With the recent bear market we experienced in 2022, I wanted to take a look at where the overall stock market is relative to its underlying fundamentals.
A logical first stop is price to earnings (PE) ratios. If the price of the market has gone up, have the business fundamentals moved up in lockstep? One way to look at this is by using the trailing twelve months (TTM) earnings. The problem is that earnings are cyclical and can cause companies to look “cheap” at the top of the cycle when earnings have peaked. When earnings drop, the multiple usually drops as well.
Another approach, developed by Robert Shiller, is the Cyclically Adjusted Price to Earnings ratio (CAPE). This approach averages the earnings over the past 10 years to help smooth the cyclical rise and fall of the earnings. The problem with this approach is that over the long run, earnings are growing and that growth will be delayed through the 10-year average.
Up until the late 1980’s, CAPE worked pretty well in terms of telling you where you were at in the economic cycle. It would oscillate around the median price ratio of x16; and when you were above x20, the market was probably expensive. Also, if CAPE is significantly above the TTM multiple, it has indicated tough times for equities (the great depression in the 1930’s, stagflation of the 1970s, and the 2000 “.com” bubble). After 2000, CAPE stopped working in this regard. From 2005 to 2020 the CAPE ratio has been above x20 and significantly above the TTM ratio. It bounced off the median during the 2008 financial crisis, but not nearly as low as in previous downturns.
Impact of Interest Rates
Interest rates have been going down since the 1980s. This affects the price of equities because lower rates discount cashflows more gently. In other words, a dollar tomorrow is worth more today. You can also think about it like there is more “easy money”, and this bids up the price of all assets.
To account for this, I plotted the CAPE ratio against the 10-year treasury yield and fitted a curve to the data.
Using this curve, we can account for what the CAPE ratio should be, given the current interest rate.
This plot shows that in the late 1990s (“.com” bubble) the price of stocks was way too high given the levels of interest rates and earnings. It also shows the period after the 2008 financial crisis as a great time to buy (CAPE was lower than it should have been given interest rates).
To make it easier to visualize, I divided the current CAPE ratio by the interest-adjusted CAPE value to normalize it. Given current interest rates, the S&P 500 looks about 9% above fair value. Back a year ago it was 26% above fair value. The recent bear market of 2022 has helped close that gap to fair value significantly, but not all the way.
“The best single measure of where valuations stand at any given moment.” — Warren Buffett
Buffett has since backpedaled a little on this statement, noting that one simple metric is insufficient to account for something so complex as the US Stock Market. I like to think of this ratio as a Price to sales ratio for the entire country. Market cap is the price you would pay to purchase all publicly traded businesses, and GDP represents the “revenue” of all the businesses in the country.
I created a plot of this using GDP data and the Market Capitalization of the Wilshire 5,000 to include as many public companies as possible. Both data sets came from FRED. I also created a normalized plot by dividing the ratio by the median value. It doesn’t change the data a ton, but it can give us a sense of how far from nominal the current data is (83% high in this case).
The 83% above the historical median does not jive with the previous analysis of PE ratios. Because Market Cap/GDP is more like a price-to-revenue ratio, it doesn’t take into account changes in operating margin. If businesses have generated higher operating margins, it won’t show up in this metric.
To adjust for margins, I calculated them using Price to Revenue and Price to Earnings data. I also found another source that provided direct TTM margin data. The big takeaway for me was that operating margins have more than doubled since the mid-’90s (5% ->12%).
What will margins do going forward? One possibility is that they stay flat or continue to improve slightly. The index is made up of more large and advantaged businesses (GOOGLE, Apple, Meta, etc). It’s possible that their respective “moats” allow them to maintain high margins, and more of the total market capitalization moves away from “old world”/commoditized businesses with lower margins.
Another possibility is that operating margins revert to the mean. This would be very bad. Operating leverage cuts both ways, and if margins collapse, the stock market is probably much closer to the ~40–80% overvaluation we saw in the initial market cap to GDP ratios. If I had to guess, I would expect that most of the margins are here to stay. They may go down a little in the short term like in 2008, but I think it’s unlikely they revert permanently to 6%.
If we multiply the GDP (pseudo revenue) times the operating margin, we can convert it to something closer to earnings (“GDP earnings”). This makes it much closer to something like a typical PE ratio.
The “PE” ratio here is on average lower than the S&P 500 PE ratio because GDP captures revenue that is tied to private companies as well as public. The result is that the “GDP earnings” are overstated. The median “PE” ratio is 11.7 across the 30 years of available data (2.5% above the typical value).
Another factor to consider is that a lot of US companies have global footprints and more of the revenue is generated and produced outside our borders. It was difficult to piece together a comprehensive data set, but I found a recent MSNBC article, a 2010 S&P 500 study, and a 2018/2019 data point from Standard & Poor’s.
Increasing the “revenues” to account for international sales, it might improve the accuracy of the estimate. In truth, globalization didn’t change as much as I was thinking. To make this easy to see I normalized the Market Cap to GDP Earnings and the Adjusted International Earnings and plotted them together. In this plot, a value of 1 would represent “fair value”.
In both plots, you can see the “.com” overvaluation, the good buying opportunity after the 2008 financial crisis, and the post-Covid bubble that resulted from government stimulus. After accounting for international sales, the current price is a little higher than previously seen (6.8%).
Using both data for GDP and PE ratios, it seems the stock market is slightly overvalued (2–9%), but not to the extent we saw during the “.com” bubble or the roaring ’20s. Using multiple different sources of data allows us to triangulate the approximate range of current market prices relative to fair value. Similar to valuing an individual company, the intrinsic value of the stock market is better represented by a range of values, as opposed to a single number.
It is probably worth considering that a recession in 2023 could impact both earnings and margins. This might be offset by the FED lowering rates. All these items (and many more) could affect what the market does in 2023. This article was meant to take a snap shoot of where we are today, rather than make predictions about where things are headed in the future.
If you enjoyed this article, feel free to “applaud”, and you can follow me on Medium or sign up for emails to be notified of more stories like this.
Note that this article does not provide personal investment advice and I am not a qualified licensed investment advisor. All information found here is for entertainment or educational purposes only and should not be construed as personal investment advice.