US equities are, relative to most of their history, expensive. We trust this is not too controversial a statement – and certainly it should come as little surprise to regular visitors to the value perspective. Still, if anyone needs more convincing, we would point to the 10-year cyclically adjusted price-to-earnings ratio of the US’s S&P 500 index, as we have done several times in the past in articles such as Profits warning.
But let’s cut the market some slack and use the more generous measure of price-to-peak earnings. Here, rather than dividing the index’s price by its average profits over a prior period (plus an adjustment for inflation) we instead use its peak profits – namely the highest level of combined profits the companies in the index have ever made in any one year.
It is not a measure we would normally choose to focus on – particularly in relation to individual companies – but, for broad indices such as the S&P 500, it can be a handy cross-check of how much optimism is baked into a stockmarket. After all, it is hard to argue a market that trades at a high multiple of peak historic profits is conservatively valued.
As you can see from the graph below, the S&P 500 recently reached its third most elevated level ever on this metric. To bolster our case further, the graph shows – this time on the left-hand scale – that the S&P 500’s price-to-book metric has also only ever been higher on two occasions in its history.
Chart source: Minack Advisors, July 2014
Believe it or not though, the point of this piece is not just to express concern about US equity valuations and the below-average future returns history suggests this will result in – for that you can read any number of articles on the value perspective. Instead this data is intended to flag up that, no matter where valuations stand now, there were still two other periods in history where they moved through the current level and went on to become even more expensive – the late 1920s and the late 1990s.
This should serve as a reminder that, while valuation has been an excellent predictor of future long-term investment returns in the past, in the shorter term, there is no rule that prevents a fairly expensive valuation turning into a ludicrously expensive one. What is more, if the market does decide to attribute what we would see as irrational – ok, silly – valuations to equities, then things can grow decidedly uncomfortable for value investors for quite a period of time.
The dotcom boom was a prime example of this, as can be seen in the chart above. The S&P’s price to peak earnings multiple exceeded the previously-known peak level more than a year before it eventually peaked in late 1999. There was nothing value investors could do about this but try to remain disciplined and not become swept up in the hubris of the time.
Emotionally difficult as this doubtless was, by staying away from the areas where valuations were at such eye-wateringly high levels, value investors avoided much of the pain of the subsequent stockmarket falls and the poor future returns that followed – and kept more of their powder dry to snap up bargains with during the early 2000s.
Here at The Value Perspective, we sometimes like to consider such periods of market irrationality as one of the barriers to entry or ‘costs’, so to speak, of the outperformance the strategy of value investing can deliver over the longer term. If it were not so difficult to stick with from time to time, then everyone might do it.