In my book Predicting the Markets (2018), I reviewed various valuation models that stock investors follow. My main takeaway was that, “Judging valuation in the stock market is akin to judging a beauty contest. … Not only is beauty subjective, Hollywood tells us—it can be dangerous. At the end of the original version of the movie King Kong (1933), the big ape’s death is blamed by his handler on Ann Darrow, Kong’s blonde love interest, played by Fay Wray: ‘It was beauty that killed the beast.’ Valuation is in the eye of the beholder too. And buying stocks when they are most loved and very highly valued can also be deadly.”
In today’s politically correct times, it’s probably best to compare valuation to a talent contest rather than a beauty contest. Like any objective judge at a talent show, I want to see the contestants compete before I pick the winner. In recent years, I’ve given more of my votes to the contestants that incorporate inflation and interest rates into their acts. That’s led me to a more sanguine opinion about stock valuation than suggested by the more traditional reversion-to-the-mean P/E models, especially the ones based on trailing earnings.
Here’s an update of four of the valuation models that I reviewed in my book:
(1) Buffett ratio. Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world (Fig. 1). The data for the numerator are included in the Fed’s quarterly Financial Accounts of the United States and lag the GNP report, which is available on a preliminary basis a few weeks after the end of a quarter. Needless to say, they aren’t exactly timely data. However, the forward price-to-sales ratio of the S&P 500, which is available weekly, has been tracking Buffett’s ratio very closely. The quarterly series is back at the 1.90 peak just before the bear market of 2000-2002. The weekly series was 2.07 at the end of October. Buffett has remained bullish, observing that historically low inflation and interest rates justify these high ratios.
(2) Rule of 20. The “Rule of 20” was devised by Jim Moltz, my mentor at CJ Lawrence. It simply compares the S&P 500 forward P/E to the difference between 20 and the inflation rate, using the y/y percent change in the CPI. When the sum of the forward P/E and the inflation rate is above (below) 20, stocks are deemed to be overvalued (undervalued) (Fig. 2). It was slightly below 20.0 during October. This rule of thumb has had a few hits and misses, as have more sophisticated models.
(3) Real earnings yield. The earnings yield of the S&P 500, which is simply the reciprocal of the P/E based on reported earnings, is highly correlated with the CPI inflation rate on a y/y basis. The real earnings yield (REY) of the S&P 500 is the difference between the nominal yield and the inflation rate (Fig. 3). The result is a mean-reversion valuation model that logically includes inflation.
The average of the real yield since 1952 through Q3-2019 is 3.19%. The model tends to anticipate bear markets when the yield falls close to zero. Our friend John Apruzzese, the Chief Investment Officer of Evercore Wealth Management, examined this model in a November 2017 paper titled “A Reality Check for Stock Valuations.” Based on the REY model, he found that “stocks appear more reasonably priced than the conventional P/E ratio suggests during periods of low inflation and rising markets, and more expensive during periods of high inflation and falling markets when they otherwise might seem cheap.”
According to the model, stocks remained reasonably priced during Q3, with the REY at 2.92%.
(4) Misery-adjusted P/E (MAPE). The Misery Index is the sum of the unemployment rate and the yearly percent change in the CPI inflation rate (Fig. 4 and Fig. 5). The Misery Index tends to fall during bull markets and to bottom before bear markets. It was down to 5.4% during October, almost matching the most recent low of 5.0% during September 2015, which was the lowest reading since April 1956. What you’re about to hear may be hard to believe, I know, amid all the naysaying by all the naysayers, but the truth is: Most Americans have never been less miserable, at least in terms of how they’re affected by the performance of the macro-economy.
I’ve found that there is a reasonably good inverse correlation between the forward P/E of the S&P 500 and the Misery Index (Fig. 6). That makes sense to me. When we are miserable, we aren’t in the mood to drive up the valuation multiple. When we are happy, we tend to become exuberant, driving up the P/E. However, a high P/E, by historical standards, may not necessarily reflect irrational exuberance if interest rates are historically low because inflation is subdued. In other words, the current readings of the Misery Index are historically low and may justify P/Es that exceed the historical average.
My homebrewed MAPE is the sum of the S&P 500 forward P/E and the Misery Index (Fig. 7). It averaged 23.8 from September 1978 through October 2019. Readings above (below) the average suggest stocks are overvalued (undervalued). It was 22.6 during October, i.e., below average. MAPE correctly warned that stocks were overvalued prior to the bear markets of the early 1980s and 2000s. It did not anticipate the last bear market, but that’s because the problem back then was the overvaluation of real estate, not stocks.
In today’s politically correct times, it’s probably best to compare valuation to a talent contest rather than a beauty contest. Like any objective judge at a talent show, I want to see the contestants compete before I pick the winner. In recent years, I’ve given more of my votes to the contestants that incorporate inflation and interest rates into their acts. That’s led me to a more sanguine opinion about stock valuation than suggested by the more traditional reversion-to-the-mean P/E models, especially the ones based on trailing earnings.
Here’s an update of four of the valuation models that I reviewed in my book:
(1) Buffett ratio. Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world (Fig. 1). The data for the numerator are included in the Fed’s quarterly Financial Accounts of the United States and lag the GNP report, which is available on a preliminary basis a few weeks after the end of a quarter. Needless to say, they aren’t exactly timely data. However, the forward price-to-sales ratio of the S&P 500, which is available weekly, has been tracking Buffett’s ratio very closely. The quarterly series is back at the 1.90 peak just before the bear market of 2000-2002. The weekly series was 2.07 at the end of October. Buffett has remained bullish, observing that historically low inflation and interest rates justify these high ratios.
(2) Rule of 20. The “Rule of 20” was devised by Jim Moltz, my mentor at CJ Lawrence. It simply compares the S&P 500 forward P/E to the difference between 20 and the inflation rate, using the y/y percent change in the CPI. When the sum of the forward P/E and the inflation rate is above (below) 20, stocks are deemed to be overvalued (undervalued) (Fig. 2). It was slightly below 20.0 during October. This rule of thumb has had a few hits and misses, as have more sophisticated models.
(3) Real earnings yield. The earnings yield of the S&P 500, which is simply the reciprocal of the P/E based on reported earnings, is highly correlated with the CPI inflation rate on a y/y basis. The real earnings yield (REY) of the S&P 500 is the difference between the nominal yield and the inflation rate (Fig. 3). The result is a mean-reversion valuation model that logically includes inflation.
The average of the real yield since 1952 through Q3-2019 is 3.19%. The model tends to anticipate bear markets when the yield falls close to zero. Our friend John Apruzzese, the Chief Investment Officer of Evercore Wealth Management, examined this model in a November 2017 paper titled “A Reality Check for Stock Valuations.” Based on the REY model, he found that “stocks appear more reasonably priced than the conventional P/E ratio suggests during periods of low inflation and rising markets, and more expensive during periods of high inflation and falling markets when they otherwise might seem cheap.”
According to the model, stocks remained reasonably priced during Q3, with the REY at 2.92%.
(4) Misery-adjusted P/E (MAPE). The Misery Index is the sum of the unemployment rate and the yearly percent change in the CPI inflation rate (Fig. 4 and Fig. 5). The Misery Index tends to fall during bull markets and to bottom before bear markets. It was down to 5.4% during October, almost matching the most recent low of 5.0% during September 2015, which was the lowest reading since April 1956. What you’re about to hear may be hard to believe, I know, amid all the naysaying by all the naysayers, but the truth is: Most Americans have never been less miserable, at least in terms of how they’re affected by the performance of the macro-economy.
I’ve found that there is a reasonably good inverse correlation between the forward P/E of the S&P 500 and the Misery Index (Fig. 6). That makes sense to me. When we are miserable, we aren’t in the mood to drive up the valuation multiple. When we are happy, we tend to become exuberant, driving up the P/E. However, a high P/E, by historical standards, may not necessarily reflect irrational exuberance if interest rates are historically low because inflation is subdued. In other words, the current readings of the Misery Index are historically low and may justify P/Es that exceed the historical average.
My homebrewed MAPE is the sum of the S&P 500 forward P/E and the Misery Index (Fig. 7). It averaged 23.8 from September 1978 through October 2019. Readings above (below) the average suggest stocks are overvalued (undervalued). It was 22.6 during October, i.e., below average. MAPE correctly warned that stocks were overvalued prior to the bear markets of the early 1980s and 2000s. It did not anticipate the last bear market, but that’s because the problem back then was the overvaluation of real estate, not stocks.
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