How big is the market?
S&P 500 Market Cap. Source: Bloomberg
That depends on what you mean by the market. The US stock market is worth about $20 trillion. That’s the value if you add up all the shares traded times their market price – the market cap of the S&P 500. When you divide the market’s total value by the total earnings (and losses) produced by those companies, you get the market’s PE ratio—a basic measure of valuation.
A lot of folks are concerned that this ratio is getting stretched—that the market’s valuation is moving up towards levels we haven’t seen in long time—times we’d rather not go through again.
S&P 500 trailing PE ratio. Source: Bloomberg
But that may not be the best way to look at valuation. For one thing, it ignores the apples-to-apples issues we have with earnings. In the 1990s the accounting profession started to get a lot more aggressive about reporting on non-cash items. First there was the S&L crisis in the early ‘90s. Then there were a series of scandals involving swaps and other off balance sheet contracts. Finally, there was Enron and the prosecution—and destruction—of Arthur Anderson in 2001. There were good reasons for accountants to include more mark-to-market calculations in their figures.
As a result, the absolute valuation levels may not be comparable. But changes in valuation over time can still help us understand the market.
From 2000 to 2011 the general trend in valuations was lower. Part of this was the market coming off the excessive optimism of the late ‘90s. Part of this was the adjustment the market made to the 2001-2002 recession. And of course the market had to be cautious during the financial crisis, and later the Euro crisis. This conservative trend in valuations resulted in one of the lowest 10-year return periods for stocks ever. It made sense during that time for investors to be cautious.
But after having bottomed in 2011, PEs have moved steadily higher. Whether it’s been ultra-low interest rates or better earnings or new products or – now – optimism about tax and regulatory reform, the market has been more and more optimistic about corporate earnings. Valuations—as measured by PEs or price-to-book or some other measure—have all been trending upwards.
As a result, I think equity investors can be optimistic as well. The trend—hopefully—will be our friend. Until it ends.
Douglas R. Tengdin, CFA
Chief Investment Officer