Examining Dualing Market Outlooks

Does anyone else find it pretty strange that two people can look at the exact same set of data and reach two dramatically different conclusions? I’m speaking of market strategists who try and determine if the overall equity market is overvalued or undervalued. The bulls think we are 20 or 30 percent undervalued and the bears see the exact opposite scenario. How can people differ that much on the outlook for the domestic stock market? It’s not like we’re are trying to value a single company, where I could understand widely varying outlooks. The stock market as a whole can’t be overvalued and undervalued at the same time.

The key to analyze this dichotomy is to look at the S&P 500 P/E ratio, which is the most widely used metric to value the overall market. This isn’t as simple as it sounds though. You arrive at different numbers depending on if you use the trailing twelve month (TTM) P/E or the forward P/E. Personally, I use forward P/E ratios when valuing stocks, because equities are claims on future earnings, not profits already earned. However, the most bearish market strategists use trailing numbers because doing so results in higher P/E ratios, which imply higher valuations. For the purpose of this piece, I’ll use TTM P/E ratios, mainly because historical data is easier to find.

Another point of contention is which earnings calculation to use. The two most commonly cited are operating earnings and GAAP earnings. Operating earnings are meant to gauge how much cash a firm’s operating businesses are generating, whereas GAAP numbers are really more of an accounting standard and don’t always reflect true profitability. For instance, one of the biggest contributors in GAAP earnings is stock options expense. Accountants insist that companies issue GAAP income statements that place a value on expenses incurred by issuing stock options, even though no economic cash cost is incurred.

Currently, the P/E on the S&P 500 index is anywhere between 15.4 (forward operating earnings) and 18.0 (trailing GAAP earnings) depending on which of the four measures (forward vs trailing/operating vs GAAP) you use. I don’t think we need to agree on which P/E to use to analyze whether or not the market is wildly overpriced or underpriced. For the most part, the bears think P/E ratios should be lower, or will be lower shortly. The bulls think if P/E multiples do anything, they should go up, not down.

Keep in mind, I am referring only to those people who think the market is meaningfully mispriced right now, say by 20 percent or more in either direction. I fully understand that this is only a subset of all market pundits. I’m simply interested in looking at the dichotomy that exists between them.

Let’s take a look at an interesting chart that should shed some light on this debate. The graphic below shows the historical trailing P/E of the S&P 500 index (blue) along with a five-year moving average (black).

As you can see from the chart, the stock market typically trades at a P/E of between 10 and 20. Depending on which number you use, we are currently either right smack in the middle of that range, or on the upper end of it. If you are using P/E ratios as your yardstick, you really can’t make a compelling argument that stock prices are dramatically too high or too low.

The real question in this analysis, if we assume the historical range is a pretty good guide to stock market valuation, is whether we should be closer to 10 or 20. How much investors are willing to pay for equities can depend on many variables, but the most important ones are interest rates and inflation. Don’t take my word for it though, both logic and historical statistics back up this assertion.

Since stock prices reflect future earnings discounted back to present day values, there is a negative correlation between interest rates and stock prices. When rates are low, investors are willing to pay higher multiples of earnings, and vice versa. Inflation measures have the same effect on demand for equities. When inflation is high, the “real” (net of inflation) return on stocks goes down or becomes negative, which crimps investor demand for equities, lowering multiples.

Since the economic backdrop is crucial in determining the appropriate valuation level for stocks, the fact that the United States currently is operating a growing economy in a low interest rate, low inflation environment sheds a great deal of light into where stock prices might trade. The middle or upper end of the historical range is not only not unrealistic, but it makes a lot of sense.

Making the argument that P/E ratios should be dramatically higher is simply not prudent given the historical data. Defending a P/E toward the low end of the range also isn’t very compelling given the current economic backdrop. As a result, I think a simple look at history, coupled with a basic overview of current economics, shows that the market is neither wildly overvalued, nor wildly undervalued.

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