Jeremy Siegel, author of Stocks for the Long Run, and professor at the University of Pennsylvania’s Wharton School, offered a promising view of stock market opportunities in his conference call with advisors April 14.
The way Siegel determines whether markets are overvalued, undervalued or neutral is largely based on the ratio of stock prices divided by expected earnings for companies. This is called the price/earnings ratio. If you take the collective price of the companies in the S&P 500 and compare it to those company’s estimated earnings for 2011, you get a price/earnings ratio of approximately 13.5. This is an attractive figure compared to historical P/E ratios but Siegel suggests that the P/E ratio declines to 11.86 if you look forward to the expected company earnings for 2012 compared to today’s S&P 500 value.
These numbers speak to clear undervaluation, at least for large U.S. companies. Siegel estimates that “stocks have good room to appreciate another 15%.” He thinks this is particularly true because the low P/E ratios are also supported by very low interest rates.
Siegel thinks European stocks are an even better buy. He estimates that they trade at a 20% discount to U.S. stocks. The general P/E ratio of broad European markets is in the 10-11 range and even in the single digits for many companies when looking to 2012 earnings.
Of course, Siegel’s view is not shared by everyone. An argument exists over whether the present attractiveness of the market should be viewed with projected future earnings in mind or from the standpoint of actual past earnings. Siegel contends that stock prices are based on future earnings expectations so it is logical to evaluate whether they are over- or undervalued solely by looking at projections. Many others, particularly Yale University’s Robert Shiller, suggest that the past earnings are a more important measure. From this view, the market looks moderately overvalued.
The investment management team at Dodge & Cox, an 80-year-old mutual fund management firm, sides with Siegel in their outlook. In doing so, they wrote the following four reasons for optimism in their annual report.
1. The S&P 500 traded at a 14 price/earnings ratio at the end of 2010. “A price-to-earnings ratio of 14 times has historically been an attractive starting point for equity returns.”
2. U.S. companies still hold record amounts of cash, estimated at $1.5-$2 trillion. “We see that as a positive sign of the overall health of the economy and for investors.”
3. Signs of progress in economic recovery include the highest quarterly corporate profits in 60 years, rising manufacturing and exports.
4. Economic growth in the developing world continues to raise the standard of living for millions of people. Growing populations with rising income should purchase and use more consumer products, technology, pharmaceuticals, etc.
Whether you look forward or back to evaluate the value of the stock market, what seems to be growing in consensus is the idea that high-quality stocks have more upside potential than riskier stocks of companies with low-quality financials. This has not been the case for the majority of the recovery rally. More speculative and smaller stocks have had the best returns off of the bottom. Through April 15, small-cap stocks, represented by the Russell 2000 Index, had gained 143% since their low in March 2009. The S&P 500 Index of larger companies gained 95%. It seems that companies with less debt, higher cash flow, higher dividends and competitive advantages may be well positioned to extend gain.
The Royce Funds annual report captured this sentiment well. “As value investors, we are always all for caution, but we see the intelligence with which so many companies have managed themselves over the last two or three years as more meaningful than the economic problems we are currently laboring to solve. This is what inspires our confidence in the economy going forward. … We suspect that the reign of high-beta (volatile prices), often low-quality companies is likely to end soon, usurped by companies with characteristics such as high returns on invested capital, free cash flow generation and dividends.”
Forward to a friend
Stock market rally justified by earnings, reasonable market value
The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.
This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.
While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.
So on with the show.
Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.
This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.
The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.
So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.
Add January’s price appreciation and the forward P/E ratio is about 13.3.
The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.
Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.
The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.
Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.
Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.
Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.
The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.
~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA
www.BHJadvisors.com
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Tagged earnings, investments, market valuation, s&P 500, stock market, stocks