We have shown in previous blogs that much of what academia and Wall Street tell us about how to calculate the most foolproof price-to-earnings ratio for the S&P 500 at any point in time is . . .well, foolish.
1. Professor Robert Shiller, the creator of the CAPE method of valuing stocks, which has many academic adherents, says that stocks are wildly overvalued. The only problem is he has been saying that for nearly six years, and in interviews, he cautions that CAPE is not a good metric for timing. But, professor, what good is a valuation metric if it is correct only once every decade, or so? That sounds a bit like the accuracy of a dead clock: it's correct twice a day but fails at telling time during the other 23 hours 59 minutes and 58 seconds of the day. CAPE currently suggests that the S&P 500 P/E is approximately 80% above it fair value.
2. There is another crowd of soothsayers who hold to the idea that the long-term average P/E of the S&P 500 is the correct metric to determine its fair value. These folks argue that a P/E of 16x is the right multiplier, and, that being the case, at 21.3x, stocks are currently about 33% overvalued. History shows us that if you would have bought every year when the S&P 500 was below a 16x P/E and sold or shorted every year above that level you would have crashed and burned a long time ago.
3. Many on Wall Street believe that the best way to calculate the normal P/E for the S&P 500 is to subtract the rate of inflation from 20. In our judgement, this crowd has had a better track record over the last 50 years than Dr. Shiller or the 16x crowd, but we have previously shown, there is a more statistically significant way to determine the right P/E at any point in time. That methodology is what we call the earnings yield to inflation' ratio.
Our work shows that since the 1960s, earnings yield (the inverse of P/E) minus core inflation has averaged 3.35% with a correlation coefficient of .70. For our calculations, we use earnings before extraordinary additions or subtractions and the core personal consumption deflator inflation (PCD, the data most favored by the Fed.) The current reading for these two data points are as follows. PCD is 1.6% and the trailing 12 month earnings yield is 4.70%, or a P/E of 21.3.
To determine where the model says the current earnings yield, (P/E) ought to be, we add the current PCD rate of 1.6% to the long-term constant of 3.35%, or 4.95%. Converting this back to P/E, we find the model predicts the correct P/E is now 20.2x. With the S&P 500 now trading at 21.3 times earnings, that would suggest that stocks might be about five percent overvalued. But there's more. The stock market is a discounting mechanism. That is, it is always looking ahead and pricing in where it believes current financial and economic data will be in the future. Currently the consensus view of analysts and economists is that the PCD inflation rate will climb to 2% by year end and S&P 500 earnings will grow to approximately 160. If these estimates come to pass, that would put the fair value of the S&P 500 at about 3200 by year end.
With the S&P 500 currently sitting at 2727, that would mean it is about 17% undervalued. That's my best guess and I'm sticking with it no matter how much volatility we see over the next few months. I'll update the model in the coming months.
Earlier, I said the correlation coefficient on our P/E model is approximately .70. Being less than 1.00 means that it has not perfectly predicted annual stock market moves (surprise, surprise). I offer it here because the model is simple and has done a reasonably good job of predicting stock market action over the last few years. We have another model that has more complexity and with an even higher correlation coefficient that also predicts stocks are undervalued by double digits. I'll show it in a future blog.
