Equity Valuation, Earnings and Relative Yield: A Compelling Point in the Cycle?

By Richard Skaggs, CFA, Senior Equity Strategist

 

Large capitalization US stocks, as represented by the Dow Jones Industrial Average, quadrupled in the 1980s, and quadrupled again in the 1990s. Given this historical perspective, the market’s long pause since 2000(note 1), accented by calamitous financial events, particularly in 2008, has left investors impatient and fearful. That said, investors would be wise not to wallow in this sentiment and overlook the long history of stocks returning to good form following lengthy periods of underperformance. In my opinion, the S&P 500 Index could be on the cusp of a positive long-term cycle based on its valuation, earnings and relative yield.

 

Equity Valuation in Context

 

The charts below created by Ned Davis Research (NDR)(note 2), show the S&P 500’s historical performance (top chart) and price/earnings(note 3) (P/E) multiples since 1926. The equity rally during the 1980s and 1990s was truly historic. In the early 1980s, the S&P 500 was trading at just seven to eight times operating earnings, and it traded below 100. That is quite a contrast compared to its level of 1,183 on October 31, 2010! In fact, total returns assuming dividend reinvestment compounded at an average annual rate were in the high teens for all of the 1980s and 1990s (see table on page 3).

 

Looking at the year 2000, the S&P 500 had soared in price and valuation to a record level. In fact, its late 1999 and early 2000 P/E of just under 30 was the highest since 1930 by a wide margin. We recall, admittedly with some fondness, the soaring sentiment and money flow in favor of equities throughout the 1990s, culminating in the “technology bubble” of 1999-2000. It left investors in the S&P 500 holding a portfolio of very expensive stocks relative to history, and quite vulnerable in the event of an economic slowdown. As it turned out, investors did not have to wait too long, as a recession began in 2001, followed by a second, far more severe recession beginning in 2007. Slowing economic growth in recent years, relative to optimistic expectations built up during the huge return years prior to 2000, has seemingly left many investors disappointed, or worse, perhaps disheartened about the prospects for equities. One way this has manifested itself is in rising investor allocations to bonds, even as stocks have returned to historical long-term average valuation levels, as indicated in the chart below.

 

 

With equity valuations back in the “normal”(note 4) range at the end of October, I believe investors could find opportunities to capture returns from a continuation of generally solid operating performance of leading US companies represented by the S&P 500. As can be seen in the chart on the previous page, the 25-year average P/E of 18.8 is far above the October 31 level of 15.0. If the bottom-up earnings estimates, generated by Wall Street analysts and aggregated by Standard & Poor’s (see next chart), prove accurate and valuations move toward the average P/E of the past 25 years, the market could see an upward move.(note 5) For the sake of conservatism, I prefer to consider longer time frames, recognizing the past 25 years are not likely to be replicated in the future. Applying the 50-year average P/E multiple of 15.7 to forecasted earnings could present upside potential. Using the 75-year average, which includes many years in the 1940s, 1950s and 1980s when stocks were valued at single-digit multiples, the market has the potential in the years ahead for stock prices to at least track forecasted earnings growth based on current valuation levels.

 

THE EARNINGS OUTLOOK

 

Equity investor skepticism has become so ingrained in recent years that expectations of future earnings growth are being given little credit until the results are actually demonstrated and obvious to all. I believe the current moderate stock valuations seen in today’s market, coupled with a healthy earnings outlook amid investor skepticism, are potentially supportive of a positive long-term outlook for equities.

 

As shown in the chart below, corporate earnings for the S&P 500 have recovered from September 2009 and posted strong gains, and Wall Street analysts’ estimates have them reaching all time highs as soon as next year. P/E multiples have fallen by 50% during the past decade. Even if multiples were simply held constant at the October 31 level of 15.0, capturing earnings growth in equity returns could provide very respectable results. As seen in the chart below, the S&P 500’s trailing operating earnings set a record at $91.47 in the second quarter of 2007. As of October 26, Wall Street analysts were forecasting that the S&P 500 would once again reach record trailing earnings by the end of 2011. At historical multiples in the range of 15 times trailing operating earnings, current analyst estimates translate into an S&P 500 level of potentially 1,415(note 6) at the end of 2011. Notably, that would still be below the S&P 500’s previous record highs above 1,550 first reached in 2000 and again in 2007.

 

 

RETURNS AMONGTHE INDICES VARIED CONSIDERABLY OVER THE PAST DECADE

 

While performance of the S&P 500 disappointed investors during the past decade, many other indices fared better. The S&P 500’s capitalization weighting worked against it materially. Its overvaluation at the peak in 2000 was concentrated in the large capitalization stocks, particularly in technology. As the table on the following page illustrates, in the past decade, the S&P 500 and Russell 1000 indices generated negative total returns. However the Dow Jones Industrials and MSCI World managed to generate small positive average annual returns of 1.29%  and 0.23%, respectively, while mid cap and small cap indices fared much better. To be sure, the broad group of indices listed below did not generate the double-digit average annual returns equity investors crave, but the S&P 400 Midcap, the Russell 2000 and the MSCI Emerging Markets indices posted average annual returns from mid-single digits to marginally double-digit returns.

 

Perhaps the most surprising set of statistics are the returns of the S&P 500 calculated giving equal weight to each of its 500 holdings (known as the S&P 500 Equal Weighted Index). Eliminating the effect of capitalization weighting within the S&P 500 gives a higher exposure to its smaller capitalization companies and a lower exposure to its large capitalization constituents. From the beginning of 2000 through 2009, the annualized total return of 5.13% for the S&P 500 Equal Weighted Index, compared to the -0.96% return for the capitalization-weighted S&P 500, illustrates just how severe a penalty a capitalization-weighted structure imposed on performance. By weighting them equally, the same 500 stocks produced a return differential of more than 600 basis points annually for a decade. Year-to-date through October 29, 2010, the S&P 500 Equal Weighted Index was up 12.72% compared to 7.86% for the capitalization-weighted index. The trend against mega caps(note 7) appears to have remained in force through October.

 

Since the valuation and price peak of 2000, small and mid cap companies as well as S&P 500 stocks (unweighted) and emerging markets stocks have been the places to be in equities. But returns overall were not exceptional by any means. It’s just that they are not necessarily negative. The data taken as a whole suggest that while equity performance has been modest, it hasn’t been uniformly negative across the board.

 

STOCKS ATTRACTIVE RELATIVE TO BOND YIELDS

 

Stocks also look compelling relative to the bond market. In fact, we have to go back to the early 1950s to find a period when stocks were as attractively valued versus bonds as they are now. The charts below compare the ratio of Moody’s Baa bond yield of 5.72%(note 8) to the S&P 500 operating earnings yield of 6.57%(note 9). A similar valuation advantage of stocks versus Treasurys is evident, as shown in the second chart below.

 

 

INVESTOR SKEPTICISM APPARENT IN EQUITY FUND FLOWS

 

As indicated in the chart below showing money flows into equity, bond and money market mutual funds, long-term flow-of-funds data appear to complement the current perception of investor risk and opportunity. The money flow cycles, once established, can potentially persist for very long periods. For example, when flows to equities turned positive in the early 1990s, they remained positive and nearly uninterrupted for more than 10 years. Money market fund flows were positive nearly every month from 2005-2008 as investors sought shelter from the equity bear market and financial crisis. More recently, money market flows turned negative as yields plunged and bond funds became a beneficiary with very steady and strong inflows. While equity funds have had a few months of positive numbers here and there since stocks bottomed in early 2009, flows have been consistently negative since the “flash crash” in May 2010.

 

Since flow-of-funds trends can be quite long, they shouldn’t be used as short-term market timing indications. We know that investors at the margin are skittish and seeking relative safety in fixed income versus the potential for higher, although more volatile, returns in equities. I believe it is this skepticism that could give investors with long time horizons an opportunity to buy stocks at very reasonable valuations. I also think equity flows are likely to improve in the future, but it is impossible to estimate when that will happen. Explicit improvement in the employment data may be one of the most important factors that could lead to relative improvement in equity flows.

 

 

SUMMARY AND CONCLUSION

 

Despite a remarkably volatile global business climate during the past decade, which included two recessions, S&P 500 earnings data for the period shows fundamental business execution was favorable at most companies. The median company within the S&P 500 posted average annual earnings growth of 8% per year during this period. While many have been weaker than this, of course, more than 150 companies within the S&P 500 grew operating earnings at or above a 15% annual rate during the decade in spite of macroeconomic challenges. Multiple compression(note 10) has masked the earnings strength demonstrated by many of these S&P 500 companies.

 

I believe this pressure on valuations may be close to running its course. Stocks are trading at attractive levels relative to bonds and most are within their long-term P/E valuation averages, while equity investors have remained skeptical amid improved corporate earnings growth. Returns of the 1980s and 1990s did “borrow from the future,” as many commentators suggested at the time. I believe multiples just got too high. However, stock prices have been far more volatile than fundamental business execution would indicate. As discussed above, the earnings of S&P 500 companies could be poised for significant growth within the next 12 to 18 months absent a double-dip recession.

 

ADDENDUM

 

Ned Davis P/E Chart, Page 1: In the Ned Davis S&P 500 chart on page 1, the middle blue line at 14.3 is the mean S&P 500 P/E over the history of the chart (3/31/26 – 10/31/10 monthly data). The zone marked Normal, between 18.0 and 14.3, represents where P/E’s fell approximately 2/3 of the time during the chart’s review period. The area above the Expensive line (18.0) is where P/E’s fell 1/6 of the time and the area below the Bargain line (8.4) is where P/E’s fell 1/6 of the time.

 

S&P 500 Index: The Index includes 500 leading companies in leading industries of the US economy.

 

S&P 500 Equal Weighted Index: The S&P 500 Equal Weight Index (S&P 500 EWI) is the equal-weight version of the widely regarded S&P 500. The Index has the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight.

 

Dow Jones Industrials Average: The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.

 

Russell 1000 Index: The Index measures the performance of the large cap segment of the US equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current Index membership. The Russell 1000 represents approximately 92% of the Russell 3000 Index.

 

S&P Midcap 400 Index: The Index seeks to remain an accurate measure of mid-sized companies, reflecting the risk and return characteristics of the broader mid cap universe on an on-going basis.

 

Russell 2000 Index: The Index measures the performance of the small cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current Index membership.

 

MSCIWorld Index: The Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. As of May 27, 2010 the MSCI World Index consisted of 24 developed market country indices.

 

MSCIEmerging Markets Index: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of May 27, 2010 the MSCI Emerging Markets Index consisted of the 21 emerging market country indices.

 

Indexes are unmanaged and you cannot invest directly in an index.

 

 

Notes:

1 The S&P 500’s compound annual return was -0.96% from 12/31/99 - 12/31/09.

2 Ned Davis Research, Inc. is an independent financial research provider (NDR.com). Please see addendum for definitions of terms used in the charts throughout the paper.

3 The price earning ratio (P/E) measures a stock’s price relative to its earnings per share. Operating earnings were used in the P/E calculations.

4 See addendum for definition.

5 This is only one potential scenario for market performance and not a guaranteed outcome.

6 Fifteen times the S&P 500’s 12/31/11 projected operating earnings per share of $94.31 excluding dividends.

7 Companies with market capitalizations greater than $50 billion.

8 As of October 31, 2010

9 As of October 31, 2010; operating earnings yield is the inverse of the P/E ratio

10 Multiple compression occurs when a stock trades at a certain P/E multiple, and while earnings may grow, the stock price does not advance.

 

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