Wednesday, April 27, 2016

C’mon, Man: There Is No Such Thing as a “Normal” P/E

And now for the most exaggerated, overblown, annoying, and ignorant claim in the financial media today: “The stock market is dramatically overvalued and headed for a fall.”
The financial media from the Wall Street Journal to CNBC and everyone in between would have us believe that the S&P 500 is dangerously overpriced.  Stocks are currently trading at a P/E ratio of nearly 19, which is 15% higher than the long-term “average” P/E ratio of 16.5.

[Cue the financial media freakout]

C’mon man (woman).  You don’t know what you’re talking about.  Using the average P/E to determine whether or not the market is fairly priced is like using a thermometer to determine how fast the wind is blowing.  A thermometer is a useful device for measuring body temperature, but useless for measuring wind speed.  As we will soon show, using the average P/E alone to value the market is also useless.

The chart below alone is enough to prove that average P/Es don’t tell you a thing.  The blue line shows the actual P/E ratio vs. the long-term average P/E shown by the orange line.

Can any useful information be derived from this chart?  Does the orange line tell you anything about the blue line?  
There are; however, a few things we can glean from the chart.  
1. Stocks Almost Never Trade at “Average P/E” Levels
With the frequency that “average P/E” is thrown out at us, you would think stocks often trade at the average P/E.  But they don’t.  In fact, stocks have traded at or near their long-term average in just 9 out of 676 months going back to 1960.  That’s 1.3% of the time.  The other 98.7% of the time, stocks did not trade at their long-term average P/E.
Can we just get the message through to the financial media: stocks almost never trade at their average P/Es.  In effect, there is no such thing as a “normal” P/E.  Please stop referencing it. It doesn’t exist.
2. Today’s P/E Ratio Isn’t Particularly High
Look at the far right of the chart showing where P/Es stand today vs. the historical average.  Does it look all that high to you?  It’s not.
The S&P 500 has traded at a P/E of 19 or higher nearly 30% of the time.  Are P/E ratios higher than they have historically been?  Yes.  But it’s not like 19 is uncharted territory.  It is still well within what we have seen before.

3. Stocks Can Still Go Up from “Elevated” P/Es

Even when the media are proclaiming that P/Es are “elevated” compared to historical averages, stocks have produced good results.  Since 1960, when stocks have traded at a P/E of 19 or more, they have produced positive price returns more than 66% of the time over the next 12 months.

Do P/E Ratios Make Any Sense?

Historical P/Es look completely random, don’t they?  Why did stocks trade at 7 times earnings in 1980 and then 30+ times earnings in 1999? Let’s see if we can find anything that would suggest why P/Es traded where they did over the last 50 odd years.  If we can, we would have an honest to goodness valuation tool.

What is the “Right” P/E?
We’ve seen that stocks almost never trade at their average P/E.  So that’s obviously not the “right” P/E.  But if not the average, then what? To determine that, we need to flip our thinking upside down. We’re going to look at what is called the “earnings yield,” which is simply the P/E ratio flipped into an E/P ratio.  If you buy a stock for $100 that generates $8 per year in earnings, you have paid 12.5 times earnings (P/E = 12.5).  Flip that upside down and you would see that your “earnings yield” is $8 divided by $100 = 8%.
The “earnings yield” is more useful when comparing stocks (and businesses) to alternative investments that are quoted in percentages.  When earnings yields on stocks are higher than bond yields - stocks are a better bargain.  When bonds are yielding more than stocks - you might be in favor of buying bonds, instead.
Our research shows there is a high correlation between earnings yield (P/E upside down) and inflation.  The chart below shows earnings yield as the blue line and inflation as the orange line.
There is a clear relationship between earnings yield and inflation.  When inflation goes up, the earnings yield also increases (meaning the P/E ratio goes down).  The statistical correlation between the two data series is more than 70%.
In the 1970s and 1980s, inflation was higher than we’ve ever seen it.  At one point, inflation reached nearly 15%.  At that time, the earnings yield for stocks reached nearly 15%.  If you flip a 15% earnings yield back into P/Es - we calculate 1 / 15% = 6.7.  So high inflation means high earnings yield (low P/E ratio).
The reverse is also true.  When inflation is low, earnings yields should also be low (P/E ratios high). And that is what we have seen.  In periods where inflation has been less than 3%, earnings yields have averaged approximately 5.2%.  Flipped upside down, that means the P/E in those low inflation periods was 1 / 5.2% = 19.
So that brings us to one last chart.  This shows the “real” earnings yield for stocks, which is simply the earnings yield (E/P) minus inflation.  According to our research, this metric is a much better indicator than the simple P/E for determining the relative value of stocks at any given point in time.
When the real earnings yield (blue line) has been below the long-term average (orange line), that has meant that stocks were overpriced relative to the then current inflation levels.  When the real earnings yield have been higher than the orange line, stocks have been a good buy.
You can see that this model correctly predicted that stocks were way overvalued in the mid-1970s, early 1980s, in 1987, during the “tech bubble” in the early 2000s, and during the Great Recession of 2008.
It also correctly indicated that stocks were a great value in the early 1980s and again in 2009.
So… Are Stocks Overpriced Today?
Today’s real earnings yield spread is 4.4%, which is significantly higher than its long-term average. If the earnings yield were to trade at it historical relationship to inflation, the appropriate real earnings yield today would be 2.8%.  When you add back current inflation of 1%, we see that the appropriate earnings yield for the S&P 500 is about 3.8%.  When you flip that upside down into P/Es, we get 1 / 3.8% = 26.3.  
Are we suggesting that P/E ratios should go to 26.3?  Not necessarily.  But we are saying that the current low-inflationary environment should result in stocks trading at higher P/E ratios than the “average P/E.”  If we were to see inflation remain at 1% for the next decade, it is entirely possible (and reasonable) that stocks could head towards a P/E of 25+.  The CNBC broadcasters are starting to sweat at the thought of it.
For those of you that are still skeptical that stocks can go higher from here, just think about this.  The current real earnings yield for the S&P 500 is 4.4%.  There have been 123 months since 1960 when stocks have traded for a higher yield than that.  With those months as a starting point, the average return over the next year was 21.5%.
So can P/E ratios expand from here?  History tells us overwhelmingly that they can.  Not only that, but the current inflationary environment says that they should.
Are we saying stocks are going to go up 21.5% over the next 12 months?  Maybe yes, maybe no. There is reason to believe that the current slow economic growth will likely reduce future earnings growth and, thus, impact future stock returns.  However, it should be clear that stocks are not trading at significant premiums to where they should be.  Unless earnings collapse or inflation explodes, stocks could (and probably will) continue to move higher on the back of rising P/Es.
So next time you’re out with your friends or watching some talking head on CNBC and the topic of P/E ratios being high – remember that average P/Es are meaningless as a valuation tool.  Anyone who says they should trade at 16.5x just because that has been the average doesn’t know what they are talking about. There is no such thing as a normal P/E.  

Monday, February 15, 2016

Mad Markets: Why This Correction Is Just Noise

Stocks can decrease in value for any number of reasons -- many of which don’t make a whole lot of sense.  Hillary Clinton tweets about drug pricing and all Healthcare stocks decline in value. The Fed raises rates and stocks go... up?  Wait, and then the Fed raised rates too soon -- so now stocks go... down?  Then oil prices collapse, which means the largest part of the U.S. economy (consumers) is now doing better.  Sell, sell, sell!

The manic depressive behavior of the stock market is maddening.  That’s why you can drive yourself nuts checking your account five times a day.  It’s going to be up and down -- sometimes for no apparent reason.

But let’s take a step back here and get back to the basics.  What is a stock?  It is ownership shares in a real, tangible business.  If stocks represent companies, the real question is not what the stock market says they are worth.  The real issue is: What are the underlying companies worth?

If you own your own business, its value to you is represented by one thing: How much cash that business produces for you each year.  Let’s say your company produces $10,000 per year in cash profits.  The year after that, it generates $12,000.  Then $15,000.  Then $20,000.

What is happening to the value of the business?  It’s going up, of course.

On the other hand, if your $10,000 profits fall to $8,000 then $6,000 then $0 -- what is the business worth?  Well, not much.  You’d be better off in a checking account.

The stock market is down by 12% to start the year.  Traders have decided that U.S. businesses are now worth 12% less than they were just 42 days ago.  Does that make any sense to you?  Is it possible that companies have lost more than a tenth of their earnings power in just 1.5 months?

Probably not.

So if we can’t rely on the stock market to value businesses, on what do we rely?

Where Real Company Value Comes From

Going back to 1960, our valuation models indicate that dividends and earnings can explain more than 90% of the annual movements of stock prices.  That means 10% of the market’s movements is just “noise” -- shouting broadcasters on Fox news, tweets from political leaders, and the latest news flash.

The 10% is what we see every time we check our account statements.  It’s either + or - some number.  But that’s not reality.  The reality is in the 90%: the dividends and earnings.  Over an extended period, these two forces will drive stock prices either higher or lower.

So what has happened to the real value of U.S. businesses over the past 1.5 months?  Let's look at what drives value: dividends and earnings.


Since the beginning of 2016, the dividend announcements for S&P 500 companies has been impressive.

Companies in the S&P 500 have increased their dividends by 0.7% so far in 2016.  That’s on pace for 6.2% annual growth.  That rate of increases isn’t impressive, but remember that many Energy companies are cutting their dividends.  So the rest of the sectors are doing quite well.

Perhaps more importantly, the dividend estimates have been coming in about in line with expectations.  Unless we start to see disappointing announcements, dividend growth appears stronger than the long-term average of 5.5%.  


If dividends aren’t declining, falling stock prices must be mirroring earnings.  Dividends come from earnings, so a sharp drop in earnings will impact a company’s ability to pay and grow dividends in the future.

By our calculations, the market is pricing in a 24% decline in earnings for 2016.  If other investors expect a reduction of that magnitude, where will it come from?

The most obvious place is Energy and Materials.  These sectors’ earnings declined 57% and 15%, respectively, in 2015.  If they repeated that performance in 2016, that would drag down the overall S&P 500’s earnings by less than 4%.

OK, so a 24% decline in earnings isn't solely from Energy and Materials.  Where else will it come from?  For another 20% decline in earnings, we need widespread earnings recession across all sectors.

But we’re not seeing that.

The Consumer Discretionary earnings continue to be strong (+15% year-over-year).  Excluding the dollar’s impact, Consumer Staples companies are reporting impressive numbers.  Healthcare continues to be a bright spot despite political issues (+12%).  Utilities (+4%), Technology (+7%), and Telecom (+16%) are also showing strong earnings growth.

Patches of the Industrial sector have seen earnings expectations decline, but overall -- the industry still reported positive year-over-year growth in the most recent quarter.  The lower expectation for Fed rate hikes has hurt the Financial sector, but not enough to drag down the S&P 500’s earnings by 20%.

When you add it up, the overall expectations for earnings are diminished, but not by anywhere close to what the market has priced in.  As of February 15th, earnings expectations had declined by 3% in 2016.  That’s not enough to warrant what we’ve seen from stocks.


If dividend and earnings are still largely intact, we can conclude that the fundamental value of U.S. businesses is relatively unchanged.  If that’s the case, then the market’s 12% drop for 2016 has been mostly driven by “headline risk” rather than real decay in fundamentals.

As an investor in stocks, you can’t focus on the market prices on a daily basis.  That’s maddening.

Ask yourself two questions:

1) Do I believe that U.S. corporations are going to be earning more money in 10 years?  

2) Do I believe that those companies will be paying out more cash dividends in 10 years?

If the answer to both of those questions is “Yes” -- you will be rewarded for owning dividend paying stocks.  Over the long term, higher earnings lead to higher dividends, which leads to higher value of the companies that pay them.  The stock market prices will have no choice but to follow.

We can’t know what tomorrow holds.  The stock market could be in a good mood, or it could be in a bad mood.  What we can know is that dividend payments will continue to be paid.  And those checks will continue to grow each and every year.  As long as this continues, these market gyrations don’t make a difference for disciplined investors.

Friday, August 28, 2015

The Dividend Investor's View of Market Volatility

Today marks the close of one of the wildest weeks we’ve seen in the U.S. stock markets in a long time.  At DCM, we have developed several valuation models that help us gauge where the fair value of the major indices are at any given time.  These models help us separate the emotional roller coaster of the stock market against the reality of what the fundamentals are telling us.
We know these models are never going to be 100% accurate, but they have been particularly good over the long-term.  We have used them for many years to help us navigate uncertain times.  With the markets getting choppy this week, we thought it would be helpful to show you what those models are currently saying.
Model #1: Long-Term Divearn Model (going back to 1962)  
This model uses dividends amongst a couple other variables to predict the fair value of the S&P 500 index.  This model has predicted roughly 91% of the movement of stock prices going back to 1962.  For brevity’s sake, we’ve shown only the years from 1990 through 2016 in the chart below.
The grey bars represent DCM’s predicted fair value.  The “blue shadow” represents the model’s error range.  And the red line is the S&P 500’s actual price.
As you can see, the red line (price) always tends to move towards fundamental value (grey bars). In most years, the S&P 500’s price stayed within our model’s fair value range (blue shadow).
Over the years, this model has been very effective.  The market was grossly undervalued in the early 1990s before becoming grossly overvalued in the late 1990s.  In 2002, the market came right back down to fair value. The financial crisis of 2008-09 again presented a great value.  Since then, the market has moved up towards fair value and stayed right with our predicted fair value.
At this moment, the model is predicting the current fair value of the S&P 500 is 2,148 (+8% from here).  There is an error on either side of that number.  The market’s low this past week was 1,867 – just modestly below the lower range of our model’s estimates.
Model #2: Forward Divearn Model (going back to 2009)
The second model uses the same inputs as the first, but with two differences: (1) It uses forward earnings/dividends and (2) it uses the most recent 6 years (2009-2015). It has predicted roughly 93% of the movement of stock prices going back to 2009.  
Again, you can see that the price (red line) follows closely to the fundamental value (blue bars). The market got outside of the error range (blue shadow) in just 5 out of 23 quarters.
You will note that the market got too high in the 1st quarter of 2015.  Since that brief overshoot, we’ve seen stock prices go flat and now down.  The primary culprit was the decrease in the energy sector’s forward earnings.  Once those were past us, we’ve started to see fundamental value increase as we move towards the end of 2015.
You’ll notice that the S&P 500’s price has reached the lower end of the model’s range. This would suggest that stocks are trading at a discount to their current fundamental value. According to this short-term model, the fair value of the S&P 500 over the next 12 months is 2,153 - a roughly 9% discount from the market’s price as of today (Friday).      
What Does It Mean For You?
Both of our models are saying the same thing.  As long as there is not a recession on the horizon, these models give us confidence that stocks present a good buying opportunity at this point.  As we talked about in a previous blog post, the “dog” (stock prices) can’t get too far away from their “master” (dividends) over a long period of time.
While this market volatility can shake your confidence, it presents an opportunity for the long-term investor.  Looking at the fundamentals (dividends and earnings), it appears that we are trading lower than we should be.

Tuesday, August 11, 2015

F.A.N.G.: The 4 Companies Driving the Stock Market

2015 has been a challenging year for investors in individual stocks. So far this year, we’ve seen the price performance of individual stocks vary much more than it had been previously.  If you haven’t been invested in the right sector or had a decent amount of your portfolio in just a few high growth stocks, it is unlikely that your portfolio has kept up with the S&P 500.

Nothing illustrates this more than the acronym FANG, which stands for the darlings of 2015: Facebook, Amazon, Netflix, and Google.  As a whole, these stocks have accounted for more than 75% of the S&P 500’s returns year-to-date.

Amazon is up 68% so far this year.  Facebook and Google are both up by 21%.  Netflix is up a staggering 153%.  These four stocks comprise just 3.5% of the S&P 500, yet have contributed 75% of its performance.  Together, they have driven the S&P 500’s total return up by 1.6%.  The S&P 500 is up by just 2.1% so far this year.

If you own individual stocks and you don’t own these four companies, your portfolio is going to have a very hard time getting close to the market’s performance.

The question that must be asked is this: If just four stocks in the S&P 500 have been doing so well, why not own these four stocks? Why not buy shares in Amazon, Facebook, Google, and Netflix?

  1. None of them pay a dividend.

An investor who puts money into a stock that doesn’t pay a dividend can only profit in one way: If someone else is willing to pay them more for their shares in the future.  

We invest in companies for which their market price growth closely follows dividend growth.  A company that pays a dividend has shown that it can create cash from its business operations and is willing to share that cash with shareholders.

A company that doesn’t pay a dividend either (1) doesn’t make money consistently enough to afford to pay a dividend (2) is growing rapidly or (3) is not shareholder friendly.

Without a dividend, a company’s stock price is based far more on speculation about future earnings.  We’ve seen over time that earnings can be volatile.  In 2008-09, earnings for the companies in the S&P 500 plunged by more than 50% with price going right along with it.

  1. They all trade for extremely high multiples.

The price-to-earnings (P/E) ratio is a quick way to see how optimistic other investors are about a stock’s future.  It tells us how much investors are willing to pay for $1 of that company’s earnings.  The current P/E for the S&P 500 is right around 18.  That means the average stock delivers $1 in earnings for every $18 the investor pays to own it.  That represents an annual return on investment of 5.6% ($1 divided by $18).

All four of these stocks are trading at extreme premiums to the rest of the market.  Facebook’s P/E is currently just under 100.  Netflix trades for a staggering 277 times earnings.  And Amazon doesn’t even have a P/E because it doesn’t have positive earnings over the past 12 months.   Google appears to be the “value” of the group trading at a price-to-earnings (P/E) ratio of 33.

The higher a P/E investors pay, the more hope they are putting in the future.  If the next few years don’t pan out like investors currently expect, a company trading at a sky high P/E can see its stock price fall dramatically.  Buying these stocks means signing up for a return on investment of:

  • $1 divided by $33 = 3% (GOOG)
  • $1 divided by $100 = 1% (FB)
  • $1 divided by $277 = 0.36% (NFLX)
  • $1 divided by negative profits = ? (AMZN)

If these companies don't have dramatically higher earnings in the future than they have today, their returns will be unattractive, to say the least.  The only way you can profit from these shares is if you can find someone to pay even more at some point in the future.

  1. Who knows what these stocks are worth?

Are these P/E ratios too high?  Maybe.  They might also be too low. No one has any idea what Facebook, Netflix, Google, or Amazon will be worth 10 years from now.  

It’s quite possible that one or more of these companies will be trading far higher than they are today.  It’s also quite possible that at least half of these companies will have been replaced by the latest and greatest technology of the day.  

What’s clear is that earnings are not the major factor underlying the current market price per share.  Instead, it’s what each investor is willing to imagine about the company’s future.

Trying to predict the future of these companies is nearly impossible. Predicting what people will pay for them is even more impossible. We believe most investors would be better off not to try, especially not with money they need to live on in retirement.


Wall Street is obsessed with trying to find the next “home run”.  Who is the next Netflix or Facebook?  Who is going to triple in price over the next few years?  Betting on these types of stocks is not much different than going out to the casino and plopping down money on the roulette wheel.  Your payout is big when you win, but the odds are against you over the long-term.

We find it much easier to hit “singles and doubles” investing in high-quality dividend growth stocks.  Our multiple regression tool helps us identify stocks that are 10% to 25% undervalued.  We know these companies aren’t going to blow the doors off of the market, but we do know this: The price of nearly every company in our portfolio is highly predictable based upon its future dividend payments.  

For virtually all of the companies we invest in, the dividend has predicted 80-90% of the movement of its stock price over a multi-year period.  That gives us confidence that our portfolios will continue to grow in value over the long-term.  Investors in FB, NFLX, AMZN, and GOOG can’t say the same.

NOTE: Data as of 8/7/2015

Thursday, July 23, 2015

The Stock Market & Its Master

We’re just past the midway point in 2015.  So far, stocks have had a fairly underwhelming year. The S&P 500 has returned right around 4%, which is on pace to hit the lower range of what we predicted to start the year. The Dow Jones average is only up by 1.5%.

If you break the S&P 500 down into its components, you’ll find a more sobering story.  Nearly half of all stocks are in negative territory for the year.  A full third are down by 5% or more.  As a result, the average mutual fund has underperformed the S&P 500 by roughly 3% year-to-date (source: Morningstar).

Dividend stocks have been hit especially hard.  The perfect storm of a higher U.S. dollar, modestly rising interest rates, and collapsing oil prices have all hurt dividend stocks.  Both the Dividend Achievers Index and High Dividend Yield Index have struggled to stay positive for the year.

What's a Dividend Investor To Do?

We’ve been following the same dividend growth strategy for more than 20 years.  Over those years, we’ve seen dividend stocks outperform and we’ve seen them underperform.  In recent years, dividend stocks have been in favor as investors seek to find income.  In 2015, however, they’ve been out of favor.

We periodically fine tune which rising dividend stocks are in our portfolios based upon our market outlook.  However, we have seen that over a long period of time, dividend growth stocks generated higher than average market returns with more income and less risk than the market.

The Dog & It’s Leash

To illustrate what we mean, let’s consider a dog tied to his leash.  There are times when the dog will bound ahead of its master.  The dog cannot get too far ahead, however, because the leash will eventually yank it back.  There are also times when the dog will stand still while its master walks ahead.  This can only last for so long.  Once the dog falls too far behind its owner, the leash will yank it ahead again.

The same concept applies to dividend stocks.  There are times when the price of a stock bounds ahead of its dividend, creating an overvalued situation. There are other times when the dividend pulls ahead of the stock price, creating an undervalued situation.  There are other times when the dividend and stock price are moving along with each other, creating a fairly valued situation.

Dividends are the masters of price.  Prices are not the masters of dividend. Our research shows that dividends can predict roughly 90% of the movement of stock prices over the long-term.

To find out what the future of dividend stocks looks like, all we need to do is look at what companies are doing with the dividend.  If dividend growth is weak, we can expect future stock price growth will also be weak.

Dividend Growth in 2015

In 2015, dividend growth has been anything but weak.  With a good portion of dividend hikes already in, the stocks in our portfolios have grown their dividends significantly.

  • If end-of-year projections come in like we expect, Cornerstone stocks will have grown dividends by 10.8% in 2015 compared to last year.
  • Capital Builder dividends will be up 14.7% over 2014. 
Dividend stocks haven’t been the place to be in 2015, however, that will reverse at some point in the future.  The best thing we can do during times like this is to follow the dividend.  If dividend growth continues to be strong, we know prices will eventually take care of themselves.  We can’t know how long the master will outpace the dog, but we can know that the dog must eventually catch up to its owner.

NOTE: All data current as of 7/21/2015

Monday, June 29, 2015

3 Headwinds for Dividend Stocks: Will They Continue?

This blog was written prior to today's news about Greece. Based upon everything we see thus far, the Greece situation has short-term implications, but not long-term. Investors and financial institutions have had seven years to get used to the prospects of a Greek default. Furthermore, Greece represents only 2% of the European Union, which is a fraction of the global economy. We will have more to say on this over the next few months.

Dividend investors have had a difficult time so far this year.  While the S&P 500 Index has risen 3.0% on a total return basis, the Dow Jones Dividend Index is down 2.2% and the Vanguard Dividend Achievers Index is down 0.4%.  As usual, the nay-sayers are neighing that dividend investing is dead. But whoa Nellie, there have been three disparate forces that have pulled in the reins on stocks with higher than average dividend yields:

1.       Rising long-term interest rates
2.       Sharply appreciating U.S. Dollar versus most world currencies
3.       Collapsing energy prices

In many ways, the confluence of these three forces is unusual and not likely to last.  Over the last 20 years, long-term interest rates have been negatively correlated with oil prices and oil prices have been negatively correlated with the dollar.  One or two of these economic measures would be rising in a "normal" environment, but not all three at the same time.  It would be highly unusual if these three price trends continue in the same direction for much longer.

As strange as this time has been, the result has been clear. The current trend of these three economic measures has had a negative impact on many of the most important stock market sectors for dividend investors:
  • The rise in interest rates has hit the prices of the utilities, REITs, and telecoms sectors in much the same way as it has bonds.  
  • The rise in the dollar has significantly lowered multinational companies’ earnings and dividend growth, along with their stock prices.  
  • The collapse in oil prices has sent big oil and pipeline stocks down by as much as 30%.
The only sector with higher than average dividend yields to escape the adverse prevailing forces has been the financials, whose net interest margins and profits normally improve with rising interest rates.

As dividend investors, we have been facing all three headwinds for the last six months.  The question most of us are asking is, “How much longer can the headwinds last?”

Here is our view of these trends over the short and intermediate-term trends:

Interest rates:  With Greece teetering on the edge of default, we expect money will be in a flight-to-safety over the near-term.  This will push U.S. Treasury yields lower and allow for a modest rally in interest-sensitive stocks such as utilities and REITs.  How long the rally prevails will depend on how long it takes for the markets to digest the final outcome of Greece.  Regardless, we expect long-term interest rates will slowly move higher once the crisis is over. 

Oil prices:  The supply and demand of oil is nearing equilibrium. If that is the case, oil prices may have seen their lows.  Despite their rally in recent months, they are still 40% lower than a year ago. We have difficulty believing that a rally in oil stocks is near.  The Greek tragedy is a deflationary event. If it lasts very long, we would expect oil prices to trend lower. Furthermore, we will likely see some negative surprises from those oil and pipeline companies with high debt loads.  The companies in our portfolio are of the highest quality in the industry, which means they are in better shape to handle sustained low oil prices than their peers.

U.S. Dollar:  The flight-to-safety we spoke of would benefit U.S Treasury bonds and should also push the U.S. dollar higher.  The Greece concerns may not be a long-term occurrence, but will continue to produce near-term headwinds to most big multinational companies’ earnings and dividend growth.

Our analysis of the headwinds that have held back the performances of many great dividend stocks in the first six months of the year suggests that the second half will be modestly better than the first. However, we don’t see big moves in interest rates, oil prices, or the value of the dollar.

Companies that can produce double digit earnings and dividend growth in this environment will be highly prized.  We will continue to favor higher dividend growth versus higher dividend yield in the coming months.  We particularly like companies that derive more than 60% of their earnings in the United States. These kinds of companies are not as sensitive to the movements of the dollar as are the multinational stocks.  In addition, their higher growth can trump changes in interest rates.

In addition, most of them are benefactors of lower oil prices.  As long as these companies can produce above average earnings and dividend growth, we believe investors will continue to push their stock prices higher. We'll talk about some of our favorites in future blogs.

Finally, a near-term modest fall in interest rates would seem to be a negative for the financials.  In addition, they have all experienced strong price growth year to date.  With the trouble in Greece filling the headlines, we would not be surprised to see the financials tread water for a few weeks to months.

The Greek tragedy seems to be a never ending story that will lead surely to a catastrophic ending, but investors have had five years to get out of the way of a doomsday scenario for Greece.  We doubt the effects will be long lasting.

Friday, May 15, 2015

The Great P/E Debate: Are Stocks Overvalued?

Janet Yellen made headlines last week with her comment that stock market valuations “generally are quite high.”  The market took note, driving down prices.

Is she right?  Are stocks overvalued?

It certainly feels that way to most investors.  Stocks are trading at all time highs and are in the midst of a bull market that has seen the S&P 500 move up more than 200% since mid-2009 lows.

However, investing based upon feelings isn’t usually a very good idea.  That’s why we rely so much on statistical models to help us be objective about where market valuations stand at any given point in time.  Let’s see what we can uncover.

The Average P/E Says… Stocks Overvalued

It is most likely that Yellen was referring to the price-to-earnings (P/E) ratio in her speech.  Stock market pessimists have been promoting doom-and-gloom for years now.  The #1 argument they make is that the P/E ratio is higher than its long-term average.

Below is a chart showing the S&P 500’s P/E ratio going back to 1962, as represented by the red line.  The blue line is the S&P 500’s long-term average P/E of 15.  

The current P/E of 18.5 is higher than the long-term average. Taken at face value, this would indicate that stocks are frothy.  However, this argument has several critical flaws.

1. Stocks seldom trade at average P/Es.

Since 1962, the S&P 500 spent virtually no time at its long-term average of 15. In many years, it traded at a P/E far from its long-term average.

2. A “fair” P/E ratio is impossible to determine in isolation.
What is a “fair” P/E ratio?  Is 15 fair?  If so, what makes it fair?  The point is that P/E ratios mean little in isolation. There are other factors that we must consider to get the entire picture.

The Missing Link: Inflation

What is the most important factor in determining fair P/E ratios?  We have looked at correlations between P/E ratios and all kinds of variables.  We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth.  We have found that inflation is the best predictor of P/E ratios at any given point in time.

To make this more intuitive, we’ve converted the P/E ratio into E/P, which is known as the “earnings yield”.  In other words, if the S&P 500 paid out 100% of its earnings as a dividend, what would the yield be?

The chart below compares the S&P 500 earnings yield and the personal consumption deflator, which is what the Fed uses as its inflation measure.

As you can see, there is a clear visual relationship between the two.  To measure the relationship mathematically, we created the scattergram shown below.  On the left axis is earnings yield and the bottom axis is inflation. Drawn through the middle is a linear regression line.

The correlation between inflation and earnings yield is not perfect, but it is there.  Using this regression, we arrive at the formula shown in the bottom right corner.  That formula is:

y = 0.9048x + 0.0366

In the above formula, “y” represents the estimated earnings yield and “x” represents the current inflation level.  If we plug in today’s level of inflation, the formula will predict where today’s earnings yield should be based on the historical relationship between inflation and earnings yield over the past 212 quarters.

In the chart below, we’ve applied this formula to each quarter going back to 1962.  The blue line represents the “predicted” earnings yield and the red line represents what the actual earnings yield was.

Most people aren’t used to looking at charts of earnings yield, so we converted the earnings yield (E/P) back into P/E.  That chart is shown below.

The chart above clearly has more predictive power than the “average” P/E.  If you were simply following this chart, you would have predicted that stocks were about fairly valued in most periods except the following:

  • Overvalued from 1968 to 1973
  • Undervalued in 1985
  • Overvalued in 1987 (right before the market crashed by 25%)
  • Significantly overvalued from 1992 through 1994
  • Significantly overvalued from 1998 through 2001
  • Undervalued from 2009 through today

What does this mean for today’s market?

This model tells us a few things:

1. Stocks are not overvalued.

Far from it.  According to this model, the appropriate earnings yield is roughly 4.7%, which translates to a P/E just over 21. If the personal consumption deflator were to hold around 1.1%, the market would likely continue P/E expansion.

2. The stock market can handle some inflation.

The Fed has stated that their target inflation level is 2% vs. today’s 1.1%.  If inflation does rise to 2%, our formula estimates that the fair P/E would be about 18.5, which is exactly where we are now.  The stock market appears to be pricing in the expectation that inflation will rise.

3. The Fed isn’t going to wreck the stock market.

Investors across the globe are concerned that stocks will be hurt when the Fed starts to raise rates.  According to our research, however, this just isn’t the case.  Inflation is twice as correlated with P/Es as interest rates.  In our judgement, a gradually rising Fed funds rate won’t bring down the market. As long as the Fed does not aggressively raise rates, signalling that they see a significant risk to higher inflation, stocks can handle a period of rising interest rates.

The Great P/E debate will surely rage on for decades to come, but we believe many investors - including our own Fed chairwoman - have completely missed the point.  Average P/Es have no predictive ability for future P/Es without taking inflation into consideration.   

Unless inflation rises above 2%, the S&P 500 will be driven primarily by the future growth of earnings and dividends.  In this regard, there is plenty of good news.  Wall Street analysts are currently projecting double-digit growth in both earnings and dividends over the next 12 months. 

If Fed chair Janet Yellen jawbones inflation worries higher, that could derail stocks.  If she focuses her attention on containing inflation rather than forecasting stock market valuations, we would all be better served.