William S. Barker

Portfolio Manager

A Different Look At Stock Prices

The stock market soared higher for most of the year before hitting turbulence in October. I recently sat down with my colleague Matt Trogdon to discuss stock prices and where I think the market could go from here.

Matt: Thanks for your time, Bill. There are a lot of articles out there about whether the stock market is expensive or not. Some, including one by Robert Shiller, compare prices in today’s market to some of the scariest market peaks ever, like 1999 and 2007. How do you look at current stock prices?

Bill: Well, one thing I’ve been doing for a few years is following the quarterly S&P earnings data. Howard Silverblatt does a great job of putting that out on a near-weekly basis with updates to the most recent quarters, actual earnings, and the expected earnings of the next several future quarters. He started doing this in 1988, which is certainly not the beginning of the history of the market, but it is now a 30-year period. I like to look at where the price in the market is today, compared to the last 30 years, as one way of seeing how expensive things are.

What I see is that the market is just slightly more expensive than the average over the last 30 years in terms of the P/E ratio, whether you’re talking about operating earnings or GAAP earnings, and in comparison to the peak earnings and the trend earnings. All of those, right now, show that things are just slightly ahead of average or slightly more expensive than average. At a level of 2725 for the S&P, the market is even to about 4% pricier than average based on which EPS metric you are using as measured over the last 30 years.

“What I see is that the market is just slightly more expensive than the average over the last 30 years in terms of the P/E ratio.”

Matt: What would you say are the strengths and weaknesses of looking at stock prices this way? And how is this different from what other people do?

Bill: I think that by keeping it to a 30-year period, you’re acknowledging that you aren’t including the rest of the data. And the rest of the history of the market unquestionably is one of lower valuations, in terms of multiples over most market measurement periods beginning in the 1870s up through 1988. There are a couple of market peaks — late 1920s, 1960s, in terms of multiples that are pricy as well— but mostly you’re looking at a data set outside of this range that makes the market look at the last 30 years as consistently expensive. That’s one limitation of the data.

On the other hand, a 30-year time period does tell you something. At least investors should consider whether there are things in the market that mean that a higher multiple, which has been more or less sustained for 25 to 30 years, is a function of things that are different in this market than was the case 70, 80, 90 years ago.

Matt: Before we jump to any conclusions about today’s prices, looking at the last 30 years, what jumps out at you? Is there anything about past market valuations that you learned that you didn’t already know?

Bill: I like to take the Silverblatt numbers, run them through an Excel heat map, and look at the colors. Instead of trying to say “this is what was happening,” “this was the excuse for this happening,” I just want to answer the question: “What does a simple math calculation look like?” There are times of bright, bright, bright red. That signifies elevated P/E numbers, and in theory that’s when you shouldn’t have been investing. And you can see that all over the late 1990s, starting about 1997 and really extending into 2002. And then there are periods of bright green, which signifies lower P/E numbers, and that includes late 2008 and all of 2009, of course, although many people thought the market was expensive then.

But there are a couple of periods where some indicators of the P/E ratio told you the market was expensive, and some indicators told you it was cheap, like the depths of 2008. If you were just looking at a simple GAAP price-to-earnings, the market looked like it had never been that expensive due to temporarily collapsed earnings – especially on GAAP earnings, less so on operating earnings. But if you’re looking at price-to-trend earnings, it looked extremely cheap. And if we were to end that experiment today, we would say, “Turns out trend earnings is what investors should have been looking at, rather than the GAAP earnings because if they did invest in late 2008, early 2009, they’ve done very well for themselves.”

Matt: What, of all these ways of looking at price to earnings, is the most predictive?

Bill: The price to the trend. And the way I’ve done this is take the beginning of the data set, the 1988 earnings, and run that through what is the growth, with that being the starting point? And the end of 2017 being the endpoint. You’ve got earnings per share compounding at a little bit above 6.2% annually, through the S&P 500. So there are times when earnings lagged a little bit, and there are times when they get ahead a little bit. And part of what I see in this data set is earnings getting ahead of that trend in the late 1990s. Earnings were growing faster than that, and investors got overly enthusiastic about extending that growth rate out ahead of themselves for a couple of decades. The earnings didn’t end up growing faster than 6% annually, even though they were temporarily growing a good deal faster than that.

That is a warning signal for today’s investors. We might be looking at the current earnings-per-share growth, this year versus last year, at somewhere around 28%, 29% growth. That’s absolutely not going to continue. Part of that has to do with tax cuts and the very real and permanent effects that the tax cuts have on earnings levels. And I calculate that as a one-time jump of 8.5% above the previously established trend. I think investors are going to get in trouble if they start extending their forecast of earnings growth out above about 6% from today’s levels though.

“That is a warning signal for today’s investors. We might be looking at the current earnings-per-share growth, this year versus last year, at somewhere around 28%, 29% growth. That’s absolutely not going to continue.”

Matt: Looking at some of these P/E measurements, we’re starting to get back into the green, or less expensive, zones for valuations on your heat map. Is that optimistic or not?

Bill: Well, I think the reason the end-of-2019 expected earnings produce seemingly attractive P/E ratios on today’s prices is they are quite optimistic — and these are the earnings calculations for Wall Street analysts compiled by the S&P. And they’re always optimistic. The future is always looking good to Wall Street analysts. But I don’t think that on top of this year’s 25+% rise of earnings per share you’re not going to get another 15%-20% earnings over the next five quarters, as is the published expected EPS growth rate for next year. That, to me, seems quite optimistic. 

Matt: Even so, today’s P/E ratios, they aren’t looking terribly high compared to historic norms. Given that, what are some of the danger areas we might see in the market?

Bill: Well, the earnings are real and good. What are the causes of those? The tax cuts are real and will continue. The thing which might be more ephemeral is margins, which are about 50% higher today than they have been over the last 20 years. So when you’re looking at theories of what might revert to the mean, if margins revert to the mean, that’s going to be a major hit for earnings.

Why would they revert to the mean? That’s Capitalism 101. High margins attract competition, and competition caps the margins that you can get. On the other hand, why might one be bullish about margins staying at or near today’s rates, which are around 11.5%, compared to an 8% operating margin range in the past 20 years? Well, the growth of tech produces more attractive margins, and the growing percentage of tech in the S&P 500 and in the economy provides some reason to be optimistic when you’ve got so much of the earnings previously produced by commodity companies. That is one of the reasons that someone could be more optimistic about the margins being maintained.

Matt: So speaking generally about the bull and bear argument about where the market is headed, how would you articulate those based on this data?

Bill: Well, the bull argument is hinged on that growth of tech continuing and providing an EPS story that outpaces a sales growth story. And that’s possible and that could continue. The bear case is the reversion of the mean for margins or a slowing down of the economy. Obviously, the economy has been reasonably strong over the past several quarters, and it has spent most of the last decade growing slower than it is growing today. Given limits on population growth, I think it is quite possible the bear case that the economy can’t grow beyond 3%  without an extreme increase in productivity is sound.

Matt: If you were a retail investor looking at this data, or if you were a financial intermediary working with a client, what are the one or two takeaways for people trying to position their portfolios going forward?

Bill: Stocks on an earnings multiple basis are not extremely expensive, as some headlines are portraying them. To those who are reading those headlines and thinking, “Hey, is the market as bad as it was in 2000?” I would say the multiples in 2000 were largely projections of huge growth in the economy continuing unabated and at historically high norms. And that didn’t materialize.

And I think that the other thing to keep in mind is that earnings per share have grown about 6% per year over the last generation – the last 30 years. You add EPS of 6% and dividends of 2%, 8% returns could be achieved if the market maintains this valuation level and you ignore inflation, which might be 2%-3%. This is something that investors might be able to expect, but it depends on the valuations that actually do appear inthe future. I don’t see any reason why the market in the next 30 years can’t value stocks the way it has over the last 30. But I wouldn’t look for an even more optimistic multiples in the future.

“Stocks on an earnings multiple basis are not extremely expensive, as some headlines are portraying them.”

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