John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.
I believe strongly in using cold, hard data when investing. The problem is that any single piece of data can lie. That's why it's so important to consider a variety of information. You might say that, when it comes to the numbers, there is safety in numbers.
My Guru Strategies, each of which is based on the approach of a different investing great, examine dozens of different data points when analyzing individual stocks.
You can apply a similar approach to assessing the broad market. Rather than focusing on a single measure of whether the S&P 500 is expensive, you can consider several. Here are some of my favourites:
The price/earnings ratio: The trailing 12-month P/E takes the market's current price and divides it by the amount of per-share earnings companies have reported over the past four quarters. Using Standard & Poor's earnings data and the Dec. 12 close, the S&P 500's P/E was about 14.2. The figure is lower than the 1872 to 2000 historical average for U.S. stocks of 14.5.
The 10-year P/E ratio: Yale economist Robert Shiller believes a better way to measure the market is to look back on current prices in relation to the average of the previous 10 years' earnings, adjusted for inflation. The benefit of this approach is that it compensates for short-term anomalies in earnings. The downside is that the period it examines is arbitrary. Typically, business cycles run about six years. So the 10-year P/E ratio can be skewed if the past decade has happened to include an unusual combination of recessionary and expansionary periods.
The 10-year P/E has hovered around 20 for the past couple of months. That's significantly above its 140-year historical average of about 16, though far from the peaks hit in 1999 (44.2) and 2007 (about 27.5).
The stock market/GDP ratio: This compares the total market value of the stock market to the value of all the goods and services produced in the U.S. for the year – the gross domestic product.
Warren Buffett has said the stock market/GNP (gross national product) is one of his favourite valuation metrics, and GDP and GNP tend to run quite close to each other. The website GuruFocus.com tracks the daily stock market/GDP ratio, and as of Dec. 13, the ratio was 86.1 per cent. That sits in the "fair value" range (75 per cent to 90 per cent), which was derived by an analysis of historical data, the site says.
The price/sales ratio: The money manager Ken Fisher pioneered the price/sales ratio (PSR) in the 1980s as a way to value individual stocks. His logic: While earnings can fluctuate wildly from year to year, sales are far more stable, and provide a better gauge of a company's position.
Two of my Guru Strategies use the PSR. My Fisher-based model finds PSRs below 0.75 to be tremendous values, and those between 0.75 and 1.5 to be good values. My James O'Shaughnessy-based model looks for PSRs below 1.5. According to data from Morningstar, the S&P 500 currently has a PSR of 1.2.
The market yield: Just as bonds have yields, so too do stocks. One key indicator is the earnings yield, which is generally calculated as the inverse of the P/E ratio. Using the trailing 12 months' reported earnings, the earnings yield of the S&P 500 is 7.0 per cent.
That's a pretty healthy figure. According to data from New York University finance professor Aswath Damodaran, the average earnings yield for the S&P 500 from 1960 to 2010 was 6.86 per cent. In what has been a rarity in recent decades, the other main type of stock yield – dividend yield – is actually significantly higher than the 10-year Treasury yield. The S&P's dividend yield is 2.54 per cent, while the 10-year Treasury yields about 2.03 per cent. That's a bullish sign.
Projected P/E: Rather than using past earnings, analysts will often look at the market P/E using projected earnings for the next year. Using this approach, the S&P 500 is trading for 11.9 times operating earnings, and 12.8 times as-reported earnings.
Over all, these indicators paint an attractive picture. P/E ratios and earnings yields that use one year's worth of earnings are now cheaper than historical averages. The market's price/sales ratio seems reasonable, and the stock market/GDP ratio is in "fair value" territory. Only the 10-year P/E looks high.
All of that suggests that the market is trading pretty close to its fair value. Throw in the fact that the market's dividend yield is more than 25-per-cent higher than the yield on the 10-year Treasury, and stocks seem priced to perform much better over the long term than the Treasury bonds that everyone has been piling into.
John Reese