Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The theme for the past few months for the market has been concerns over major economic headwinds resulting in depressed stock prices. As you covered in this week’s Sector Watch, stocks are actually trading at a significant discount based on projected earnings and their historical valuations. How cheap are stocks right now?
Stovall: Based on the S&P 500’s closing price on Dec. 14, and looking at the S&P Capital IQ’s consensus estimates for the next 12 months, the S&P 500 is currently trading at 13x projected earnings, which is a discount of about 23 percent to the median of 16x that we have seen since Capital IQ has been keeping the next 12 month forecast. For those that don’t really trust forward estimates, if we look to historical P/Es on trailing operating results, we are trading at a little more than a 20-percent discount to the median over the past quarter century. That’s the same for GAAP (as reported) earnings as well. So whether you look to projected or trailing results, or GAAP or operating results, we’re trading at a 20-plus percent discount over the past 25 years or so. If you look at GAAP earnings going back to 1936, we’re trading at a single-digit premium to that median over the past 80-plus years.
EQ: How has inflation impacted the valuation of stocks?
Stovall: Frequently people will express worry to me regarding earnings because of the possibility of a single-digit P/E environment like we saw in the 1970s. My answer to that is, yes, that’s a possibility, but history says we would have to see interest rates rise dramatically. At no time since 1953 has the market traded below a P/E of 11x without the yield of a 10-year note above 7 percent. Usually, what causes interest rates to rise is the threat of inflation, thereby reducing the discounted cash flow and discounted earnings stream that analysts look at to decide the intrinsic value of the stock.
So to determine how much the current market is trading at a discount based on historical inflation to the median, I went back to 1948, which is as far back as the Bureau of Labor Statistics has seasonally adjusted headline CPI data, and broke down all of the quarterly observations into quintiles. I also looked at what the S&P 500 did 12 months later historically. I found that in the inflation range of 1.5 to 2.5 percent, the market normally trades at a 20x P/E, whereas we’re currently at around 16.4x. So that’s a discount of over 18 percent to that median P/E ratio, and on average, the S&P 500 rose 10 percent in the subsequent 12-month period, with a frequency of advance of 81 percent. That should be encouraging to investors.
Therefore, if you’re looking at a very low inflationary environment, the market traditionally is able to support a much higher P/E ratio than we have right now, which is also encouraging to long-term investors.
EQ: How can stocks also serve as an inflation hedge?
Stovall: Stocks benefit from rising inflation if investors also anticipate that interest rates will rise. When you invest in bonds, it’s like being on a seesaw with rates at one end and prices at the other. If rates rise either in anticipation or in actuality of higher inflation, then that would push down the value of bonds. So investors will likely sell their bonds and look for new places to invest their cash. In that case, it usually ends up being equities. So it’s not until inflation gets out of hand and the yield on the 10-year note goes above the 6- to 7-percent level that investors start to fear stocks as well. One thing that could be driving equities prices higher in 2013 is if we start to see a meaningful move higher in interest rates, which would then cause investors to get out of that asset class that they have been favoring for the last five years, and that’s bonds.
EQ: What do investors need to see happen in order for the market to return to the median P/E?
Stovall: In addition to higher interest rates, I think investors would have to feel a little more confident in the drivers that are going to push the market and economy higher. Obviously, higher interest rates can be a reflection of an improving global economy, but I think investors would also like to see the forecasts for economic growth in 2013, as well as the earnings estimates advance. Right now, global GDP growth is still stuck at about 3 percent, with the emerging markets likely to show about 5 to 6-percent growth, whereas the developed nations are continuing to show 2 percent or less. So if we start to see a ratcheting higher of these economic growth projections, investors should feel good. Also, if we start to see improvements to earnings estimates in 2013, then that could provide investors with additional confidence that bond yields will start to creep higher and make it worthwhile to move back into equities.
EQ: Based on the current discount that the market is trading at and the SIPC’s forecast of a 10 percent advance over the next 12 months, is this a good opportunity for long-term investors to add to their positions?
Stovall: I think so, especially if you currently have a less-than-normal exposure to equities based on your time horizon, risk tolerance and investment strategy. I would say to use this as a reasoning to get back to where you should have been. You might have been sitting on the sidelines with more cash than normal trying to anticipate a correction that has really not come in a meaningful way. So my feeling is that if you’re a long-term investor, at least bring yourself up to a more neutral equity exposure. If you feel you’re a bit more nimble, well then certainly it’s up to you as to whether you want to go further out on the risk curve. Either way, I would use valuations as a justification for maintaining your equity exposure.
However, there’s no guarantee of what the market will do and when it will do it. We’ve come to learn that anytime you think you can be pretty confident about a forecast, the market has a way of humbling every good forecaster. That’s why I recommend that you’re really better off buying on dips than you are bailing out entirely. You are smarter, in my opinion, when you simply stick to your overall investment plan and not try to outsmart it.