This week, we look at stock valuations to try to gauge the potential opportunity for stocks. Amid the dizzying volatility and news cycle that investors have had to deal with lately, it can be difficult for many investors to take a step back and see beyond the daily headlines. We try to do that this week by focusing on what lower stock market valuations relative to corporate profits may signal for stock market performance over the next year and beyond.
LOWER VALUATIONS PROVIDE OPPORTUNITY
The latest reduction in stock market valuations has been dramatic. While the all-time high for the S&P 500 Index was set on September 20, 2018, the highest point for stock valuations—based on the price-to-earnings ratio (PE) for the index (using FactSet consensus earnings estimates for the next 12 months)—actually occurred in January 2018. This PE measure (referred to as forward PE) is a measure of how much market participants are willing to pay for expected earnings per share over the next year for S&P 500 constituents.
Investors are willing to pay a lot less now than they were a year ago, as the valuation reduction has been significant. From January 22, 2018, through the recent low on December 24, the S&P 500 PE fell about five points (18.4 to 13.5). Since 1995, a drop that big or bigger within a one-year time frame has occurred only four times, during either the 2001-2002 or 2008 bear markets. Over the one year following those declines, the S&P 500 returned an average of 10% (median 12.7%). The current environment looks much better to us than either of those periods, suggesting investors may be getting a bearmarket discount for better-than-bear-market earnings.
A different cut at this is even more compelling. Over one-year periods, if the PE drops by at least 3 points, the subsequent average return is nearly 17%, with gains in eight out of nine observations [Figure 1]. The S&P 500 currently meets this criterion even after Friday’s big rally, suggesting stocks can generate above-average returns in the coming year.
STOCKS LOOK CHEAP VERSUS BONDS
Another way to gauge stock valuations is by comparing the earnings generated by stocks with bond yields, which are essentially earnings generated by bonds. We do this by comparing the earnings yield for the S&P 500 Index (S&P 500 earnings per share divided by the index price level) with the yield on the 10-year Treasury.
This statistic, referred to as the equity risk premium (ERP), has averaged about 0.5% over the past six decades. However, the ERP has climbed recently as both stock valuations and bond yields have fallen, bringing it to a historically high level at 3.4%.
Historically, a higher ERP has pointed to better future stock market performance. Since 1960, when the gap between the earnings yield and Treasury yields has been above 3% (as it is now), the S&P 500 has gained 12.4% on average over the following 12 months [Figure 2]. The biggest returns have occurred when the equity risk premium has been above 2%, which has largely been the case since the end of 2016.