If you think a three-year decline in stocks has created a compelling and historically cheap market, think again.
While some analysts have advised clients to buy stocks on the basis of the
supposedly low price-to-earnings ratio of about 16, that analysis is based on forecasts for the market's operating earnings. Such results are tenuous and tend to exclude big charges.
In fact, the S&P 500 still trades at 30.4 times trailing GAAP earnings, well above its 53-year average of 16.2, according to Diane Garnick, global equity strategist at State Street Global Advisors. Because earnings are currently depressed, some analysts say the comparison isn't meaningful. But even when this cyclicality is backed out, the market still looks pricey.
Doomed to Repeat
Brett Gallagher, head of U.S. equities and deputy chief investment officer at Julius Baer, has smoothed out reported earnings going back to 1959 (removing the recessionary troughs and bubble peaks) and found that the median P/E is around 16. On the basis of "trend line" profits, he said the market is currently sporting a P/E of about 22.
In truth, though, it's hard to tell precisely how the S&P 500's price-to-earnings ratio compares with those of yesteryear, because the number of variables that go into the market's P/E has changed so much over time.
"There are a lot of caveats in terms of making any long-term historical comparisons," said Ned Davis Research analyst Sam Burns. "A committee picks the stocks that go into the S&P. It's a portfolio, not a whole market."
Gallagher noted that the composition of the S&P 500 is now very different from what it once was. In the early 1980s, for example, energy stocks made up a much larger portion of the index than they do now. A higher weighting from one sector can affect the P/E ratio, because different industries have different valuation norms.
"Financials tend to trade at a lower P/E than industrials," he said. "So if you have a higher weighting in financials, that would artificially depress the ratio."
In order to get a more accurate gauge of the market's historical P/E, Gallagher said, it is necessary to freeze the industry weightings as they are today and apply those same weightings back through history.
The difficulty in locating such figures makes P/E comparisons less reliable over time.
Another complication is the issue of ever-changing accounting practices, which specifically affect the "E" part of the equation. Edward Ketz, a professor of accounting at Penn State's Smeal College of Business, noted that revenue recognition practices became much more liberal in the 1990s, meaning that earnings were also unusually high. While there has been a recent push toward more conservative accounting, revenue recognition policies are still different from what they were 20 years ago.
Ketz also noted that the Financial Accounting Standards Board recently eliminated goodwill amortization, meaning that when one company acquires another, it no longer needs to take a big charge against earnings for the price it paid over and above the true market value. Such accounting changes directly affect GAAP earnings, and that in turn distorts the P/E.
"Historical P/E comparisons are affected by the fact that accounting rules have changed over time, and historical index earnings are generally not restated even if a company restates its earnings," said Burns. "But unfortunately, there's not really any way to quantify those tendencies."
Nevertheless, Burns still believes the S&P is overvalued. He noted that the dividend yield on the S&P is less than 2% right now, below its long-term average of 3% to 3.5%.
"Dividend yields are much less prone to being distorted because it's a simple cash payment," he said. "From most absolute valuation perspectives, we still see the S&P as fairly expensive."
Gallagher agrees that the market isn't cheap. He noted that debt levels relative to sales are much higher than they have been historically, and that if valuations were adjusted to account for that factor, stocks would look even pricier.
"Our view is that the market today looks expensive on the most logical measures of valuation, which is trend earnings," he said. "If we adjusted it for everything that we should, it makes it look even more expensive."
Other analysts disagree. Salomon Smith Barney analyst Tobias Levkovich argues that operating earnings are a reliable measure of a company's performance. Using these numbers, the S&P 500's P/E on a trailing basis is around 17.
"In the first quarter of 2002, two companies took goodwill charges that in the aggregate eliminated the actual earnings of the S&P 100," he said. "Thus, if we summed up the numbers, it would provide a very serious misrepresentation of corporate earnings, since many fine companies that truly earned money would be maligned by the actions of a few."
Unfortunately, it's also misleading to simply exclude these charges. And it's worth noting that since 1985, the gap between operating and GAAP earnings has widened, as companies have become more liberal with their definition of operating profits.
Tom McManus, equity strategist at Banc of America, recently raised his equity weighting to 75% from 70%, saying the market's P/E, based on consensus estimates for the next 12 months, has fallen down to 15 times earnings, having traded as high as 25 in mid-1999. Because inflation is low and competition for capital is weak, he feels stocks are undervalued.
Garnick agrees, saying that because the number of analysts following stocks has hit its lowest point in more than a decade, the market and many individual companies are going unrecognized by investors. "What that's doing is creating a scenario that I call the neglect effect. The possibility of a company
or the market being undervalued increases pretty dramatically."
As for the relevance of S&P historical comparisons, she said that's "the same as comparing a DVD player to dad's reel-to-reel."