratio from 1936 to 1995, excluding the data from the bubble years, the average is only 13.8. On average, operating earnings are higher than reported earnings. I estimate by 5 to 10% (I would have to calculate this). So the average P/E-ratio for operating earnings should be 5 to 10% lower than the one for reported earnings, i.e., about 14.4 to 15.2 over all years, or about 12.4 to 13.1, when the bubble years are excluded. Thus, even if one accepts forward operating earnings as a valid metric that contains more information than just how wishful thinking looks like, it doesn’t look so cheap anymore, either.
rc
April 6th, 2010 at 1:23 pm
@flip: I’ve already assumed that’s where we’re headed.
April 6th, 2010 at 1:26 pm
but aren’t “operating earnings” themselves a bit like “core” inflation – taking out all the stuff that hurts you?
i always used to laugh when companies would write off their massive “one-time” expenses and losses that would be ignored by the market… only it happened EVERY QUARTER!
April 6th, 2010 at 2:43 pm
Uh, I may not be a genius, but when I see betas like the ones I’m seeing, I am not thinking “cheap.” Where the heck are the future profits coming from, when the business is currently cannibalizing all excess capacity to post quarterly profits?
Sorry, but when Hussman says anything along the lines of “insanely overbought,” I’m unlikely to believe the likes of JP Morgan. Ok, I never believe JP Morgan.
April 6th, 2010 at 3:35 pm
Amusing that you post this on the same day that dshort posts this: http://dshort.com/charts/guest/SP-and-PE10-with-resistance.gif
What flavor tea leaves do you prefer?
April 6th, 2010 at 4:02 pm
I’m not sure I would say cheap.
Easy and cheap is better. Good for a fast ride. Happy to tell you you’re the best, please come back for more. Pay me now, I promise to make it worth your while, honey.
April 6th, 2010 at 4:09 pm
Followed, later, by “I don’t know what happened, dear. She seemed so honest and sincere.”
April 6th, 2010 at 4:16 pm
Look heres 50% of the market cap of the S&P 500, individual weighting followed by a cumulative total.
If you take out the financials (who are earnings protected by the Gov) – I see many solid companies that actually make and sell things – quite well. Further, more so than ever – these companies have growing international sales components. Oh yea and they pay dividends of 2.2% and growing. Until I can earn 5% in cash I’ll take my chances.
What I am implying is that Apple, Exxon, Kraft, Intel etc.. can be profitable in the face of reduced domestic demand more than they ever could in the past. They are getting leaner and have additional markets to tap into should domestic demand stay low as households retrench. Its a decoupling. Different than before. Global.
And sure – if collectively the American public wakes up one day and starts demanding better value in terms of mulitples – then hell yes we tank. But we just went down that path for 10 years (massive accounting fraud) and people still love them some stocks… So that ship has sailed in my eyes.
But as always – you pays your money and you takes your chances…
1 ExxonMobil 3.00 3.00
2 Microsoft 2.08 5.09
3 Apple 2.02 7.10
4 General Electric 1.84 8.95
5 Procter & Gamble 1.73 10.68
6 Bank of America 1.70 12.37
7 Johnson & Johnson 1.68 14.05
8 JPMorgan Chase 1.68 15.73
9 IBM 1.57 17.30
10 Wells Fargo 1.52 18.83
11 Chevron 1.45 20.28
12 AT&T 1.45 21.73
13 Cisco Systems 1.40 23.13
14 Google 1.29 24.41
15 Pfizer 1.27 25.69
16 Berkshire Hathaway 1.25 26.94
17 Coca-Cola 1.18 28.12
18 Hewlett Packard 1.18 29.30
19 Intel 1.16 30.46
20 Wal Mart 1.10 31.57
21 Merck 1.09 32.65
22 PepsiCo 1.01 33.66
23 Oracle 0.93 34.59
24 Philip Morris International 0.93 35.52
25 Goldman Sachs 0.85 36.37
26 Verizon Communications 0.83 37.20
27 Citigroup 0.78 37.98
28 Abbott Labs 0.77 38.75
29 ConocoPhillips 0.74 39.49
30 Schlumberger 0.73 40.22
31 McDonalds 0.68 40.91
32 Occidental Petroleum 0.67 41.58
33 QUALCOMM 0.67 42.24
34 United Technologies 0.65 42.90
35 Disney 0.64 43.53
36 United Parcel Service 0.59 44.13
37 3M 0.56 44.68
38 Amgen 0.55 45.24
39 Home Depot 0.52 45.75
40 Boeing 0.51 46.26
41 Comcast 0.50 46.76
42 Kraft Foods 0.49 47.25
43 American Express 0.48 47.72
44 U.S. Bancorp 0.47 48.20
45 Medtronic 0.47 48.67
46 CVS/Caremark 0.47 49.13
47 Bristol-Myers Squibb 0.43 49.56
48 Amazon 0.42 49.98
49 Altria 0.41 50.39
50 Ford Motor 0.40 50.79
51 Colgate-Palmolive 0.39 51.18
April 6th, 2010 at 4:39 pm
Is it off topic to add to the quote for the day?
If not I’d like to complete it:
“In the old days a man who saved money was a miser; nowadays he’s tortured”.
April 6th, 2010 at 4:57 pm
I’m not so sure it’s cheap, exactly. Maybe tawdry is a better word.
April 6th, 2010 at 4:58 pm
damn! DH beat me to it.
April 6th, 2010 at 6:02 pm
I hate it when people show charts regarding valuations that only go back to 1990 and then label a certain number as AVERAGE. Almost the whole period was historically OVERVALUED and the long term returns were equally subpar. Might I recommend reading http://www.hussmanfunds.com/wmc/wmc070820.htm and expecially pay attention to the chart http://www.hussmanfunds.com/wmc/wmc070820e.gif as you can see a forward PE of 15 is associated with the most overpriced markets 1986-87 and the whole 60s.
April 6th, 2010 at 6:43 pm
Look how cheap the market was in 2007; I’m kicking myself for not having bought more, uh, waitaminute…
April 6th, 2010 at 7:28 pm
Any idea what the impact of stimulus is on earnings? Stimulus will fade in the second half of the year. Earnings and profit margins are still at historical highs, I wonder how sustainable that is, in view of consumer lending collapse.
April 6th, 2010 at 8:30 pm
I have to agree with scharfy . Most S&P 500 companies are international in scope. If they had to rely on domestic consumers, they would be overvalued. But many if not most are growing rapidly overseas and should continue to do so for quite some time as the global middle class expands. It is this paradigm shift in global reach that is keeping profit growth and PEs at higher levels.
April 6th, 2010 at 9:14 pm
I found this fascinating interview with Leon Cooperman from August 2007 where he claims, “my outlook for the next 12 months has not changed. I believe there’s limited downside risk in the U.S. stock market from current levels, and returns over the coming year should be in the low double digits”, based on P/E ratios among other things.
Sample jaw-dropper: “it’s hard for me to believe that Bank of America stock won’t outperform ten-year government bond returns over the next decade — the company raised its dividend 14% in July. ” Of course the decade isn’t over yet but this was with BAC @ $50.
http://money.cnn.com/2007/08/07/markets/cooperman_market_analysis.fortune/index.htm
April 6th, 2010 at 9:28 pm
I don’t know how relevant historical p/e ratios are anymore. I mean yes, they certainly mean something, but it’s all context. Some things to keep in mind:
• Over the past couple of decades p/e ratios have expanded because of increased equity investments by the general public, foreign investors, pension funds, etc. It’s possible that the common folk will continue to pull money from equities and pour it into fixed income, but with the market going up its highly unlikely. With interest rates set to go up (even if not soon), bonds will fall at some point and some of that money will be moving somewhere.
• P/E ratios should be highest in an economy coming out of a recession – just after companies have cut some fat and are ready to capitalize on better margins and returning sales.
• A p/e of 15 means to me that a company is earning a return on my investment of 6.67%. If the company is reinvesting this money with a positive ROE then the returns on my money are increasing annually. 6.67% growing annually versus … ?
In my mind, there are still many attractive equity positions on the market. Take for example one Dow Index member I have in mind. Currently priced at a p/e of around 15, they recorded their first sales decline in 76 years in 2009. They have a bullet proof balance sheet and their bonds yield less than the US Treasury. The div yield is approx 3% and they have a very good habit of creating solid positive ROE for shareholders. Is there a reason that this is not attractive as an investment compared to alternatives? With a 50% payout ratio (they are less) and even assuming a paltry 10% ROE (this is likely to come in higher due to cost cutting and an assumed increase in sales for 2010) we’re talking 8% return on my money.
If deflation happens, the gubmint prints more moolah. If we have low growth then I’m happier than bonds. If inflation happens, then I’m happier than if I was in bonds. If stagflation hits, then I’ll release my golden parachute for a softer landing.
April 6th, 2010 at 9:45 pm
Its interesting that there are a bunch of ad hominem comments, negative with no subtance.
And then the 2 or 3 substantial comments conclude current valuations are quite rational and, in a recovery, likley headed much higher.
In the negative comments there are a bunch of blatant mistakes:
– average of 1930 to 1995 is said to be BETTER than average PE since (wtf?!?)
– operating vs net earnings (currently there is very little gap. the major diff is simply “goodwill” writedown which are just an accounting fiction. what is the opposite of goodwill write-downs? Why not include this as a huge positive in eps?)
– where is the earnings growth going to come from? (duh! recent Qs have had 50% to 300% YoY earnings growth. Earnings look set to continue growing 30%/yr the next two years of recovery.)
– balance sheet asset quality and CASH is at the highest levels ever
Good luck with the negative trade. I’ve been saying it for more than 6 months… SPX will post more than $80/shr in earnings in 2010 and close to $100/shr in 2011. New highs will be reached in late 2011 (which has some nice symettry — flat indices on 4-yrs and 11-yrs).
Again, I’ve been saying it the last 3 months — the credit cycle has turned… look at the financials: RF, ZION, MTG, BAC, GE, C, WFC, etc…
Kudos to the guy who pointed out that many MAJOR blue chips — AAPL, MSFT, HPQ, PG, PFE, XOM, GS, etc — have sub 15 PEs and nice +2% divs (or great eps growth, like aapl), large cash balances, and consistent profitability… many never had a losing Q.
April 6th, 2010 at 10:13 pm
cognos,
“In the negative comments there are a bunch of blatant mistakes:
– average of 1930 to 1995 is said to be BETTER than average PE since (wtf?!?)”
What’s your problem? You don’t understand the math? There is no mistake there.
The P/E-ratio averaged over 1936 to 1995 is lower than the P/E-ratio averaged over 1936 to 2008. For reported earnings, it’s about 13.8 vs. 16. This is due to the extremely overpriced stock market during the bubble years.
The 16.7 for the average P/E-ratio based on operating earnings, which is shown in the graphic, must be bogus, made up, fantasy or calculated using a period that isn’t long enough to get a reliable normal for the stock market. Since operating earnings are systematically biased upward compared to reported earnings, the average P/E-ratio based on operating earnings can’t be higher than the average P/E-ratio based on reported earnings. This is all quite simple math. Think about it, if you don’t understand it.
rc
April 6th, 2010 at 10:34 pm
You know that the market and participants are in a constant state of “Institutional Memory”, The only thing they know is based on the Empirical, Not the Statistical or historical or Scientific.
It’s the same mistake the Folks of the CDO made. “it hasn’t happened in our lifetime… therefore it’s impossible.” Every Knob, throws together a chart with the past 30 years of data, and assumes it’s going to be correct, and it almost never is.
A 3+ standard deviation event “Boomer stock bubble”, and somehow Forward PE’s should normalize to 17x FPE When a 15PE is a standard historic “Strong Growth” environment.
Let alone, when we have the “Come to Jesus” about the headwinds over the next 20 years.
April 6th, 2010 at 11:18 pm
If only these people could just use their food stamps to buy stocks, then they too could be “rich”.
http://globaleconomicanalysis.blogspot.com/2010/04/food-stamp-usage-hits-record-39-million.html
April 6th, 2010 at 11:37 pm
RC-
Anyone who thinks the last 20 years are LESS relevant than the 1930s, 40s, 50s… I’m sorry, that makes no sense.
Stuff can be out of line for a few years, even 5yrs… But not 20 yrs. PEs were way low in the 80s bc interest rates were above 10%. The 16.5x is quite fair. Once girth becomes accepted by the “chasers”, I would expect an overshoot to 18x or even 20x PE. (That MIGHT be a top, depending on the business cycle and events).
Then – what is the opposite of a “goodwill write-down”? Accounting always balances. There IS an offset. The correct offset would be to claim EARNINGS on ALL BUYOUTS. The difference paid above book value is “earnings” in the same way that massive asset write downs in 2008/09 are “neg earnings”.
We avoid thus problem, by just looking at operating earnings. Cashflow is greater than op eps.
April 7th, 2010 at 10:11 am
Cognos and rootless_cosmopolitan
There is no need to shoot the messenger for providing this provocative chart. I agree with Barry’s comments that precede the chart. Having used the several of the sources used to compute the chart, the numbers appear realistic, but have been scrubbed. One needs to compare the delta between the forecast vs. the actual numbers in a historical framework. The actual earnings and forecasted earnings in 2007 were questionable, as could be the case now. What has changed that the linear trend in earnings equates to $100 earnings in 2011? Global growth, Yes, but the degree of this is subjective. Yes, I acknowledge the global growth will have a positive contribution to the earnings, but it is unrealistic to believe without additional leverage not available in several developed countries, why would our domestic indices hit an all time high is earnings in only two years removed from a second depression. One other metric that has to be normalized is the productivity rate. Do you really believe the run-rate at the current level of 6.9% is sustainable? This will be a cost that will negatively impact earnings going forward. It will be marginal at first accelerating as the economic environment improves.
There are many ways to skin a cat, but to look at just one metric is problematic. One way to address each of your comments about PE multiples is to look at the underlying margins used to calculate earnings, normalized earnings, and forecasted earnings. The question that needs to be asked to the talking heads, what margins are you using in your forecasted estimates?
Additional variables and constraints are needed to help model forecasted earnings, which was a problem that is being reviewed today at leading Universities. What roll did financial engineering play in the global recession? Where the models robust enough to account for the tails?
Reversion to the mean needs to be incorporated in your analysis.
April 7th, 2010 at 11:43 pm
cognos, I’ll defer to hussman’s refutation of your premise: http://hussmanfunds.com/rsi/valuationforwardearnings.htm
As for myself, I would say we are overvalued currently, and I have not invested since last October. I missed a bit of remaining rally, and cannot say if it will continue, however, I will stick to my valuation indicators that tell me not to throw money in, and rather put it in my high yielding (not so much these days) checking account.
An interesting thing you argued earlier is that we can’t take into account long term P/E’s due to the massive wave of investment by the common man in the “Boom” or “Bubble” period. I have thought similarly in rationalizing the P/E expansion. Analyzing the long term data, it seems as a regression of the P/E is upward sloping. This, in theory should not occur over infinite time scales. Suffice to say, that it should return to nearing a flat line in the future. Whether this is in the near future due to a marketwide P/E contraction due to disillusionment in investing in stocks as opposed to other places by the general public(or demographic stock exposure reduction) or instead is in the long term future due to a gradual smoothing of the curve as the data set enlarges is up to debate. I am betting on the former.
Needless to say, you can still make money investing in any market, and there will still be individual companies that are great investments even in this environment. You often point out that good companies valuations have been brought down by the overall malaise, even though they have strong balance sheets, great prospects, and growth potential. The question is, is it worth investing in these companies now value wise? A conundrum I evaluate all the time.
April 12th, 2010 at 11:32 am
[...] Last week, I showed JPM’s chart of why some investors perceive the market as cheap. [...]