After our last week’s report on the NASDAQ, we further analyse PE ratios, their meaning and the factors that drive them this week
Researchers from the NY Fed have raised the point that the Equity Risk Premium (ERP) – conceptually defined as the excess return expected from investing into stocks compared to the yield of a risk-free bond – is just off all-time highs. The authors report a value close to six per cent, and while we believe that the number per se can be misleading, given that it comes from the averaging of disparate models, the trend is certainly worthy of attention. In fact, the ERP can be likened to a gauge of investors’ risk attitude, and a high value tends to signal that investors are still in a risk-off phase.
Does this mean that stocks are not yet fully valued? A conventional metric that we refer to when assessing whether stocks are correctly valued is the PE ratio, and this gives us a contrasting signal, since the PE ratio of the S&P 500 is well above its historical average of around 15x to 17x, depending on the timeframe one uses.
Considering past high PE ratios cycles, one knows that these periods are usually associated with a lower ERP[1], a high growth rate of earnings[2], or a low bond interest rate[3]. By the evidence on the NY Fed paper referred previously, it is possible to exclude the first factor, and, with current US growth revisions pointing to the downside, the second factor is unlikely. What is, in our opinion, behind both the high ERP and PE’s of today is then the extreme looseness of monetary policy and the low bond interest rates that it entails.
One knows the negative relation between the price of a stock and the interest rate from basic Corporate Finance courses. And one also knows that the earnings of a company are an indicator of its performance. So one could roughly say the ratio of Earning/Price – the Earnings Yield – could be close to a rate of return[4]. Looking from this perspective, we should not expect high Earning Yields considering the low yield climate we are into.
There is actually a model used by practitioners – the Fed Model – that relates the Earnings Yield to the 10 Year T-bond. Behind this model there is the idea that stocks and bonds are competing asset classes for investors, and as any other model it has been contested for diverse reasons, but it states that stocks as an asset class are fairly valued if their Earnings Yield are equal to the 10Year T-bill return. From this follows that a decrease in the interest rates should lead to a decrease in the Earnings Yield that can only be obtained by an increase in the PE ratio. Analysing the biggest US indexes’ PE ratios, inverting them into Earnings Yield and then comparing to the 10Y T-bill of a year ago, we conclude that following the Fed Model we are not in an overvalued stock climate, since the Earnings Yield of stocks is higher than the risk-free rate.
Source Wall Street Journal and FRED St. Louis
In order to put this finding into perspective, we compare the results that the same analysis would have produced in January 2007 and January 2000. Comparable PE data are only available for the S&P 500 index, so we focus on the latter.
Source multipl.com
We notice that we would not have been able to call the top of the stock market in 2007, but we would have been able to spot the bubble in stocks in 2000.
Summing up, taking into account the environment of very low yields across all asset classes and bonds in particular, we believe that stocks are not overvalued if yields do not depart much from the current levels. The biggest factor to watch out for is then how the monetary policy normalisation will play out. If, as market participants expect, rate hikes will be gradual and short-term rates will stay substantially lower than the previous long-run average of around 4%, PE ratios that are higher than the historical average may well be justified and, indeed, the new normal.
With all this reasoning we are not going against Joel Greenblatt’s great quote “Buying good businesses at bargain prices is the secret to making lots of money”, but we are more into Warren Buffett’s quote “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Of course, the prices today can feel a bit inflated, but that is part of the risk investors are willing to take compared to a riskless asset. If one finds a great company to do an investment, it should not be because of the possible “inflated PE” that the deal should not go on.
[1] a lower equity premium might lead to higher prices due to lower returns on equity
[2] a higher expected growth rate leads to an increase in the expected value of the stock in the future, increasing its price today
[3] a lower risk-free rate will also lead to a low return on equity, leading to an higher price of the stock
[4] ignoring the fact the earnings do not have a perfect correlation with dividends
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