Today’s Smart Guy: Marshall Bolden, CFA
Vice President & Chief Investment Officer
CapSouth Partners
Q:
Marshall, can you tell us what is meant by the expressions, “stocks look cheap”, or “stocks look expensive” and what those valuations may mean for 2014?
A:
I want to start 2014 by making a bold prediction . . . the S&P 500 will not do as well this year as it did in 2013. Ok, that’s not really stepping out on a limb since 2013 was the best year it has had in a decade. I would love a 32% return every year; it’s just not likely to happen. The primary reason I don’t see a repeat performance in 2014 is that valuations have steadily increased over the last year, and it’s now hard to make an argument that stocks look cheap. For another large gain in 2014 to occur, we really need to see a jump in corporate earnings or the market will just be getting more overvalued.
Let me start with a basic explanation of the valuation measure that is probably used most often – the Price/Earnings, or P/E, ratio. I will use the S&P 500 Index as our index, or measuring stick, throughout this discussion. The P/E ratio for the S&P 500 is simply the current level of the index divided by the earnings sum of all its constituents. So if the S&P 500 is at 1500 and the earnings of the index are $100, the P/E ratio would be 15, or 1500/100.
One wrinkle to note with the P/E ratio is that the earnings portion may be calculated a couple different ways. One method is to use the earnings from the past four quarters; the result of this is a trailing twelve months (TTM) P/E. The other method is to use the expected earnings of the next four quarters; this results in a forward or next twelve months (NTM) P/E. I’ll primarily use the forward P/E in this discussion because I have more data for this measure. Either method is fine; you just have to make sure when comparing P/E ratios across time that a consistent measure is being used.
The P/E ratio is mean reverting over time. This simply means that it should float around a long-term average number. The average will depend on the time frame. Over the last 25 years, the forward P/E of the S&P 500 has averaged 14.9; over 15 years it has averaged 16.2. If we use longer time periods, the average will generally be on the low-end of these numbers. So I’m going to use 15 as a good estimate of the long-term average. This means that if the current P/E is below 15, stocks would appear to be undervalued (or cheap) and if the current P/E is over 15 stocks would appear overvalued (or expensive).
At the end of 2013, the P/E stood at 15.4, slightly higher than our long-term average of 15. (This is one of the reasons I stated in the first paragraph that it is hard to make an argument that stocks look cheap.) At the end of 2012 the P/E was 12.5. Digging a little deeper you may notice the P/E ratio only increased 23% in a year in which the price, or S&P 500 index, increased 32%. The factor in the P/E ratio I’ve yet to mention, earnings, is responsible for this gap. Because earnings also increased over 2013, the P/E increase did not match the S&P 500 gain. I realize this is somewhat technical, but it leads into the next part of this discussion.
Returns from 2013 resulted in valuation expansion – the P/E increased – as opposed to being primarily driven by increasing earnings. We are now at valuations in line with or slightly above the long-term average. If valuations continue to rise, the S&P 500 will undoubtedly look expensive versus historical averages. And an expensive stock market is generally not good for future returns.
So what needs to happen for stocks to continue experiencing good gains, gains that don’t just lead to an overvalued market? The earnings component must rise. If earnings experience good growth, the stock market can continue to have positive returns without getting more expensive. Our simple example from above may help here. If the S&P 500 is at 1500 and earnings are $100, the P/E is 15. Now say earnings rise 20% to $120. The S&P can also rise 20% to 1800 without the P/E changing (1800/120=15). There is no valuation expansion in this example (the P/E did not rise), only nice stock gains due to rising earnings. This is what I would like to see going forward – a continued rise in the S&P 500 supported by commensurate increases in earnings.
The P/E ratio is just one valuation measure. Many other measures, such as the price/book ratio and price/cash flow ratio, operate in a similar manner. With these two measures, book values and cash flows need to see consistent increases as the market increases or the ratios will increase in a manner similar to the P/E increase over the last year. Just as P/E ratio, higher P/B and P/CF ratios indicate higher valuations and an increasing likelihood the market is getting expensive. Both these measures may also be compared to their longer term averages. In order to keep this commentary within a normal length, I’ll just summarize by saying I believe both these ratios also point to a fairly valued to slightly expensive market.
I just reread the Investment Update from October. It was a great reminder of how most ‘stories’ are just short-term noise, do not have any long-term impact on the markets, and should not induce either you or us to take any action. The news then was saturated with stories about the debt ceiling and government shutdown and the effect these issues could have on the economy. Well that’s all yesterday’s news now; nobody is talking about it and there was little to no long-term impact. Fortunately that is the outcome we predicted; I only wish all our predictions were that accurate!
About Marshall: As Chief Investment Officer, Marshall serves as chairman of the Investment Committee and is primarily responsible for the CapSouth mutual fund portfolios and CapSouth Market Opportunity portfolio, and is the manager of the CapSouth Value portfolio (an equity portfolio). Through his work on the Investment Committee, he leads the firm in setting & monitoring asset allocations, in choosing & monitoring investments, and in setting the guidelines and methodologies by which their work is done. Marshall graduated from Auburn University in 2001 with B.A. degrees in Economics and Finance. In 2005 he earned the right to use the CFA designation. He is a member of the CFA Institute and the CFA Society of Alabama. The CFA designation is globally recognized and is considered by many in the financial industry to be one of the most prestigious designations related to investments.
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Growing in popularity within employer sponsored 401(k) retirement plans are the target-date funds. Simply explained: You pick the date you plan on retiring, then select the target date fund closest to that year, and voila, you’ve just implemented an investment strategy. Based on that date, your 401(k) will be allocated with a corresponding mixture of stocks, bonds and cash equivalents. The further out your retirement date, typically, the larger allocation of stocks you’ll have. And over time, as you get closer to that “target date”, your stock allocation will decrease and your bond allocation will increase. Even more simply put: The target-date fund puts your 401(k) on autopilot – becoming more conservative as you get older.
