Valuing U.S. Equities: A Historical Perspective

By Chuck Bath, CFA With Austin Hawley, CFA and Nate Palmer, CFA, CPA

September 26, 2014

As presented at the 2014 CFA Institute Financial Analysts Seminar, Chicago, Illinois,

Executive Summary

Using history as a guide, we considered the appropriate price-to-earnings (P/E) ratio that will provide investors a sufficient return on investment, relative to current interest rates, and reward them for equity market risks. We examined periods of extreme market valuation and came to the conclusion that, with the exception of the late 1990s, equity investors have been properly rewarded for the risk taken. We also concluded that in today’s environment of very low inflation and interest rates, a market P/E ratio in the high teens is not unreasonable.

Valuing U.S. Equities: A Historical Perspective

In the second quarter of 2014, the S&P 500 Index reached a new all-time high. This was part of the long process of recovering from the market decline of 2008-2009, and the recovery has been a welcome respite from the turmoil of the financial crisis. I believe that the strong market performance of 2013 is an indication that the financial crisis is finally behind us. However, as value investors there are important issues that must be addressed, particularly with the market at new highs. Are market valuations sustainable at current levels or has the recovery led to speculative valuation levels?

Ric Dillon, Diamond Hill portfolio manager and CEO, has created a spreadsheet to monitor overall market valuation levels. The DuPont model analysis that he uses is fairly traditional and straightforward. Traditional long-term growth rates and payout ratios create a targeted valuation for the market. While the inputs are tied to historic norms, I would argue we are not in historically normal times. Interest rates on both the short and long end of the yield curve are so low that normal valuation parameters seem inadequate. In particular, the traditional long-term price-to-earnings (P/E) ratio has to be called into doubt considering that competitive rates of return are so low. However, I do not want to abandon traditional valuation benchmarks simply to justify even higher prices. To help determine an estimate of proper valuation, I looked back at important inflection points of market valuation throughout recent history for guidance as to what the correct market valuation should be in today’s environment.

While it is purely a coincidence, the market behavior around the time I began my career in 1982 was very interesting. Although it could provide a guideline for today’s valuation since it was also a time of market extremes, the excesses were the exact opposite of today. In October 1981, the secular bond bear market was ending. This bond bear market, which began shortly after World War II, had taken bond prices to unprecedented levels. Yields were in excess of 14%, yet bond buyers remained reluctant.

I was reminded of these events thirty years later by an unusual anomaly: The 30-year return on bonds from October 1981 to October 2011 exceeded the return on stocks as illustrated by Exhibit A. This was not supposed to happen. The equity risk premium required to attract investors to equities was meant to assure, over the long-term, that equities would outperform bonds. Thirty years is a long time to explain away as a short-term market anomaly.

Exhibit A

Print

What was it about asset prices in October of 1981 that led to this unusual market response? Were equities mispriced relative to alternatives? How can investors look at bond prices to help determine the proper valuation for equities? As competitive assets, the price of bonds should impact the valuation of equities. In addition, interest rates serve as the discounting mechanism of future cash flows to equity holders. Equities should not be valued in a vacuum. The difficulty comes in trying to determine the degree of impact that unusual bond pricing should have on equities. Exhibit B shows how assets were priced at the time.


Exhibit B

Print
Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

With 20/20 hindsight, how should equities have been priced to provide a competitive return?  More importantly, what does the relationship tell us about equity prices today to assure we are earning an adequate equity risk premium?

I have struggled with this issue for some time, and it is an issue that, in my mind, does not receive enough investor attention.  As a value investor, it is easy to feel comfortable valuing the market when valuations are below the historical average.  Yet, as we witnessed in 1981, valuations which might appear inexpensive may be insufficient to properly reward shareholders for the risk they are taking.  To be sure, investors did earn outstanding absolute returns from those 1981 levels, but history shows those low valuations were necessary to provide the returns required to reward shareholders for the risks they were taking.  Higher equity valuation levels in 1981 could not be supported when attractive return options with less risk were available to investors.  Exhibit C shows the returns earned subsequent to that market low in 1981.


Exhibit C

Exhibit C

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

What I find interesting now is the exact opposite situation. Bond yields are historically low and bond prices appear very expensive.  In this environment, shouldn’t equities be priced above the historic norms to provide a normal equity risk premium?  It appears unreasonable for equities to be priced to provide normal long-term rates of return when Treasuries are priced to yield 3%.   Equities should be priced at a premium to the historic average.  But what is the correct premium?  This is where equity valuations become difficult for value investors.  I am very comfortable buying equities at 12 times earnings but dealing with a market P/E ratio of 16-17 is more difficult.  Is this appropriate?  Is it expensive?  Is today’s market at 17 times earnings actually cheaper than previous periods when the market might have been at 15 times earnings but interest rates were higher?

To get a perspective on this question, I decided to look back on valuations at important points in recent market history to determine if equities are currently cheap, fairly valued, or expensive.

The time period surrounding the market crash of 1987 provides a good perspective for relative valuations at that time.  Exhibit D shows the relative market values at the beginning of 1987.


Exhibit D

Exhibit D

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

However, the beginning of year valuations tell us little about market conditions surrounding the crash in October of 1987.  By mid-August, stock prices had appreciated almost 40% during a difficult period in the bond market.  Courtesy of Ed Hyman at ISI, Exhibit E provides a snapshot of conditions in the fixed income market leading up to the crash.


Exhibit E

Exhibit E
Source: ISI

Clearly, stock and bond markets had become disconnected.  During my 30-year career, I cannot remember a time when stock and bond prices diverged to such an extent.  Prices which may have been in alignment were very much disconnected by the fourth quarter of 1987.  I often heard discussions of portfolio insurance causing the market crash, and that was certainly a contributing factor.  However, the fundamental market conditions were in place for a significant decline.  We simply needed a catalyst to bring price and value back in alignment.  Subsequent returns proved this to be the case.  Annualized returns as shown in Exhibit F illustrate how tightly aligned those returns are even for investors who purchased these assets in 1987.


Exhibit F

Exhibit F

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

The tight relationship of the asset classes, adjusted for the equity risk premium, remains in effect.  Value investors may feel they were hurt in the crash of 1987 by paying more than 16 times earnings.  However, that was not the case.  Subsequent long-term returns show that investors were properly rewarded for the risks they took over the long-term, even if the short-term was very painful.

The next period of significant market decline was 1990, which was led by a flight from high risk debt, and was mostly concentrated in the financial services sector.  Lincoln Savings and Loan was a large S&L that failed at this time, and brokerage firm Drexel Burnham Lambert went out of business.  Executive Life Insurance was the largest life insurance company in California, and it failed as well.  The source of the turmoil was the bear market in below investment grade bonds. This was a very difficult time for equity investors, but value investors were relieved that P/E ratios had contracted during the period following the 1987 market decline.  These lower valuations, illustrated in Exhibit G, could also be explained by interest rates that were more than 100 basis points higher.


Exhibit G

Exhibit G

 Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

Once again, despite a period of market turmoil, it is clear that equity returns were adequate compared to alternatives available to investors at that time. Given a long-term time horizon, equities provided investors a 300 basis point risk premium as shown in Exhibit H. Subsequent to the financial crisis of 1990, markets stabilized and normal conditions returned. Equity investors were properly rewarded and the bond bull market continued.


Exhibit H

Exhibit H

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

As the bull market continued in the 1990s, speculative activity accelerated and valuations became stretched. This was the period of the “tech bubble,” and equity valuations reached unprecedented levels. This was also a terrible period for value investors, and their discipline led them to avoid the markets which, for a considerable period of time, continued to ignore value. Value investing was clearly out of favor and, as shown in Exhibit I, valuations were at unsustainable levels.


Exhibit I

Exhibit I

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

In all of the periods that we examined, this was the period in which long-term investors were not able to earn their risk premium as illustrated by Exhibit J. A starting P/E ratio of 29 was unsustainable and the subsequent bear market was incredibly painful. This is the period of time value investors will often point to in expressing their concerns about the increasing market valuation. However, today’s valuations are nowhere near the extremes of 2000. Still, in periods of rising P/E multiples, investors reluctant to pay higher prices in the marketplace often reference the 2000 market, and that is certainly understandable. Indefensible arguments about “new era” investing and grandiose predictions of huge returns available to investors led to ill-fated investments by many investors at that time. However, this does not mean that rising P/E multiples in any market cannot be defended or that premium valuations are not the likely and expected result of a low interest rate environment.


Exhibit J

Exhibit J

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

There is a tendency for investors to focus on total market valuations and returns as we have done in this paper. However, I would be remiss if I did not recognize that high valuations in the broad market can mask attractive valuations available in select segments of the market. This was classically the case in 2000 as the high broad market P/E ratio was driven by very high valuations among technology and large market capitalization companies. However, as Exhibit K shows, there was a broad portion of the market which sold for 12 times earnings or less. While the returns of the broad market indexes were poor during the period subsequent to the tech bubble, astute investors had the opportunity to provide meaningful outperformance by avoiding the stretched valuations of the favored stocks of the day.


Exhibit K

Exhibit-K

By 2007, the bond bull market had continued and valuations had recovered from the market lows of 2002. However, a financial crisis much more severe than that which occurred in 1990 would follow with more serious ramifications for investors. Still, as Exhibit L shows, valuations relative to interest rates entering 2007 were much more favorable to investors, and as a result, the long-term impacts were not as severe as many had feared.


Exhibit L

Exhibit L

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

The immediate sell-off was severe and the short-term impact was painful, but as we look back, equity investors have recovered as shown in Exhibit M. While the returns to equity investors since that time were not adequate, the time horizon is still relatively short to judge the valuations entering this time period. Given enough time, I suspect the 16.6 P/E ratio will be viewed as a favorable valuation given the alternatives available at that time. Only time and subsequent events will prove if I am correct.


Exhibit M

Exhibit M

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

Finally, we have today’s valuation illustrated in Exhibit N.


Exhibit N

Exhibit N

Sources: http://pages.stern.nyu.edu/~adamodar, http://research.stlouisfed.org, Diamond Hill analysis

The 17.0 P/E multiple on today’s earnings might seem high, and it is certainly high compared to the historical average. However, the alternative return in the fixed income market would argue for an even higher valuation. But how high? That is the dilemma. At periods of extreme valuation such as today or 1982, it is difficult to use historical reference points to determine the correct valuation. That is why there seems to be no consensus of opinion of the proper valuation for today’s market. We are in uncharted territory.

While I have made a case for a higher P/E ratio for the market as a whole, this is insufficient to judge whether the market is cheap or expensive. What P/E ratio gives investors a sufficient return on their investment, relative to today’s interest rates, to reward them for equity market risks? Using today’s market valuation combined with normal long-term trends in earnings and dividend growth, I attempted to calculate a reasonable P/E ratio. I assumed that market valuations return to normal at the end of the ten-year period to introduce some conservatism to the calculation. An important variable to this calculation is the required equity risk premium. For this number, we relied on the work of NYU professor Aswath Damodaran, who has studied long-term equity risk premiums. His calculations are shown in Exhibit O.


Exhibit O

Exhibit O

Note: “LT” indicates the “Long-term” risk free rate, which in Professor Damodaran’s work is the 10-year Treasury.

Source: http://www.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls

Using this risk premium and the parameters discussed previously, the calculation becomes fairly straightforward. The calculation is shown in Exhibit P.


Exhibit P

Exhibit P_revised

Exhibit P_revised

Sources: http://pages.stern.nyu.edu/~adamodar, Bloomberg, Diamond Hill analysis

Using this approach, the P/E ratio we calculate is approximately 19 times earnings. This is only an estimate of an appropriate level of valuation. Still, I believe this is a useful tool to judge the relative valuation in the market.

Determining the proper valuation level includes several key assumptions. An important consideration is the earnings per share (EPS) growth rate. In an environment of very low inflation and interest rates, is it likely that “normal” EPS growth rates can be achieved? Perhaps, but it may be difficult. Also, we have maintained very low interest rates for a long period of time. Are they sustainable? Skeptics have argued for higher interest rates for quite some time, but still we remain below 3%. The rally in equity markets in the last few years may, in part, reflect a market becoming more comfortable with the prospect that interest rates will remain at low levels for longer than skeptics originally believed possible.

I take comfort in our estimate from the data provided in Exhibit Q.


Exhibit Q

Still-Tame Inflation Suggests Earnings Multiples Not at Great Risk Cyclically

In the context of the inflation outlook in the  U.S. and the developed world, there appears to be very little risk for earnings multiples in the short term. Historically, zero to 2% inflation has remained the sweet spot for valuations. Even slightly higher readings, say 2-4%, don’t appear to be the death knell for stocks some fear. It’s only when investors see signs of deflation (<0%) or greater than 4% inflation that multiples appear at great risk.

AVERAGE S&P TTM P/E BY CIP Y/Y TRANCHE
(1950-CURRENT)

Appendix A

Source: Strategas Research Partners

During periods of low inflation, history has shown that high P/E multiples can be sustained, so it is not unreasonable to expect P/E multiples to achieve and sustain the estimated levels in the high teens. What we have not found is justification for P/E multiples above 20 times earnings. Surely the experience of 2000 has shown the risk associated with P/Es greater than 20.

More important and interesting is what the long-term ramifications might be from equity valuations driven by historically low interest rates. Rising equity prices are the market’s means of lowering future returns. The adjustment that occurred in 2013 valuations was important and necessary to bring equity valuations in-line with other asset classes. However, once the adjustment is complete, we are left with a market that offers return opportunities less than equity investors have come to expect. Very long-term oriented equity investors have historically earned over 9% in the equity markets. However, that is not a sustainable level of return in an environment in which the 10-year Treasury yield is less than 3%. Once the adjustment is complete, we believe future returns will be much lower. That is one reason why it is very important to be invested in equities while the price adjustment is being made. In a sense, current returns are being borrowed from future years such that future returns will be less than historic norms.

Equally interesting is how investors will respond to the reduced opportunity for equity and fixed income returns. Will investors accept more risk to try to capture greater return? Is this appropriate? Should a portfolio exceed prudent risk parameters in its search for return? In my opinion, this seems to be a recipe for disaster. If a certain level of risk is inappropriate at higher rates of return, it is inappropriate at lower rates as well. However, if history is a guide, I would expect investors to seek more risk in their search for return.

I believe this is part of the downside of the Federal Reserve’s policy of quantitative easing to drive asset prices and stimulate the economy. This policy has been effective, but it encourages risk taking. Hopefully, the Fed will remain conscious of the potential risks and, as a result, risk in the economy will be managed properly. Only time will tell if they will be successful.

An important portion of this analysis that we left out is the difference between nominal and real rates of return. Until now, we have only spoken of nominal rates of return. Investors should be much more interested in real rates of return, and higher real returns should be one source of potential optimism for investors in an environment of lower nominal returns. The inflation rate has been historically low. If this continues, today’s lower nominal rates can still provide real rates of return that compare favorably to the real rates of return of past years. However, if there is one variable that needs to be monitored closely, it is inflation. If the inflation rate can remain at today’s low levels, equity investors will be well rewarded with competitive real long-term rates of return. This is an opportunity but also a risk.

In conclusion, we have shown the extreme valuation levels achieved in the 1999-2000 time period were excessive and could not be justified by subsequent events. At the same time, normal P/E ratios around 15 do not reflect the reality of today’s market environment. Our estimate of approximately 19 times earnings is an attempt to determine a base case valuation level so we can judge the relative attractiveness of today’s equity market. While it is only an estimate, it provides a good starting point for value investors to evaluate investment options in the framework of today’s market.


Appendix A (1 of 2)

2014 Does Not Look Like 1987

Fed tightening of +125 bp in 1987, which helped precipitate the Crash, was in part response to an acceleration of inflation (see next page), which was in part driven by a doubling of Brent.

Appendix B

Source: ISI


Appendix A (2 of 2)

2014 Does Not Look Like 1987 Continued

The doubling of Brent in 1987 helped push inflation up from roughtly +1.0% to +4.5%. Nominal GDP growth surged from +5.0% to +7.5%. At the same time, the Fed tightened, causing a liquidity crunch. Because the economy was OK, as soon as the Fed eased, the S&P started to rebound as the liquidity crunch eased.

Appendix B continued

Source: ISI


Appendix B

Appendix C

Sources: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french, http://www.federalreserve.gov, Diamond Hill analysis

 

Chuck Bath

Chuck Bath, CFA
Diamond Hill Capital Management, Inc.

 

Austin signature

Austin Hawley, CFA
Diamond Hill Capital Management, Inc.

 

Nate Palmer

Nate Palmer, CFA, CPA
Diamond Hill Capital Management, Inc.

 

Originally published September 26, 2014

The views expressed are those of the research analyst as of July 22, 2014, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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