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Showing Interest In Valuation

Posted on August 9, 2016

“There's always been an inverse relationship between interest rates and P/E ratios." - Ed Keon, director of quantitative research at Prudential Securities

2016-08-09_interest.jpgOne of the persistent questions faced by investors is whether stocks are undervalued, overvalued or fairly valued. After all, the “cheapness” of a stock at the time one invests is probably the single most important driver of the long-term result. Throughout history there have been a handful of short-lived periods where the valuation of the stock market was clearly stretched too far in one direction or the other – the tech bubble of the late 90’s being an obvious example. But unfortunately most of the time ascertaining whether or not valuations are too high or too low isn’t that clear cut.

There are a multitude of metrics that are used to measure the valuation level of a stock, but the most common one is the Price-to-Earnings, or “P/E” Ratio. In a simple number this ratio tells us what price is being paid per dollar of earnings on a particular stock or index. For instance, if a stock is trading at $100 a share and produces $5 of earnings-per-share its P/E Ratio would be 100/5 = 20. Obviously high P/E Ratios imply a stock might be considered “expensive” or “overvalued, and vice versa for a lower P/E Ratio.

Given the simplicity and familiarity of this metric, one cursory analysis that is commonly floated around is to simply show the market’s current P/E Ratio vs history. The chart below shows the P/E Ratio for the S&P 500 on a monthly basis going back fifty years. Relative to the average level of roughly 18.3 for this time period, the current value of 25 appears to reflect an overvalued market.

2016-08-09_pe_ratio.png

However, there is another level to this analysis that tells an entirely different story by reframing the P/E Ratio within the context of interest rates. The thinking is that the lower the level of interest being offered by long-term bonds, the higher a price an investor should be willing to pay per dollar of earnings in the stock market. Thus, higher P/E Ratios should in theory be justified in low interest rate environments such as the one we’re in currently. Intuitively this makes sense. If, for instance, the 10-year Treasury bond were yielding 7% instead of the 1.5% it is today, don’t you think there would be more demand for bonds relatively to stocks than there is today? The higher the yield being offered by bonds, the lower the valuation (P/E Ratio) would need to be on stocks in order to make them relatively attractive. 

Another way of thinking about this is to flip the P/E Ratio on its head and state it as an “earnings yield” (E/P). Back to our earlier example, if a stock trades for $100 and produces $5 of earnings-per-share its earnings yield is 5/100 = 5%. Earnings yield is simply the inverse of P/E Ratio, so obviously the higher the earnings yield the lower the P/E Ratio and vice versa. Stated this way, the higher the yield being offered by bonds, the higher the earnings yield would need to be on stocks in order to make them relatively attractive. 

The chart below depicts the historical relationship between P/E Ratios and long-term bond yields. The vertical axis plots the P/E Ratio for the S&P 500 while the horizontal axis is the 10-year Treasury yield over the past fifty years. Notice how the downward sloping trend line shows that, on average, P/E Ratios tend to be lower (or earnings yields higher) during regimes in which bond yields are higher. Also, notice that the current scenario (P/E Ratio of 25, 10yr yield of 1.6%) is highlighted in blue and appears to be right in line with the historical relationship as measured by the trend line.

2016-08-09_scatter.png

Base on this reframing of the P/E Ratio one might conclude that the market is currently fairly valued in light of how low interest rates currently are. However, I’d like to make a handful of important points:

  • Given how low bond yields already are one might conclude that P/E Ratios are not likely to climb much further from here. An absence of further “multiple expansion” implies returns will be relatively muted at best in the near future.
  • Although US Stocks do not appear to be overvalued based on this metric, on a relative basis they are still more richly valued than elsewhere in the world. Europe, for instance, and many emerging markets are trading at P/E Ratios below their long-term averages and even further below their interest rate-adjusted averages.
  • While this exercise in valuation analysis is interesting, it should be taken with a huge grain of salt. This is not an exact science, and there are a multitude of factors beyond a single measure of valuation that affect the performance of financial assets. It would be foolish to base any investment decision on a sole metric such as P/E Ratio.

We are often asked questions along the lines of “where we see the market going from here” or “how concerned we are about where the market is”. Based on this one isolated metric we think it’s reasonable to conclude that the US stock market is not currently in a state of extreme overvaluation like many believe it is. That said, it is far more complicated than a single metric, especially in this age of central bank intervention (see our post NIRP Is The New ZIRP about negative interest rates from two weeks ago). Our response to these questions is typically something like “we’re not smart enough to predict the future”. And we’re not just trying to be cute…we really aren’t! Furthermore, as clients of our firm already know, rather than trying to read the tea leaves we prefer to utilize a systematic trend following discipline that relies on a simple measure of price momentum and remains totally agnostic to the ever changing landscape of macroeconomic and fundamental data. So while we certainly believe in Showing Interest In Valuation, successful investing does not require using them to predict where stocks will go next.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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