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Economic Insights

Valuations remain attractive, leaving equities plenty of room to advance despite a sluggish U.S. recovery.

Since the equity rally of the past few years has brought most stock indexes to new highs, investors increasingly have expressed skepticism about the possibility of future gains. It is an understandable concern—but it also is misplaced. Stocks still carry attractive valuations, if not as attractive as in past years, and so have ample ability to continue to rise, even if, as expected, the economy only lumbers along the shallow recovery path it has traveled to date.     

Straight Price-to-Earnings Multiples
There are probably as many ways to gauge value as there are analysts and strategists in the financial community. One of the most straight forward is an historical assessment of simple price-to-earnings [P/E] multiples. Here the picture remains at least mildly positive.     

P/E multiples on most stock indexes today are just a touch over their 35-year average. The multiple on the S&P 500 Index,1 for example, stands about 22 times the earnings recorded for the four quarters ended this past March and about 18 times consensus earnings for the next four quarters. Since stocks over the past 35 years have averaged about 18 times the previous year’s earnings, the most conservative investor today could characterize the market as “fairly valued,” or only slightly richer. Because, historically, a rising stock market typically goes well above such norms before peaking, a conservative expectation would look for no further expansion in multiples, for stocks to rise in tandem with earnings. Since in a slow-growing economy the companies in the S&P 500 should generate 5–6% earnings growth over the next four quarters, such a conservative view would look for market prices to move up by about that amount. With dividend yields of just under 2.0%, investors could expect a 7–8% total return on equities, hardly comparable to the great gains of last year and the year before, but enough to warrant attention.2

Compared to Bonds and Cash
Equity valuations look much better when compared to bonds and cash. The way to compare stocks to bonds is to turn traditional multiples on their head and express earnings as a percentage yield on current stock prices. This measure for the S&P 500 (at the time of writing) equals 4.6%, or about 250 basis points (bps) above the yield on 10-year Treasury bonds. Since, historically, stocks yield 200 bps less than the yield on 10-year Treasuries,3 not more as now, this situation suggests strongly that stocks remain attractively underpriced relative to these bonds and, by implication, corporate bonds as well. On this basis, relatively attractive valuations would persist even if Treasury and other bond yields were to rise by 100 bps, although not especially likely anytime soon. If the historical relationship were to reestablish itself, stocks could do very well indeed, though such a dramatic move is also hardly likely. But even within very muted expectations, the picture remains one of strong valuation support for future stock gains.4

A similar picture emerges from a comparison of dividend yields to interest rates on certificates of deposit and other cash equivalents. Today’s stock dividend yield of about 2.0% stands some 180–190 bps above the best cash rates available to even the most resourceful financial advisor.5 Historically, the situation is just the reverse. Cash on average over the past 35-plus years offers rates some 200 bps above stock dividend rates, not below them, as now.6 The historical relationship stands to reason. The best cash can ever offer is the stated yield. But with stocks, history supports an expectation that the price will rise over time and that companies will raise their dividends over time. Because stocks offer these two additional ways to make money, they typically have offered less up-front yield from dividends than cash investments pay. The fact that matters today is the reverse shout that equities still offer good relative value. More than that, that fact argues that equities will still offer value for some time after the Federal Reserve begins to raise interest rates, as stated.

Conclusion
Though there are always shocks that might prevent equities from realizing their value, probabilities suggest that the market will continue to rise on the basis of this still-attractive pricing, as it has during the past five-plus years, despite disappointingly slow economic growth. Comparisons are less stark than they were one or two or three years ago, suggesting that future gains will track a less dramatic path than last year and in 2013. But still, the figures argue for further gains in equities going forward.

 

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged , does not reflect the deduction of fees or expenses, and is not available for direct investment.
Data from Standard & Poor’s.
3 Data from Bloomberg.
4 Data from FactSet.
5 Data from Bloomberg.
6 Data from FactSet.

 

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