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Stock valuation: A problem of perception

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12/08/2014
A consistent theme amongst investors is the feeling that the US stock market is overvalued. However, when we look at widely-used valuation metrics this just doesn't seem to be the case.

A quick review of a range of market metrics suggests large-cap US stocks are at close to average valuations. But why does the stock market feel expensive even though, by the numbers, it isn’t?

Part of the problem may lie in the length and strength of the market rally. Since hitting a low on 9 March 2009, the S&P500 index has risen, with few major corrections, for 5 years and 5 months. The index has climbed by 185 per cent over that period. Instinctively, this feels like too much of good thing.

However, this should be judged relative to an almost as impressive 113 per cent increase in S&P500 operating earnings per share (EPS) – the portion of a company’s profits per individual share of stock – over the past five years from $13.81 in 2009 Q2 to an estimated $29.37 in 2014 Q2.

This increase in earnings hasn’t been an accident. While a slow-paced economic expansion has been frustrating to many millions of American households, it has been an almost ideal climate for growing corporate profits since it has allowed companies to take advantage of revenue gains while restraining interest and wage costs via very easy monetary policy and worker nervousness.

In addition, price-to-earnings ratios – the ratio of a company’s current share price compared to its per-share earnings – in early 2009 were exceptionally low, reflecting the panic of the times. Because of this, a surge in earnings and a moderate revival in price-to-earnings ratios have combined to produce sizzling market returns without actually making the market expensive.

A second aspect of the stock market perception problem likely reflects the sour mood of the public in general.

According to nightly polling by Rasmussen Reports, currently 49 per cent of Americans believe the economy is in recession, 32 per cent believe it is not and 19 per cent aren’t sure. This is a startling result given that we are now in the sixth year of economic expansion with an unemployment rate just 0.1 per cent above its 50-year average of 6.1 per cent.

An alternative measure of the same phenomenon comes from the University of Michigan’s Consumer Sentiment Index which registered an index reading of just 81.8 for July. Statistical analysis since the late 1970s suggest that, given current trends in inflation, wages, unemployment, stock prices, gas prices and home prices, we should be at an index reading in the low 90s.

This surprisingly glum mood (given broadly improving economic statistics) could reflect a general mistrust of Washington – both Congress and the President are scoring low in approval ratings and many fear the eventual result of very easy money from the Federal Reserve. Or it could reflect the widening income and wealth gap which has prevented the majority of Americans from experiencing much of the economic recovery.

Whatever the reason for the still negative public mood, it is important not to allow it guide investment decisions except to the extent this mood impacts investment fundamentals. (Thus far, ironically, a pessimistic mood has probably helped corporate earnings by keeping workers on the defensive and prodding the Federal Reserve into maintaining an uber-easy monetary policy.)

By the numbers the market, while no longer cheap, does not appear expensive and may be able to support mid-single digit total returns over the next few years. While this does not seem impressive relative to the gains of the last five years, it is a reasonable return in a low inflation and very low interest rate environment.

David Kelly is chief global strategist at JP Morgan Asset Management.

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