Download Are Stocks Expensive? - Zevin Asset Management

INVESTMENT COMMENTARY
April 28, 2014
Are Stocks Expensive?
Are stocks over-priced? There’s the easy answer (yes), the complicated answer (it’s a little more
difficult), and the real answer (it depends). But perhaps we should ask a better question. Stock
valuations are always a key consideration for investors. Following a year when stock indices in the
U.S. rose by more than 30% and continue to trade at new record highs, while the U.S. economy has
not yet recovered from the financial crisis six years ago, it is natural for there to be concern about
stocks being too expensive.
The Easy Answer
The Complicated Answer
One valuation measure compares the cost of buying a
share of the S&P 500 index to the average annual
earnings from the previous ten years. Using this metric,
stocks are expensive. The average price of the S&P
index over the past 130 years was $16.50 while today’s
price is $25.44 (see chart). Not surprisingly though,
stocks have rarely sold at this average. A brief look at
the chart shows stocks have tended to stay either
above or below the average for extended periods of
time. As a result, this measure provides only a very
rough guide for the relative cost of stocks. Indeed
stocks have been expensive on this measure for the
past 20 years covering three bull markets and two bear
markets with only a brief six month exception during
the depths of the recent financial crisis.
Of course, investors buy companies for what they are
expected to earn in the coming ten years, not for what
they have earned over the past ten years. Looking at
historical average earnings is a simplification
intended as a guide for the more difficult task of
forecasting future earnings. Looking forward just one
or two years, most investors expect the earnings of
the companies in S&P 500 index to be larger than they
have ever been. Using these expected future earnings
as a measure, stocks do not look so expensive. The
S&P 500 index is trading near a level where each dollar of earnings expected in less than two years
costs a little over $14.50. However, even this analysis is just the beginning; the value of a stock
today is based on the earnings for the next few years and all the earnings stretching as far into the
future as the company survives. A company’s earnings far into the future will in part be
determined by management decisions, and also by many factors well outside the control of
management. Technological advancement, competition, interest rates, inflation, political events,
GDP growth, (and more impactful, GDP decline) and many more considerations are all influential
in determining future earnings. And finally, how much those future earnings are worth today is
determined by how quickly earnings grow, by current and future interest rates, inflation rates,
and the corresponding discount rate used to measure future earnings in today’s dollars. So what
will the future growth, inflation, and interest rates look like? Can we buy this future stream of
earnings at an attractive price today? Are stocks expensive?
The Real Answer
Naturally, as with any other question about the future, the answer is “it depends.” It is possible the
economy grows between 2%-3% over the next few years, as many investors expect. With still low
inflation and still historically low interest rates, companies could continue to buy back shares and
increase margins, profitability, earnings and dividends rapidly with sales growing only modestly.
This outlook looks very similar to the past four years where corporate sales grew 4% per year
while dividends grew 11% per year. If this pace of growth continues for the next few years and
then moderates towards the pace of growth in the economy, the outlook for stocks is to
outperform government bonds, but not do as well as stocks have averaged in the 20th century.
We would anticipate the stocks we hold in client portfolios to do as well or better than the global
stock market index if this relatively benign scenario unfolds. Yet, it goes without saying that any
forecast of the future is highly uncertain and risks abound to this relatively calm outlook. At the
moment Japan is treading a dangerous course in raising the value-added tax while its domestic
economy is still weak. In China the plan to transition the economy towards more household
consumption and less investment is challenged by high debt levels and entrenched political
interests. Europe has stabilized but remains haplessly incapable of solving their underlying
structural problems. Territorial disputes and the threat of armed conflict simmer in Ukraine, the
Middle East and in Asia. In the U.S., fiscal policy continues to slow the ongoing recovery. We worry
that a policy misstep or escalation of any of these situations could ripple through the world
economy. Of course, future developments will impact growth, inflation, interest rates, and other
things determining stock prices so the outlook for stock prices depends on this uncertain course of
events.
A Better Question
Over the past 142 years, stocks have returned on average 8.8%, though the average hardly tells
the story. Recessions, panics, financial crisis, wars, politics, recovery, euphoria and much more
have all been complicit in sending stocks on a far wilder path of great gains and painful losses. The
past twenty years, during which stocks also averaged a return of 8.9%, is a ready reminder that
stock returns are rarely average. Investors had the
chance to lose half their money twice during this
recent period. However, it does beg the question, what
is the chance of stocks once again suffering serious
losses? Turning to history as a guide again, it seems
foolish not to think that sometime in the next decade,
stocks may once more fall by 50%. Given this
potential for large losses, it certainly seems prudent to
invest with this in mind.
Outlook
The market is an abstraction because we don’t actually invest directly in the entire market. We
invest in individual stocks which themselves are also something of an abstraction. Stocks
represent an ownership share in very real underlying companies. Companies, much like our
children’s lemonade stands, mix labor, capital, technology, opportunity and hope, all with the aim
of generating profit. Our aim is to acquire shares in companies that are well managed, wellcapitalized, have good technology and attractive market opportunities and make those
investments at a price that will grow along with the profits of the company. We are finding some
good companies that are addressing the changing energy market in the U.S. by improving energy
efficiency and introducing alternative energy technologies; in the technology space with
companies involved in the still young and promising development of mobility, data and commerce
on the internet; and with consumer companies from housing to retailing. While we are optimistic
about the investment prospects of the companies, we also prepare as best we can for events
outside their control which can dramatically alter the development of the business or the value of
our investment. As mentioned earlier, at the moment most of the sources for this outside risk are
centered in the economic transitions taking place in China and Japan, in the political and social
transitions needing to take place in Europe and in the conflicts taking place in an increasing
number of regions. For this reason, we are continuing to shift our investments towards U.S.
companies. We have also increased the holdings of U.S. Treasury bonds as further protection in
the event of adverse developments in one or more of these regions.
Dan Thorn
Senior Securities Analyst
Dan Thorn is a Senior Securities Analyst at Zevin Asset Management. Dan has a broad range of
experience as an investment analyst over the past decade. Prior to earning his MBA and the CFA
designation, Dan was a farmer and welder.