Whats the Stock Market Worth?

by ron vlieger

ast years fourth-quarter plunge and this years rebound have prompted much debate on whether the market is undervalued. But in 2008, many learned the hard way that a low price-to-earnings (P/E) ratio is no guarantee of future outperformance, making it clear that valuation is more art than science. In fact, P/Es dont tell the whole story, but are, along with growth rates, investor sentiment, and technical indicators, just one indication of the markets possible future direction.
(See Chart 1.) But the model lacks predictive power, according to Cliff Asness of AQR Capital Management.2 The historical correlation between earnings yields and Treasury yields seems to suggest that when earnings yields are the higher of the two, stocks should rise. But that has not proven to be true. No such consistent leadlag relationship is seen. So, although there is a close correlation, that does not translate into a model for predicting stock returns, according to Asness.

fed up with the fed model

The Fed Model, so-called because it is believed to have originated at the Federal Reserve, has been widely cited as a way of gauging the markets value. It compares the earnings yield of the S&P 500 Index1 with the yield on the 10-year Treasury note, and assumes that if the market is fairly valued, the two should be roughly equal. If the earnings yield is much smaller, then stocks are expensive. If the opposite is true, then stocks are cheap. As of March 31, 2009, 10-year Treasuries were yielding 2.67 percent. Using Reuters consensus forward estimate of $57.91, the earnings yield on the S&P 500 was 7.26 percent, suggesting stocks were substantially undervalued. The correlation between S&P 500 earnings yields and the yield on 10-year Treasuries has been tight over the past 30 years.

whats behind forward earnings?

The preferred method of determining whether the market is expensive or cheap would be to derive its intrinsic value. That would involve discounting dividends or cash flows for an index such as the S&P 500, much as analysts do for individual stocks, and comparing that with the indexs current value.

Chart 1. Historical S&P 500 Earnings Yield vs. 10-Year Treasury Yield, 19552008
18% 15% 12% 9% 6% 3% 0% 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Earnings Yield, S&P 500

Yield, 10-Year Treasury

Source: Robert Shiller, econ.yale.edu/~shiller/data.

For illustrative purposes only and does not represent the performance of any Lord Abbett fund or any particular investment.

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But calculating an intrinsic value for the whole market is impractical. A truly rigorous approach would mean estimating all the necessary inputs for each company. While this is technically feasible, it would incorporate so many moving parts estimates of growth rates, risk premiums, and the cost of capital, for example that it would be hard to know which inputs drove the results, limiting the transparency and usefulness of the final conclusion. Even doing the analysis at the index level would involve making assumptions that would hinder the usefulness of the results. So, that leaves more convenient alternatives, such as applying a P/E ratio to an estimate of the next years earnings. But in the current environment, accurately predicting future earnings can be difficult, and top-down projections have been soft. Reuters consensus estimates (as of April 23, 2009) placed operating earnings at $57.91a significant plunge since September 2008, when the estimate was $80, suggesting the estimates are not reliable in this environment. Meanwhile, a more trustworthy estimate may result from normalizing earnings. This means smoothing out the ups and downs that result from the business cycle, usually by taking an average over several years. The assumption is that earnings eventually revert to this mean. The P/E 10 ratio developed by Yale professor Robert Shiller normalizes earnings by taking an average of the previous 10 years. Using this method, Shiller puts earnings on the S&P 500 at $56.40. A more sophisticated method employed by the Leuthold Group, a Minneapolis-based research firm, makes use of both historical earnings and future estimates. It also resolves the dilemma over whether to use as reported earnings, which include expenses that are out of the ordinary, and operating earnings, which exclude them. The latter are believed to provide a better estimate of ongoing profitability, while the former reflect the effects of one-time or infrequent events, such as asset writedowns. The dilemma for analysts stems from the increasing practice by some companies of repeatedly reporting some expenses as extraordinary in order to boost their operating earnings.

Leutholds normalized earnings take a five-year average, using 18 quarters of historical results and two quarters of future estimates. As of April 2009, the groups estimate of S&P 500 earnings for the year was a fairly bullish $63.19.3

discounting the p/ e
Even with a solid estimate of the next years earnings, however, the value of a P/E ratio is still open to question, especially in an economic environment like the current one. Although the ratio serves as a convenient barometer, it fails to explicitly take into account future income streams beyond one year. And these are critical to the value of equities. Clearly, P/E ratios tell us something about the value of the market, said Walter Prahl, Lord Abbett Partner and Director of Quantitative Research. But they only tell us something because theres a connection between the near-term earnings theyre based on and future earnings potential. That is, the ratio works reasonably well in normal economic circumstances because the next years earnings often reflect a growth trajectory that can be readily extrapolated into the future. In the current environment, however, in which the trend in earnings has shifted so dramatically, P/Es may tell us less than usual. If, as some investors suspect, future growth rates are slower than in recent years, then the market may be overvalued.

tobins q: what are company assets worth?

If the current economic uncertainty makes predicting earnings difficult, it may help to look at assets instead. Tobins Q, developed by Nobel Prizewinning economist James Tobin, assumes that the market value of a companys equity, or net assets, should be roughly equal to their replacement value. So, if the market value is less than the replacement value, a company is undervalued. If greater than replacement value, then it is overvalued. (See Chart 2.) Using data from the Federal Reserve, Steven Vannelli, of GaveKal Research, has shown that Tobins Q suggests the market is undervalued. Vannelli pointed out that while the Q

Chart 2. Tobins Q and Corporate Nonfinancial Net Worth

2.5 2.0 1.5 1.0 0.5 0.0 1952 1958 1964 1970 1976 1982 1988 1994 2000 2006 $15,000 $12,000 $9,000 $6,000 $3,000 $0

Tobins Q: Market Value of Net Assets / Replacement Value (Left-Hand Scale)

Net Worth at Replacement Value (Right-Hand Scale)

Source: Federal Reserve and GaveKal Research; Federal Reserve data as of March 12, 2009.

For illustrative purposes only and does not represent the performance of any Lord Abbett fund or any particular investment.

$ in billions

ratio peaked 10 years ago, at 2.0 during the height of the dot-com frenzy, it now stands at less than 0.70, suggesting that equities are trading at a 30 percent discount to their true value.4 Tobins Q has value in a relatively stable economymeaning one that is not undergoing dramatic technological changes, for example. If an economy is based entirely on building autos, for example, and that industry is stable, then the notion that an investor would attempt to place a value on it by estimating the replacement costs of the assets used in the industry is entirely reasonable, Prahl said. But if the value-generating ability of current assets is being eroded by regulation, foreign competition, or new technology, then Tobins Q may be misleading. If that is the case, Tobins Q may be low because the market is anticipating potentially dramatic changes to the value-generating ability of the assets of U.S. firms, including higher taxes, greater regulation, environmental programs such as cap and trade, or a significant shift to green technology. It also is notable that, according to this metric at least, the market can remain undervalued for long periods. The Q stayed well below 1.0 for most of the 1950s and from the mid-1970s through the 1990s.

80 percent area, buying stocks is likely to work very well for you.5 As of March 31, 2009, the ratio had fallen to 71.7 percent, indicating that stocks may be cheap. (See Chart 3.)

betting on sentiment, technicals, and long-term earnings capacity

Putting a value on the market is a hazardous exercise, especially in the midst of a severe recession. And, in fact, valuation does not tell the whole story. In fact, the approach of Thomas OHalloran, Lord Abbett Partner and Director of Small Cap Growth Investments, is not driven by valuation alone. While it is important, other factors play a role as well. Overreactions in investor sentiment, for example, can create potential opportunities. In 2008, investors thought the financial system might collapse, and so they fled to the safety of Treasuries. This pushed down to single digits the P/Es of many blue-chip nonfinancial companies. The shift in sentiment since the end of 2008 has been significant, creating the current surge that could be a cyclical bull market. Whats becoming apparent to investors now is [that] the system is not going to collapse, and that has been a powerful force, OHalloran said. Technical factors also carry some weight. The S&P 500 has just completed a bearish to bullish reversal, OHalloran said, shifting from a downtrend to an uptrend. The market formed a base over the past six months, has recently broken through the 150-day moving average, and may soon surpass the 200day moving average. The economys resilience provides some context for investment decisions as well. The economy historically has been self-corrective in nature, and this, combined with unprecedented fiscal and monetary stimulus, is likely to boost earnings. The S&P 500 is clearly capable of earning more than the $58 per share forecasted by consensus estimates. Investors who are worried that the current run-up is only temporary may take some comfort from the economys resilience.

pricing a $14 trillion economy

Another measure of value has the advantage of simplicity: the ratio of the total value of stocks to the total output of the country, or gross national product (GNP). This ratio is analogous to the price-to-sales ratio. GNP is used instead of gross domestic product (GDP) because the former includes economic activity conducted overseas that nevertheless contributes to the profits of U.S. companies, while the latter reflects total economic activity just within the borders of the United States. The ratio has come down dramatically over the past few years, and data through the first quarter of 2009 suggest that the market is cheap, at least relative to recent years. Warren Buffett reportedly considers this a reliable measure and believes that, If the percentage relationship falls to the 70 percent to

Chart 3. Market Capitalization to GNP

200% 150% 100% 50% 0% 71.7%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Source: World Federation of Exchanges and the Bureau of Economic Analysis; data as of March 31, 2009.

For illustrative purposes only and does not represent the performance of any Lord Abbett Fund or any particular investment.

Although the economy contracted by 25 percent between 1929 and 1933, the economy returned to its long-run growth rate once the Great Depression came to an end. Demand for goods and services had shrunk, but the economys productive capacity remained unchanged, enabling growth to return to normal.6 (Of course, it is important to note that the market may not perform in a similar manner under similar circumstances in the future.) Whether the upturn since March marks the beginning of a secular bull market lasting perhaps at least three years, or just a cyclical bull of six to 18 months, will depend on the broader context, OHalloran said. In addition to deleveraging by banks, both higher taxes and growing regulation are likely to hurt profitability. Paraphrasing [famed investor] John Templeton, When the government is getting in, investors should get out, and when the government is getting out, investors should get in. So, the growing intervention of the government is a concern to me, and its hard to believe we would have the beginnings of a new secular bull unless they pull back, OHalloran said.

Prahl, whose quantitative research group avoids attempting to value the market as a whole, agrees that profits may decline from the unsustainable levels of the past several years. The earnings ability of the U.S. economy in particular, and the Western worlds economy more generally, was significantly overstated for some period of time by the excess use of leverage, which was encouraged and abetted by erroneous policy, Prahl pointed out. Were now in the process of sorting out the economys true earnings ability. Ron Vlieger is a Senior Financial Writer/Market Analyst. Prior to joining Lord Abbett, he worked for 10 years at Standard & Poors as business writer, editor, and director in charge of industry research publications. In this capacity, he served clients at audit firms such as KPMG, Ernst & Young, and Deloitte & Touche. He has a BA from Wheaton College in Illinois and an MS from Cornell University. He is a holder of the Chartered Financial Analyst (CFA) designation and has been in the financial services industry since 1997.

The S&P 500 Index is widely regarded as the standard for measuring large cap U.S. stock market performance, and includes a representative sample of leading companies in leading industries. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment. Cliff Asness, Fight the Fed Model, Journal of Portfolio Management, Fall 2003. Andrew Engel, Why We Normalize Earnings, Inside the Stock Market, The Leuthold Group, April 2009. Steven Vannelli, Are Stocks Undervalued or Not? GaveKal Ad Hoc Comment, April 14, 2009. Carol J. Loomis and Doris Burke, Buffetts Metric Says Its Time to Buy, Fortune magazine, February 4, 2009. Ben Inker, Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market, GMO LLC, white paper, April 2009.

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