Just How Expensive Is The Market?
Unfortunately, more than you might think! The Leuthold Group, founded and run by Steven Leuthold, produces some of the most thorough, insightful and thought-provoking research in the investment industry. One of their charts, found to be the most telling as to whether the stock market is expensive, or inexpensive, where we are in both cyclical and secular markets and how market valuations relate to economic and interest rate cycles history, is the Leuthold Group’s Ten-Year Normalized P/E Ratios Chart for the S&P 500 – 1926 To Date. Normalization means, in this case, that ten years of earnings (actually for this chart nine years of historical earnings and one year of forecasted earnings at a particular point in time) are averaged together and divided by the current price of the S&P 500 at a particular point in time. Because earnings (the two most common time periods for normalizing earnings are ten years and five years) fluctuate widely up and down from year to year, normalizing them provides a truer picture at a particular point in time. As a result, this provides a more accurate P/E ratio and thus is more comparable to other historical periods.
This chart is enlightening to say the least. While not showing the S&P 500 rising and falling, it does show P/E ratios rising and falling. Each high point precedes a steeply falling market, sometimes for as long as a decade or so. Each low point precedes a large extended upswing for the S&P 500. What’s the most troubling part of reviewing this chart is the current valuation. In short, it is currently at the second highest point (a P/E ratio of 27) in history behind only that of the 1998 to early 2000 period. There can also be a convincing argument made that it is just finishing the first part of a secular bear market [a long-term market period – typically 15 to 20 years in length over which P/E ratios decline dramatically and there is little return over inflation]. It appears that it is near the end of the first cyclical bull market (the first part of a secular bull market which typically lasts 1 ½ to 2 ½ years). In early October, it had been two years since the cyclical bull market started. Historically, the third year has provided negative returns approximately 52% of the time.
On this page is another chart produced by Grantham, Mayo, Van Otterloo & Company (GMO) which is managed by investing legend Jeremy Grantham. This is another very well-respected organization. The chart, which was developed based upon ten-year normalized P/E ratios, provides the average returns after inflation (real returns) over the following ten-year period. P/E ratios are grouped by quintile. As one might expect, returns for the bottom two quintiles with lowest ten-year normalized P/E ratios provided the highest returns over inflation–each returned approximately 11%. Unfortunately, today’s valuations cause the market to fall into the most expensively priced quintile, which historically has provided virtually no return over inflation over the following ten-year period. If that wasn’t bad enough, try this on for size. It is not only in the top 20% of normalized P/E ratios for the modern market era (1926 to date) but it is in the top 10% of valuations according to Leuthold’s chart.
In conclusion, when combined, these two charts provide a compelling case for the views of investing legends and academics such as Bill Gross, Jeremy Grantham, Robert Arnott, Cliff Asness and Warren Buffett as well as numerous others when they forecast low single digit, if not negative, returns for the S&P 500 over the next decade.
For further information, contact Louis P. Stanasolovich, CFP ä at (412) 635-9210 or e-mail him at email@example.com