Investors are often worried about the next bear market. The reason for this concern is obvious. Avoiding the bear means they can preserve wealth. But, becoming defensive too soon means missing out on gains that allow investors to accumulate wealth. Both problems, losing wealth in a market decline and failing to accumulate wealth as the market advances, can prevent an investor from meeting their financial goals. This means investors will spend a great deal of time searching for clues that will help them spot the next bear market in advance, but not too far in advance.
To spot the bear, many investors look at valuation. This is logical since undervalued stocks should be able to deliver larger gains than overvalued stocks. An overvalued market is more likely to fall than rise under this logic. All we need, then, is a way to measure value and a way to determine whether our value metric to too high. This sounds simple enough but is one of the most complex problems in investing.
There are dozens of ways to measure value. Investors measure value in relation to earnings, sales, book value, cash flow, shareholder yields and other information. The table below shows twenty different valuation metrics. The most recent data (using data through the middle of April) is used to define the market’s condition. If the current ratio is higher than the long term average, the indicator is overvalued (except for yields where low values indicate the market is overvalued).
As you can see, most of the metrics in the chart are overvalued. Some are moderately undervalued. Let’s look at this in more detail before we develop an opinion on the current state of the stock market.
Indicators based on earnings are considered overvalued. However, earnings may be the least reliable way to measure the market’s valuation. The market consists of hundreds of stocks from various industries. Each industry requires different assumptions to define earnings and these assumptions are aggregated in the market average. Earnings are a great tool to value a company but aggregation errors make it difficult to apply these tools to the market.
Although the table shows different types of earnings, all earnings are affected by assumptions. These assumptions can be significant and analysts have developed a variety of tools to minimize the impact of the assumptions.
For example, some investors prefer to use GAAP earnings. Generally accepted accounting principles are standardized and considered to be conservative. But, GAAP is simply a set of assumptions accountants have agreed to use for now. Over time, those assumptions change. The changes can be so significant some experts argue that comparisons with the past are not reliable. The most famous debate in the field is over the use of Dr. Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE.
CAPE adjusts for inflation and looks back over the past ten years, enough time for a business cycle. In theory, this smooths the effects caused by the ups and downs of the economy and focuses on the company’s ability to generate earnings by factoring out inflation. Dr. Jeremy Siegel, a business school professor as well respected as Dr. Shiller, argues that accounting rule changes since the 1990s make earlier earnings incompatible with current earnings. They are just too many differences in assumptions.
In the chart above, the price to CAPE ratio is considered overvalued. But, if Siegel is right, this is meaningless. The truth is, he is most likely correct, at least to a degree. Since all measures of earnings are affected by assumptions, it could be best to use earnings ratios as just one input in assessing the market’s valuation. And it could be best to assign less weight to that factor.
Because of the widely understood problems with earnings, many investors prefer the price to sales (P/S) ratio or the price to book (P/B) ratio. But, revenue and book value can also be impacted by accounting assumptions. Many argue these assumptions have less impact but that is not fully accurate. In the late 1990s, for example, revenue could be counted when a contract was signed. Internet companies were even allowed to book revenue when they signed contracts to share advertising. This meant if AOL agreed to trade $100 million in advertising with Yahoo, both companies reported $100 million in revenue. Obviously, this was revenue that had no measurable impact on earnings. There is no doubt other revenue recognition rules are being used, or perhaps abused, today.
Book value most likely understates the assets of many companies and overstates the assets of others. Google, for example, has a book value of about $200 per share. This ignores the value of its in house research which is obviously worth billions and could add hundreds or thousands of dollars to the book value. Transocean, on the other hand, has a book value about four times greater than its stock price. But the company would struggle to find a buyer at book value given the uncertainty associated with the oil industry. These deviations from market value are understandable for companies but are impossible to predict for the market as a whole. The individual uncertainties make this a poor metric to value the overall market.
At the bottom of the chart, we see that metrics based on enterprise value (EV) are also overvalued. There are large variations by industry for EV ratios and these differences make it difficult to apply this concept to the market as a whole.
That brings us to the center of the charter where the various yield metrics give a more optimistic view of the market.
We see that the market is undervalued when we consider the number of shares they are buying back, the amount of cash they are allocating to dividends and the amount of cash they are using to pay down debt. These ratios tell us something is different this time.
Low interest rates are the reason a company might not pay down debt. Rates are so low it might make little sense to pay off outstanding debt. In fact, it makes sense to take on more debt, potentially using low cost funds to expand operations. This explains why companies are seeing increased cash flow, and holding on to the cash. They are looking for opportunities. This explains why dividend ratios are low. Companies can use the cash to find new opportunities and dividends for the market as a whole should not be significantly higher than interest rates.
Now, because interest rates are low, we expect P/E ratios to be low. Let’s say interest rates are 10%. Companies would then try to earn more than that with their assets. This would mean we should see an earnings yield of perhaps 12%. The earnings yield is the inverse of the P/E ratio and if interest rates were 10%, we should expect a market P/E ratio of about 8.
But, interest rates are now less than 3%. This means we could see companies targeting earnings yields of around 4% and the appropriate P/E ratio could be 25, or higher.
By focusing on metrics that tell us the stock market is undervalued, we uncovered a reason why P/E ratios should be overvalued. This is true no matter how earnings are calculated. By digging deeper, we have found an explanation for that entire table. Interest rates are at historic lows and that means P/E ratios should be at historic highs. They should be overvalued relative to their long term averages.
In this environment, cash flow ratios are most likely the most meaningful and these ratios are moderately undervalued based on history.
Based on fundamentals, we can conclude there is significant upside potential in the stock market. This conclusion is reasonable because low interest rates make the fundamentals unreliable.
There will eventually be a bear market but the next bear won’t necessarily be caused by an overvalued market. The most significant factor determining when the next bear begins is likely to be sentiment. When too many investors are scared of the bear, their fears might just become a self fulfilling prophecy.