- Valuing the market: Are shares cheap?
- Valuing the market by P/E ratio
- The cyclically-adjusted P/E ratio (PE10 or Shiller PE)
- Valuing the market by earnings yield
- The stock market capitalisation to GNP (or GDP) ratio
- Why a higher P/E ratio for the market could lead to higher returns
- Proof that most methods of making stock market predictions don’t work
Academics believe the stock market is efficient, so there’s no point asking are shares are cheap or not.
In their view, any way of anticipating future prices will already be built into prices today.
I believe the market is fairly efficient, but I’ve seen enough to have my doubts.
Living through the Dotcom crash and the credit crisis makes you question academia’s eternal truths. I also think Warren Buffett is more likely to be skilful than lucky. I sometimes think I might say the same about me – on a far more modest level!
So like Pascal, I prefer to hedge my bets.
One way to do that is to commit more money to equities when they seem better value compared to the past. You might try to do this by looking at the P/E ratio of the market as a whole. But most who do so prefer to look at the cyclically adjusted P/E ratio, which attempts to smooth out the ups and downs of the economic cycle.
Alternatively, you might compare the expected return from the stock market with what’s on offer from other investments like cash, corporate bonds, gilts, or property – and also with the rate of inflation.
A simple way to do this is to look at the earnings yield of the market.
A yearning for earnings
If shares are notionally earning 8% compared to bonds yielding 4% and cash yielding 2%, you could well conclude they’re the best place for your money.
But beware!
Like everything in investing, valuing the market by its earnings yield is not a guaranteed route to riches. Equity earnings might collapse in an unexpected economic slump. Yields on cash and bonds might be artificially depressed, making shares look better value than they are.
In fact, as far as I’m aware there’s not any conclusive research proving that using earnings yield as a buy signal for shares is any more consistently successful than simply buying and holding, or drip-feeding money in over a long period of time.
I certainly wouldn’t suggest anyone use any market valuation strategy to move entirely in and out of the stock market. Degrees of commitment is – at most – the name of the game here.
For example you might risk 70% in shares when you think they’re very cheap, versus your usual 50% allocation, if you’re dead set on trying to be clever.
How to calculate the earnings yield of the market
Before we can consider whether the market is cheap according to its earnings yield, we need to know what that earnings yield actually is.
I have written a separate article on how to calculate the earnings yield for individual shares. Once you’ve grasped those basic principles, it’s then a simple matter to determine the earnings yield of the whole market.
You merely have to work out the earnings yield for several thousand companies, and then take their average. I suggest you start with the As, and Admiral Group…
Okay, that’s clearly not feasible! And happily it’s not required, either.
As diligent readers who read my aforementioned article on earnings yields can report, the earnings yield is simply the inverse of the P/E ratio:
Earnings yield = 1 / the price-to-earnings ratio
P/E ratios are commonly available for entire markets. You can get them from newspapers like the Financial Times, from market data providers, or from our own quarterly Private Investor Roundup. P/E ratios change as the market level fluctuates, remember, so make sure you’re using an up-to-date ratio.
To see how it works, imagine the UK stock market is on a P/E of 12.
Then for the UK market:
Earnings yield = 1/price-to-earnings = 1/12 = 8.3%
Once you have the earnings yield for a particular market, you can compare that to the yield on cash, bonds, inflation, or to investing money in your Uncle Bob’s ostrich farm to see which looks the best value by this measure.
Valuing the market by earnings yield
If the stock market boasts an earnings yield of 8.3% when ten-year gilts are yielding less than 2% and cash on deposit on average 0.9%1, then you may well consider equities a bargain – subject to all those caveats I mentioned above.
(You remember – that tedious guff about nothing being certain, a recession always being potentially around the corner, and so on…)
In contrast, a low earnings yield for the market may – or may not – suggest that shares are on the whole expensive compared to some of the alternatives.
At the time of the Dotcom bubble, for instance, the earnings yield on the US S&P 500 was approaching 2%. At the same time super-safe ten-year Treasuries were yielding 6%. With hindsight, the earnings yield clearly suggested the market was poor value.
I say ‘with hindsight’ because, to repeat myself, nothing is ever crystal clear with shares. When profits collapse and P/E ratios expand, earnings yields will plunge too, making shares look a terrible investment.
Yet a profit rebound could be just around the corner.
Returning to the S&P 500, at the market lows of 2009 the P/E was roughly 65, for a puny earnings yield of 1.6%.
Awfully unattractive on the face of it, yet this turned out to be one of the best times to buy equities in a generation.
Why? Because it proved to be a cyclical low, and earnings bounced back very strongly.
A yearning for earnings
If you’re now thinking how you’ve read 1,000 words to discover that the earnings yield is no silver bullet when it comes to valuing the market – you’re right.
Sure, you will hear pundits proclaiming shares are cheap and pointing to the earnings yield. You will also hear people saying shares are expensive and doing the same.
At least you now know which finger to upraise in their general direction if they claim to be certain, especially if they’re making a short-term forecast. I think that’s quite a valuable lesson.
The market may not be entirely efficient, but it’s not a patsy. If you could successfully punt in and out of shares just by inverting the P/E ratio, then everyone would be doing it and – after a few newly minted millionaires sailed away on their yachts – the technique would be arbitraged away.
The reason that hedge funds employ teams of astrophysics PhDs sweating on seven-figure salaries is because you can’t boil the future of the stock market down to the inverse of the P/E ratio. Market timing has a very poor track record for most private investors and fund managers.
The bottom line: It’s a useful metric to know, but if you’re going to try to value the market by earnings yield, it should be just one aspect of your analysis.
- There are plenty of better rates available, but this is the average according to Moneyfacts. [↩]
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I wouldn’t get too excited about the efficient market hypothesis. It’s been fairly conclusively disproved, although there’s still a small but very loud group of academics who disagree. At this point I think we can consider them to be overly stubborn (or in some cases to have vested interests).
The Shiller PE evidence, among others, conclusively shows that returns are dependent on current valuation. They aren’t random.
“In fact, as far as I’m aware there’s not any conclusive research proving that using earnings yield as a buy signal for shares is any more consistently successful than simply buying and holding, or drip-feeding money in over a long period of time.”
Perhaps not a ‘conclusive research’, however there is quite a body of research showing that earnings yield helps with forecasting future returns. See for example these articles:
An accessible one: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2088140
Math heavy one: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2031406
I’d say use the cyclically adjusted earnings yield, whether that’s Shiller (real) or Graham and Dodd (nominal). Using 1 year figures is a bad idea because earnings are too volatile to have any meaning, as you point out for the US in 2009.
The question then is, if you’re moving out of equities because they’re expensive (for example), where do you move to?
You would also need a measure of ‘expensive’ or ‘cheap’ for where you’re moving your money too.
Personally, although I’m quite comfortable with equities I don’t have much expertise with bonds, REITs and commodities, so I use a cash ‘buffer’ instead, and adjust it based on the market’s cyclical PE. That way I always know the value of cash because it doesn’t go up or down, so I don’t need a valuation metric for it.
@W — As I say above, I’m not wedded to the Efficient Market Hypothesis, but I think saying it’s been “fairly conclusively disproved” rather overstates the case, unless I’ve missed something. I have read some behavioural-driven stuff, but I’m wasn’t aware even that had really toppled the edifice. And on a practical level, the under-performance of nearly all fund managers (albeit after costs) is a fairly practical demonstration that in everyday terms, most people ought to treat it as if it was right whatever we discover.
I say this as someone who invests actively with the majority of my funds these days (self-directed, not through a fund manager) but that’s a bet on my own vanity and arrogance! 😉
@Metodej — Thanks very much! I’ll take a look.
Shiller PE correlates to returns. How much more toppled could the efficient market hypothesis get? If it were true, no valuation metric would correlate.
A real scientific theory, when confronted with a large body of evidence contrary to the theory, is disproved. Yet for some reason we allow voodoo economics like the efficient market hypothesis to lurch along zombie-like long after disproving evidence is collected. If we did physics the way we do economics we’d still believe in the ether.
Fund manager underperformance is because fund managers are the ass end of Wall Street. They’re almost (but not quite) as bad as sell side analysts. If you can’t be trusted trading the firms money (ie. on the proprietary desk) then they stick you trading the customer’s money (fund desks). If you’re too lame even for that they make you an analyst. That’s just the way it works.
There’s a huge intellectual gap between “you can’t make money buying active funds” (basically true) and “the market is efficient” (provably false).