Is the market expensive now?
The stock market has been on a run. Since October of this year the stock market has hit a succession of new highs. A lot of folks look at this market and say that that the market is pricey. When you divide the market’s valuation by the last 12 months’ worth of earnings, the aggregate price-earnings ratio – currently 23 times earnings – is higher right now than it has been 87% of the time since 1936.
Source: Morningstar, 361 Capital
But the valuation is a terrible timing tool. If you avoided investing in the stock market when valuations had spiked, you would have missed out on some of the greatest bull runs ever. What’s more, comparing the current level of earnings to something recorded 80 years ago is foolish. Accounting rules have changed dramatically. Foreign currency transactions, construction work-in-progress, stock options, and countless other items are now included in a company’s earnings. It’s anachronistic to put our current measure of earnings into the same denominator as those from 20, 40, or 80 years ago.
You might as well say that bread is cheap now because in 1930 a loaf cost 4.5 times what a chocolate bar cost, and now a loaf costs twice as much as the candy. But a lot of things have changed – the size of the loaf, the size of the chocolate bar, and the ingredients of both the loaf and the chocolate.
Photo Evan-Amos. Source: Wikipedia
Right now, valuation measures are high because we are coming out of a 6-quarter long earnings recession. In fact, this may be the longest earnings recession ever that hasn’t led to a general downturn. But remember: the definition of earnings has changed. So, unless you can go back and re-state 80-years of history, maybe this has happened before.
I’m not saying looking at ratios is meaningless. You just have to be aware of what’s different. Accounting standards have changed. Human nature – and the desire by managers to look good – hasn’t.
Douglas R. Tengdin, CFA