It has been nearly 20 years since Alan Greenspan’s famous”irrational exuberance” comments regarding stock market valuations. So it was just a matter of time before a new Federal Reserve chief tip-toed into the minefield once again.
Last week, Janet Yellen made headlines and sent markets on a wild ride with her comment that stock values are”quite high” right now.
Only time will tell if Yellen’s powers of prognostication prove any better than Greenspan’s. After all, the S&P 500 Index went on to gain another 150 percent over the next four-plus years AFTER Greenspan’s call in 1996 before stocks ultimately crashed over the next three years.
So just like a stopped clock, you can’t exactly say Greenspan was wrong … just too early.
Here we are 20 years later and a new Fed chief decides to weigh in on stock market valuations. And you can’t say she’s wrong, but is she too early?
|You can’t say the new Fed chief is wrong with her recent comment about the stock market, but is she too early?|
How high are stock prices today?
According to a recent report from Sam Stovall, chief equity strategist at S&P Capital IQ, stocks are indeed highly valued today, no matter which way you slice and dice the numbers.
Looking at Wall Street’s favorite metric of operating earnings, the S&P 500 is priced at nearly 18 times trailing 12-month earnings.
That’s only a slight premium to the median P/E ratio of 17.4 for stocks since 1988, as Stovall points out, and my own analysis of Bloomberg data confirms.
But that’s about as good as this story gets, because here’s the cautionary part that corroborates Yellen’s call …
You see, I like to refer to operating earnings as: Profits without all the bad stuff, because they don’t tell you the whole story about a company’s profitability.
A lot of”one-time” charges and other”non-recurring” expenses — that have a persistent way of showing up year after year — get forgiven in the”operating earnings” number. This can result in overstating the profit picture for some companies and the stock market as a whole.
The market according to GAAP
If you play by the rules and follow best accounting practices, the correct profit numbers are calculated according to GAAP, or generally accepted accounting principles. GAAP earnings deduct all the”bad stuff” as true expenses, which provide a more conservative look at a company’s profits.
According to GAAP, stocks in the S&P 500 Index look a lot pricier today, with a P/E ratio of 21.3 times earnings.
That’s a 34 percent premium above the market’s median P/E (based on GAAP) of about 16 times earnings historically. And it does appear”quite high” indeed!
But there is yet another way to look at stock market valuations …
Wall Street analysts are an incurably optimistic bunch. Analysts have such a positive outlook on future earnings prospects they could make even Pollyanna look downright bearish.
Wall Street analysts like to value stocks based, not on profits in-hand (trailing earnings), but on forecast profits. Unfortunately, these forecasts often prove to be wishful thinking, and often prove far too optimistic at key turning points for the stock market, like 2000 and again in 2007.
The Pollyanna P/E
Based on Wall Street’s fearless-forecast of profits over the NEXT 12-months (see graph above), stocks today are trading at a forward P/E ratio of 17.6 times earnings now, compared with a median of 15.4 since 2000.
Again, this means stocks are overvalued by about 9 percent based on this metric. And as you can see in the graph above, the S&P 500 valuation is at the higher end of the valuation range over the past decade.
Of course the problem with using valuation tools, like P/E ratios to guide your investing decisions is that they are notoriously poor indicators for market timing.
Stocks were clearly, even”irrationally,” overvalued for many years in the late 1990’s before gravity finally took hold and stocks reverted to the mean, and then some. Also, stocks didn’t appear terribly overvalued in 2007, until overly optimistic profit forecasts collapsed in 2008, along with the world’s financial system.
Valuation metrics may not be good indicators for market timing, but they are quite accurate at forecasting the likely path of future returns in the stock market.
And here’s a key point to remember: The higher the P/E ratio is at present, the lower your expected returns will be in the future.
The Asset Management firm GMO has done a lot of research on this subject, and they regularly publish a 7-year asset class real return (after inflation) forecast.
According to the last update, GMO expects U.S. large-cap stocks to return -2 percent over the next seven years, compared with a historic return of +6.5 percent over the long run.
Unlike Wall Street profit forecasts, GMO’s return forecasts have been remarkably accurate.