Equities in the U.S. are expensive, as measured by the ratio of stock prices to earnings. U.S.-based equities are starting the eighth year of a substantial rally, more than tripling from the bottom in March 2009. The Dow Jones Industrial Average recently broached the 20,000 level.
Is it time to avoid the U.S. stock market?
One of the best measures for valuing the stock market is the ratio of stock prices in an index to the earnings of the companies included in that index, called the P/E ratio. This value ranges from less than 10 in very cheap markets to more than 20 during frothy markets. The current P/E as measured by current prices against the earnings from the latest twelve months (called trailing earnings) on the S&P 500 index is estimated to be 19 by most analysts, which puts the market into the “expensive” range.
The average P/E ratio in the U.S. at the peak of a bubble is 19.8, according to Credit Suisse (January 20, 2017 Global Equity Strategy).
In 1929 the ratio was 20.2. In March 2000, the biggest bubble of all, the ratio reached 28.9.
A long economic expansion cycle encourages elevated stock prices and higher profit margins for companies. One economist invented a ratio that tries to eliminate the influence of the economic cycle on the P/E ratio.
Robert Shiller, Nobel Prize recipient for his work on bubbles, published a more sophisticated version of the P/E ratio, which is known as the Shiller Cyclically-Adjusted P/E, (Shiller CAPE).
He uses inflation-adjusted earnings, and takes a ten-year average of earnings and compares that to the price of shares. This means that the expansion and contraction of profit margins during a cycle has less influence on the ratio.
Here’s his latest version for the U.S.:
Source: multpl.com – Updated Feb 3, 2017
Today’s value, at 28.45, is one of the highest on record going back to 1880. Only during the dot-com bubble between 1997 and 2002 was the index substantially higher (at 44.19) than today. And that peak was distorted because the S&P 500 index managers decided to include a large number of technology-oriented companies in the index. These companies were trading at extremely high valuations, and many of them had zero earnings. Some of them didn’t have much in revenue either! Almost all of those dot-com companies are out of the index now.
This Shiller CAPE index can reach extreme lows also. During period from 1974 to 1982 the index spent many years trading below 10. This represented the “buying opportunity” of the last fifty years, although we didn’t know it at the time. I started my career as an investment professional in November 1978, so my early formative experience was buying stocks trading at less than 10 times earnings.
Today the market is at the other end of that spectrum. There are few attractive choices in the U.S. There are a lot of great companies, like Amazon and Google, doing amazing things. But those companies trade at P/E ratios of 165 and 29 respectively. And the Shiller CAPE ratio sits at 28, almost three times as expensive as the early 1980s and bonds yield a paltry 2.5 percent on the U.S. 10-year note.
Based on history, the U.S. stock market is likely to disappoint investors over the next few years.
Hilliard, The MacBeth Group team and their clients may trade in securities mentioned in this blog.
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