• Samuel Zavaletta

Wherefore Art Thine Valuation?

The question on every investor’s mind is whether or not they should buy this latest dip in the stock market. Let’s consider a few facts in order to get a sense of the answer, but before we do, let’s begin by reviewing the two basic “schools” of investing:

The first "school" relies upon the analysis of an instrument’s underlying financial prospects. This is known as investing based on “fundamentals”. In the case of a company stock, this would mean analyzing the company’s position in the industry, growth rates, balance sheet, mergers/acquisitions, and other such business metrics. The second "school" relies upon the analysis of trading activity surrounding an instrument. This is known as investing based on “technicals”. In the case of a company stock, this would mean analyzing volume, volatility, bid-to-ask spreads, accumulation/decumulation, and other such trading metrics.

With that being said, let’s now turn our attention back to the question “Should we buy the dip?” from the perspective of the fundamentals. It is essentially a question of valuation. Is the market cheap, or is the market expensive?

One of the most well known valuation metrics for equity securities is the “price-to-earnings" ratio (often abbreviated as "PE" or "P/E"), which is the ratio of the price of a stock to the stock’s earnings over the preceding 4 quarters (often abbreviated as "TTM" or "T12M"). By relating price to earnings in this way, one creates a ratio that can be used in comparative analysis between alternative uses of capital. If one stock is at a P/E of 20 and another stock is at a P/E of 10, it can be said – at least on the face of it – that the second stock is “cheaper” than the first.

Here is a long-term chart of the P/E ratio of the S&P 500 Index, along with a simple moving average line and histogram:

One can observe that the S&P 500 Index is roughly in the middle of its P/E range over the last several decades. It is more or less in the center of the distribution curve, which would lead one to believe that the stock market is more or less fairly valued. At least, this is the approximation one might take away from this chart. However, all assets and enterprises are in constant competition for investment capital. One cannot then simply regard the P/E ratio of stocks in isolation. We must have something to compare it to.

Here is a chart once again displaying the P/E ratio of the S&P 500 Index (with a simple moving average), but this time I have also included the "price-to-interest" ratio of the ten-year US treasury (along with its histogram):

One can see that in recent times the valuation of the ten-year US treasury has skyrocketed beyond the upper limits of its distribution curve. Given the environment of diminishing growth and central bank accommodation, this is entirely natural. On the basis of this chart we can begin to intimate that perhaps bonds are expensive relative to stocks, but more information is required. The chart tells us where stocks and bonds are (with respect to valuation), but it does not tell us where they should be.

Consider the next chart, which takes the ratios from the preceding chart and inverts them into "yields". Rather than price divided by earnings/interest, it is earnings/interest divided by price. This technique allows us to plot the ratios alongside other metrics, such as the inflation rate:

The technique of comparing the earnings yield on equities to the interest yield on a benchmark treasury is known as the "Fed Model". By including the rate of core inflation, we have provided a benchmark against which both bond valuation and stock valuation may be compared.

Looking at this chart, it would seem that stocks have actually "discounted" themselves (relative to inflation) over the last two or three decades, whereas bonds have taken on a premium (relative to inflation). Perhaps it is bonds, and not stocks, that are expensive.

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