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January 23, 2007 at 07:00 PM
With the stock market up impressively during the past few months, many investors have raised questions about valuation–whether the fundamentals can indeed support any further rise in equity prices. The anxiety is entirely reasonable: Stocks are closer to fair value today than in a long while–but closer is not there yet. The likely pattern of earnings and, most important, historical valuation benchmarks suggest that equities can still rise even further before value becomes a major concern.
Market Progress So Far
The equity market certainly has made impressive gains. Since the Dow Jones Industrial Index’s recent lows this past summer, the headline-grabbing index has risen almost 15 percent, to new, all-time highs above even those at its peak in 2000. And the more broadly based S&P 500 Index has risen by more than 14 percent from its summer lows. Though the index is still some 10 percent below its 2000 peak, this latest rise adds to the string of market gains that has erased much of the loss that existed at its cyclical low in 2002. With not a little irony, the S&P 500–amid endless gloom, whining, and warning from the financial media–has risen each year now for four years running: 26.3 percent in 2003, 9.0 percent in 2004, 3.0 percent in 2005, and about 12 percent to date in 2006.
The technology-heavy Nasdaq stock index, however, has not, on balance, done as well as either the Dow or the S&P, although it has risen more than 20 percent from its summer lows and more than 10 percent year to date. Though it, too, has risen along with the rest of the market since those cyclical lows of September 2002, Nasdaq was in such a deep hole after the 2000-2002 crash that it remains nearly 50 percent below its high in 2000. The broad-based Russell 3000 Index has behaved more like the S&P than either Nasdaq or the Dow: it has risen almost 15 percent from its summer lows and almost 11 percent so far this year, and remains today some 5 percent below its all-time peak of early 2000.
This long rally began with leadership from value-oriented stocks–which is hardly a surprise after the especially severe 2000-2002 losses in technology stocks and growth stocks in general. Between year-end 2002 (just after the rally started) and year-end 2005, the S&P 500 value index led the market, rising slightly more than 46 percent, while the S&P 500 growth index rose just 28 percent. But recently, the market leadership seems to be passing onto growth stocks. Since the growth index’s summer lows, it has risen slightly less than 14 percent, while the value index has risen slightly more than 14 percent. Value is still leading, but by a much narrower gap than previously. If, as seems likely, growth tends to dominate in the more mature phases of a market advance, the growth style should take the lead during the additional gains expected for equities.
Looking at the market in terms of capitalization, small- and mid-capitalization stocks outperformed their large-capitalization kin throughout much of this rally so far. From year-end 2002 to year-end 2005, the S&P 600 Small Cap Index rose 75 percent, far more than the 24 percent gain registered for the large-cap S&P 100 Index. But as with the value-growth paradigm, the torch recently seems to be passing from one to the other. During the rally from the market’s summer lows, the smaller-capitalization index gained about 15 percent, trailing the larger measure’s gain of almost 17 percent. Given that larger-capitalization stocks still offer better valuation metrics–by 10-20 percent, depending on the measure–and still pay higher dividend yields on average than smaller- and mid-capitalization issues, these large-capitalization stocks should continue to lead during any further market advance.
Overall Valuation Assessment
As much as prices have risen, stocks generally still show attractive valuations, largely because earnings growth has outpaced the price advances at every turn since the stock rally began late in 2002. The accompanying table lays out relevant data. Even in 2003, when the S&P 500 enjoyed a 26 percent price surge, reported earnings for these stocks saw a more substantial rise of nearly 77 percent. And the pattern has continued since. Reported earnings rose more than twice as much as stock prices in 2004 and more than six times faster in 2005. These relative growth rates mean that the most commonly used valuation metric–price-to-earnings (P/E) multiple–has dropped significantly throughout the rally. Indeed, these valuation multiples are lower today than any time in the past 10 years. It would seem, then, that despite stock price increases, equities have become an ever-better buy throughout their advance.
A more sophisticated analysis of valuation benchmarks shows just what remarkable value remains in the equity market. The key to this historical guidance lies in the well-established relationship between stock market valuations and bond yields. It only stands to reason that bonds have played a critical role in stock valuations. They are, after all, equities’ chief competition for investment dollars. The accompanying chart captures that valuation relationship. It provides a comparison between the yield on 10-year Treasury notes and what is, effectively, the P/E ratios on the S&P 500. Since, mathematically, it is a little cumbersome to compare stock multiples directly to bond yields, this presentation adopts a practice commonly used by analysts, including those that created the by-now famous Federal Reserve model of the stock market. It inverts the P/E ratio to create a measure of earnings yield, that is, the earnings generated by the company for each dollar of its stock’s price. This metric, of course, compares easily to bond yields and moves exactly opposite from P/E multiples. When investors are willing to pay more for a dollar of current earning, P/E multiples rise, and the earnings yield falls.
As should be apparent in the chart below, bond yields typically run well above this equity earnings yield. Those relative levels would seem to stand to reason. Because stocks offer appreciation potential and bonds offer little more than their yield to maturity, investors, in most instances, will demand more current yield from bonds than from stocks. On average, over this time frame, 10-year Treasury yields have run some 100 basis points (bps) above the earning yield on the S&P 500. But today, this historical relationship is reversed. The earnings yield on the equity market stands some 100 bps above the yield on a 10-year Treasury note.
No doubt, perceptions of risk explain this difference, as it explains all variations in this stock-bond yield spread. For example, during the 1990s, the end of the cold war and the embrace of the “new paradigm” of the technology boom prompted equity investors to downplay any risk to future gains. Investors demanded little current yield from equities. Bond yields of the day stood about 200 bps above the S&P 500 earnings yield. Risk considerations came back with a vengeance, of course, with the market crash of 2000-2002, the attacks of September 11, 2001, and the subsequent “war” on terror. Investors, then, uneasy about future gains in equities, demanded much more in current earnings relative to bonds. As the chart below shows, that demand now has gone to extremes not seen since early 1980s, when the market also was very risk-averse and, notably, on the verge of a huge rally.
