Issue 08 - January 2014

Is the Stock Market too Expensive? January 2014

2013 was an excellent year for Growth stocks, but not so good for dividend paying investments.  Not to worry though, as these things tend to run in cycles.  Sometimes all or most asset classes will go in the same direction as they did in the 2008/09 downturn, and sometimes various asset classes will go in opposite directions for a while, and sometimes for a longer period than seems reasonable (commonly referred to as a “bubble”).  The latter is what happened in the late ‘90s and early 2000’s.  Growth stocks were amazing in the late ‘90’s and went much higher than almost anyone thought was reasonable and then were terrible from 2000 thru 2002.  The opposite was true for dividend paying investments and “Value” stocks.  They performed poorly relative to growth stocks in the late ‘90’s and much better in the early 2000’s.

When looking at the stock market today, after an excellent 2013 and a very good run since the bottom in 2009, one has to ask the question – is the market too expensive?  This is a question that I have heard a lot over the past couple of years and there really is no definitive answer because “too expensive” is a matter of opinion.  We like to look at current and historical valuations and data to form our own opinion, but in the end, the stock market’s direction is determined by supply & demand for stocks.

One of the more important data points to consider when determining the value of the stock market or any individual stock is corporate earnings.  A good data point for measuring earnings is the price to earnings ratio or P/E ratio.  If you take the price of a stock and divide the price by the earnings per share of that company, you get the P/E ratio for that stock.  You can do the same thing for any stock market index by using the prices for all of the companies in the index and dividing by the earnings per share of all of those companies combined.  The result gives you the P/E ratio for the index.

As an example, let’s look at the P/E ratio for the S&P 500 index.  In 2013, the index ended the year at 1848 and the earnings per share for all of the companies in the index (adjusted for their weighting in the index) comes to about $105 (a record high, though most companies have not reported the 2013 4th quarter earnings yet, but we can use estimates).   If you take 1848 and divide by 105, you get a P/E ratio of about 17.6.  Historically, the average P/E ratio of the stock market is around 15 to 15.5.  So by that measure, the market is a little expensive but you also have to look at where you think earnings are going.

Many analysts project the earnings of the S&P 500 to be around $110 to $120 in 2014 and $120 to $130 in 2015.  If you divide 1848 by 120, you get a “forward” P/E ratio of about 15.4, which is more historically in line, but certainly not cheap.  Keep in mind, analysts rarely project earnings for the overall market to go lower in future years, so they are not very reliable in projecting recessions.  However, when we look at corporate profit margins we conclude that the rate of improvement in corporate earnings is likely to slow down, if not stop or begin to decline.  Therefore, we think the analysts’ projections of future earnings for the S&P 500 might be too high.  Below is a chart that shows the net profit margins of US corporations going back to 1951:


The chart shows that profit margins are peaking and in the past they haven’t stayed at peak levels for very long.  It’s also interesting to observe that in the 1990’s, profit margins peaked in 1998 or so, but the bull market in stocks continued for another couple of years.  Below is another chart, which is quite a bit more complex, but has a straightforward conclusion.  It is basically showing us that you can approximate the average 10-year returns of the stock market going forward by looking at the current market capitalization of the stock market (excluding financial stocks like banks) and dividing by the GDP of the US:

Market Cap of Non-Financial Stocks / GDP

vs Subsequent S&P 500 10 yr total returns:


While this chart is not 100% accurate, it does seem to give a good estimate of how the stock market will do by looking at current valuations vs. current GDP.  When valuations (excluding financial stocks) reach 100 to 120% of GDP, as they are today, the 10-year average returns in the stock market tend to be around 0 to 3% per year.   And, in the ’98 to 2000 period when the valuations exceeded 120% of GDP, the 10- year return of the stock market was negative, as the chart predicted.

Our conclusion is that the stock market is likely to cool off a bit in the coming years.  Corporate profits are not likely to increase as quickly as they have in the past few years, but there’s no reason to think that they will decrease significantly this year either.  In the past we have stated that we believe the economy will grow more slowly than normal in the coming years and our research continues to support that view.   As a result, while we always look for attractive opportunities, we continue to like the investments we have made and believe we are positioned well for a slow growing economy.