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Bear with us, we are going to get technical and tell you why the stock market is undervalued and overvalued all at the same time, and why such things are really just constructs that we use to explain movements to ourselves.
The most frequently used and easiest to understand valuation metric is the Price-to-Earnings (PE) ratio. This is simply the price per share of a stock dividend by the earnings per share (EPS). Earnings are what is left over after the cost of materials, wages, taxes, and interest are paid and depreciation is deducted. The theory goes that this is what the shareholders are entitled to in the long run. PE ratios vacillate with time and are the most volatile portion of return of a stock. Looking right now at PE ratios (the blue line in the graph below), most stocks look like they are at all-time high valuations.
PE ratios rely on analysts best estimates on the earnings potential for the next twelve months (NTM). These are only estimates and during periods of massive economic upheaval (checking around to see if we are in the middle of such a time) forward looking estimates are inaccurate at best. So relying on forward looking estimates can be a bit dodgy, but it is all we have from a valuation standpoint. Nobody really cares what a company did in the past, we are looking to divine the future. So looking at this metric says that the market is near all time highs in terms of valuations and definitely stretched compared to recent norms. What if the analysts have estimated forward growth too low?
You can take the PE ratio and flip it to get a yield metric similar to what is normally done with fixed income. This means that you are calculating an Earnings Yield (EPS/P). Again if the earnings are what you as a shareholder technically have a future claim on, then you can say the earnings yield is what could be paid out. You can see in the chart below that the earnings yield (the gray line) reached a high in 2008 and has been trending down slowly ever since.
Of course we never look at any metric in isolation. So we must also look at what we can get paid for holding something else. In this case, we can look at the US 10-Year Yield, or “risk free rate”. The US 10-Year has been trending down since 2006 and is currently yielding less than 1%. That means that if you bought a US 10-year note you would realize 1% per year if you held it to maturity. So now let’s look at the interaction of the two.
The chart above says that for all of the volatility of the last year, the Earnings Yield minus the US 10-Year has stayed relatively flat. This is what Jay Powell was getting at when he took questions during his press conference on Wednesday. He was saying that stocks are not expensive when compared to historical levels of earnings versus the risk free rate.
Valuations change and “normal” valuations move over time. There are periods when the market is willing to pay a little more for something and periods when the market is willing to pay less for something. While valuations matter, and high valuations can be concerning, there also must be a catalyst for valuations to change. We said often in 2019 that bull markets don’t die of old age, they end because of some exogenous event. We saw that with a fury in 2020. So can the market continue to go up? Yes it can. Does it have to continue to go up? No it does not. 75% of the last 30 years the S&P 500 was positive, so chances are better than even that the market will be up next year.