2007-12-17

My intuition and understanding about stock valuation metrics comes mostly from authors like John Hussman, as well as Clifford Asness and Robert Arnott 

I’ve included links to (and excerpts from) a bunch of their writings

 

Arnott:

http://www.ft.com/cms/s/2/af1d2ac4-9fcb-11dc-8a08-0000779fd2ac,dwp_uuid=d8e9ac2a-30dc-11da-ac1b-00000e2511c8.html

excerpt:

Many observers point out that, following an unprecedented peak in valuation multiples (price-earnings ratios as well as price-sales, price-book and price-dividend ratios) at the peak of the bubble in 2000, p/e ratios are now back down to their long-term historical norms. That’s true. But that’s only because prices and earnings are both well above their historical trends. 

….There is a very long history of real prices and real earnings moving in a surprisingly consistent – and parallel – corridor around a long-term growth trend, albeit with large swings in prices, earnings and the p/e ratios. 

There’s also a long history of reverting back to the trend. When earnings are 40 per cent or more below the trend (2002, for instance), subsequent real earnings growth averages about 10 per cent – over and above inflation – for the next 10 years, which is terrific. When earnings are 40 per cent or more above the trend, subsequent earnings growth tends to disappoint, with average real growth of zero – just matching inflation – over the next 10 years. 

Where are we today? Both prices and earnings are 60 per cent above trend. This suggests either that things are different this time, that prices and earnings have built a base from which to leap to new heights, or that both may disappoint.

 

Hussman:

Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios

http://www.hussmanfunds.com/wmc/wmc070820.htm

 

Adjusting P/E Ratios for the Profit Cycle 

The growing gap between traditional P/E ratios and P/Es adjusted for the profits cycle

http://www.hussmanfunds.com/rsi/adjustingpes.htm

 

Profit Margins, Earnings Growth, and Stock Returns 

Investors consistently overpay for stocks in periods when profit margins are high 

http://www.hussmanfunds.com/rsi/profitmargins.htm

 

Recessions and Stock Prices 

Recession-induced bear markets are much different than "stand alone" declines 

http://www.hussmanfunds.com/rsi/recessionbears.htm

 

Fair Value - 40% Off (Not a Forecast, but Don't Rule it Out)

http://www.hussmanfunds.com/wmc/wmc070402.htm

Valuations Revisited 

Long-time readers will recognize some of the following arguments from various studies I've presented in recent years, but I believe that it is important for investors to understand how profoundly incorrect and potentially dangerous it is to accept the incessant argument that stocks are cheap on a "forward operating earnings basis." As AQR's Cliff Asness has previously noted, the belief that the current “price to forward operating earnings” multiple is reasonable is based on an apples-to-oranges comparison. It is the trailing P/E on reported net earnings that has a historical average of about 15, not the forward P/E on estimated operating earnings (which Asness estimates as having a historical norm closer to 11). 

Even that average for the trailing P/E is itself biased upward because earnings typically collapse during recessions, driving P/E ratios to extreme levels during those periods. Those get added into the average, and results in a “historical norm” of 15. If you correct for those spikes, the historical average P/E for the S&P 500 is even lower. 

To correct for the uninformative spike in P/E ratios during recessions, we can make the assumption that a given earnings level, once achieved, is likely to be achieved again even if the economy encounters temporary weakness. While that's not necessarily a reasonable assumption for an individual stock, it is much more reasonable for a diversified index like the S&P 500. Forming price/earnings ratios on the basis of the peak level of earnings-to-date (what I call the price/peak earnings ratio), we get a much better behaved measure of valuations that is more reliably correlated with subsequent long-term returns. Note that the word “peak” doesn't imply that earnings are about to decline – only that the P/E calculation uses the highest level of earnings achieved to-date. 

On that basis, the current price/peak earnings ratio is about 17.5, well above the historical average of 14 for the price/peak earnings ratio. 

But we're just getting warmed up. If we look closely at S&P 500 earnings, we find that we can draw a 6% growth trendline connecting earnings peaks from economic cycle to economic cycle as far back as we care to look. So even though earnings sometimes grow rapidly from the trough of a recession to the peak of an economic expansion, at rates sometimes exceeding 20% annually, we also find that the peak-to-peak growth rate has been very well contained historically at just 6%. 

Unfortunately, if we a) calculate the S&P 500 price earnings ratio based on those “trendline” earnings or b) look at periods where actual earnings were within 10-20% of that trendline connecting historical earnings peaks, we find that the average S&P 500 price/earnings ratio drops to just 10. 

Currently, S&P 500 earnings are again at that trendline. In fact, given the unusual spike in profit margins, they have actually moved slightly (but not significantly) above that line. On that basis, the current price/earnings ratio, normalized for the position of earnings at present, is about 75% above its historical norm (alternatively, the historical norm would be about 40% below current levels).

 

 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480

Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns 

CLIFFORD S. ASNESS 

AQR Capital Management, LLC

December 2002

Abstract:      

The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional methods evaluate the stock market purely on its own without regard to the level of interest rates. My goal is to examine the theoretical soundness, and empirical power for forecasting stock returns, of both the "Fed Model" and the "Traditional Model". The logic most often cited in support of the Fed Model is that stocks should yield less and cost more when bond yields are low, as stocks and bonds are competing assets. Unfortunately, this reasoning compares a real number to a nominal number, ignoring the fact that over the long-term companies' nominal earnings should, and generally do, move in tandem with inflation. In other words, while it is a very popular metric, there are serious theoretical flaws in the Fed Model. Empirical results support this conclusion. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates. I also examine the usefulness of the Fed Model for explaining how investors set stock market P/Es. That is, does the market contemporaneously set P/Es higher when interest rates are lower? Note the difference between testing whether the Fed Model makes economic sense, and thus forecasts future long-term returns, versus testing whether it explains how investors set current P/Es. If investors consistently confuse the real and nominal, high P/Es will indeed be contemporaneously explained by low nominal interest rates, but these high P/Es lead to low future returns regardless. I confirm that investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower and vice versa. In addition, I show that this relationship is somewhat more complicated than described by the simple Fed Model, varying systematically with perceptions of long-term stock and bond market risk. This addition of perceived risk to the Fed Model also fully explains the previously puzzling fact that stocks "out yielded" bonds for the first half of the 20th century, but have "under yielded" bonds for the last 40 years. Finally, I note that as of the writing of this paper, the stock market's P/E (based on trend earnings) is still very high versus history. A major underpinning of bullish pundits' defense of this high valuation is the Fed Model I discredit. Sadly, the Fed Model perhaps offers a contemporaneous explanation of why P/Es are high, but no true solace for long-term investors.