This week closes out a most volatile quarter. Stocks are on track to rise by the most during the quarter (+19% as of this writing) since 2009 despite a sharp contraction in the economy. The powerful rally leaves many wondering about valuations amid a pandemic and recession.

Even though price is important, we should avoid relying too heavily on standard valuation metrics such as price-to-earnings multiples because this economy is far too volatile to assess business prospects accurately and because stock values are determined mostly by long-run, rather than short-run, earnings power.

Price is Important

Overpaying for stocks can take a toll on a portfolio. Ask any investor who bought and held technology stocks in the first few years following 1999. From the Nasdaq’s peak in March 2000 through the October 2002 bottom, the index lost 77%. While the Nasdaq has turned in a stellar performance since the first years of the millennium were difficult ones for tech investors.

Bull markets tend to blind even the savviest investor from problems in valuation. When making money in such markets, it is easy to stay too long at the party. The longer the period of gains, the easier it becomes to cling to the beliefs formed during the good times. Having to change opinions, fear of missing the next run, or the prospect of paying taxes can lead to complacency. Our desire to avoid such traps is why we incorporate valuation into our estimation of future return expectations.

Beware the Common P/E Ratio

Even though valuation is important, we should avoid relying too much on traditional multiples like price-to-earnings (P/E) ratios in this environment. The current climate is far too volatile to assess business prospects properly.

According to the Federal Reserve Bank of Atlanta’s “GDP Now” model, the U.S. economy contracted at a 40% annualized pace in the last quarter. Analysts expect S&P 500 company profits to also decline over 40% from a year earlier. The shock of the virus and shutdown creates massive uncertainty and turbulence in current earnings, making it hard to value stocks on simple price-earnings ratios alone.

Looking Beyond the Cliff

What if we just wrote off 2020 and 2021’s earnings entirely? At the start of the year, long before Covid-19 was a household word, analysts expected S&P 500 profits of $180 in 2020 and $200 in 2021. If we assume those earnings evaporate entirely, $380 of value would disappear. The S&P 500 would be worth $380 less than the $3,400 price attained on February 14, all else being equal.

But we do not expect S&P earnings to fall all the way to zero this year and next, and we do hope and expect the world will recover from the virus. Moreover, increasingly meager interest rates encourage higher valuations on S&P 500 earnings out into the future. After the shock of the second quarter earnings cliff fades, we expect that most investors will focus on earnings in 2021, 2022, and 2023. This perspective is appropriate since stocks should rightly be valued on long-run, rather than short-term prospects.

A Better Way?

Keeping a long-run perspective means not over-reacting to short-term swings in earnings. A “cyclically-adjusted” measure of earnings power can help us maintain such a perspective. Professor Robert Shiller of Yale provides data in a spreadsheet that calculates a measure of S&P 500 earnings that smooths out cyclical noise. By averaging and earnings over a full economic cycle (10-years), he estimates a market price-earnings ratio free of the profit cycle (chart, below). This valuation ratio is commonly referred to as a “CAPE” ratio (cyclically-adjusted price-earnings).

Notice that today’s CAPE ratio above (28.1x) now sits above the 20-year average (26x). This premium suggests that the S&P 500 is about 8% “overvalued” compared to the historical average. Since we believe that markets are mostly rational and valuations tend to revert to averages over time, we need to subtract something from our return expectation to account for above-average valuations. If the 8% premium valuation is spread out over our 10-year forecast period, it will detract about 0.8% per year from return. It is worth noting that the degree of “overvaluation” based on today’s CAPE ratio of 28.1x lower than in 2018 when the CAPE ratio hit peaked at 33x and far lower than the sky-high 43x multiple hit in March 2000.


So it is clear that although valuation is important, investors should avoid relying on traditional multiples in this environment for two reasons. First, today’s economy is not a typical operating environment for most companies and earnings reported during the pandemic are not representative of earnings power under normal conditions. But most importantly, markets are most appropriately valued on long-run, not short-run, earnings power.

This coming earnings season is likely to offer jaw-dropping declines in earnings (-40% or more). It might be tempting to conclude that stocks are significantly overpriced based on a standard price-earnings ratio with deflated earnings in the denominator. But we think this is a mistake because we believe that valuations should focus on longer-term earnings prospects. A cyclical adjustment to earnings provides a more balanced way to start thinking about today’s stock market’s valuation.

We are not saying that valuations do not matter. They do, but at the same time, it is essential to separate cyclical swings from real, underlying earnings power.


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