US Equity Market Valuations: Where to from here?

Global markets have been exceptionally volatile since June 2007. Though the proximate cause of global market volatility was deterioration of credit quality in the securitized US mortgage market, equity markets around the world have suffered. Following the near panic selling of mid-March and the extraordinary liquidity measures provided by the US Federal Reserve Bank, markets have now stabilised and, in some cases, have enjoyed a relief rally.

Were the sharp equity market falls justified and, can current US equity market valuations shed any light on potential market direction from here?

As of this writing the S&P500 Index is trading at a Price–Earnings (PE) Ratio of 20 times, trailing 12-month earnings. Despite the recent market decline, the market PE is still well above its historic average. The average PE ratio for the market from 1900 through to 2007 is 14.9 times. However, such a snapshot market valuation can be of limited use. US corporate earnings are cyclical and it matters very much where in the cycle we are as to whether the current multiple represents good value or not. For example, at the bottom of the last recession in 2002, the market was trading at a PE multiple of more than 40 times (depressed) earnings. Despite the high multiple, this was actually a buying opportunity. At that time the market was looking through the recession toward the profit rebound which was likely to occur. Over the five years from October 2002, earnings more than doubled and the stock market was higher by 80%.

Earnings for the S&P500 companies peaked in mid-2007 at about $85 per share but have now fallen to below $70 per share. Thus, the market PE of 20.5 (on trailing 12 months earnings) is higher now than it was in July of 2007, despite the market having fallen 12%. Corporate earnings may also have further to fall, given that US consumer spending accounts for 70% of GDP and the full effect of the housing recession probably has yet to feed through to the wider economy.

At some point the market will begin to anticipate an earnings recovery in this cycle as well. Reference to a static PE ratio for the market will not help us identify a turning point. A method of correcting for cyclical peaks and troughs in earnings is to look at a ten-year average of PE ratios. The accompanying chart plots this average from 1900 to the present. It reveals the high level of equity valuations, which have prevailed over the past twenty years. Through 1987 the market PE averaged 13.3. Over the twenty years since, the market PE has averaged 22.0. To some extent, the higher recent multiples have been justified by the sustained disinflation experienced over the period. History shows that periods of falling inflation (and falling bond yields) have been associated with rising PE multiples.

However, it is not clear that the environment going forward will be benign. Global inflation rates seem to be ticking higher. US ten-year bond yields at 3.50% are currently quite low and not discounting the risk of potential higher inflation. Over the next few years, should higher inflationary pressures lead to rising bond yields, this would probably usher in a period of contracting PE multiples. Such a scenario may not come to pass, or may take some time to unfold. But the prospect of this risk in conjunction with the relatively high levels of valuation going into this recession means that the market may disappoint those investors looking for a resumption of outsized equity market returns following this economic slowdown.

By Larry Jones, Chief Investment Officer, Nedgroup Investment Advisors (UK) Limited