In our client communication, I have been thinking about why the market should recover based on fundamentals.
Ultimately, people need to have faith that business will survive and thrive and in owning a basket of stocks or bonds, you own assets that have sound economic drivers. If you own bonds, you are a lender and the debt issuer will pay you a coupon. If you own stocks, you own a stake in the business’s future cash flow and the business will return to you in dividends or go up in value.
The question would be how much we are willing to pay for a basket of these businesses.
If we pay a relatively dear price and the future outlook of these businesses does not look as great as we anticipate, then we do not have much margin of safety. We will be essentially paying $2 for what is worth $2.2. Not a good outcome. Perhaps we were wrong that the future actually looks brighter and it is worth $2.80, in that case, it is more worth it.
Currently, Mr Market seemed to be implying that if we buy today, we are paying much more for something that is worthless and we are adjusting downwards.
But ultimately, the basket of business as a whole should pay us back in cash flow and interest payments. If this principle is violated, then it does not make sense to invest in stocks and bonds.
What may work out for us is that fundamentally, the long term cash flows of these businesses should not deviate that much as a collective.
We can debate that based on the discounted cash flows of this basket of business that they may be worth $2.20 to $2.80 but if we are able to buy them reasonably at $2.00… we are not super sure but we are paying a decent price for these businesses.
A simple way to value a basket of stocks that belong to an index is to look at its historical price-earnings or its forward price earnings. The higher the price earnings, the dearer the basket of stocks and in a way the longer it may be needed for us to make back our money. But it may also imply that this basket of stocks is of higher quality.
Thus, price-earnings imply a lot of things and it is not a matter of whether low PE is cheap and better or high PE is not good.
Most would understand if we invert PE and get the forward or historical earnings yield. For example, currently, the forward PE (based on forward forecasted earnings per share of the basket of stocks) is 19.5 times.
This implies an earnings yield of 1/19.5 = 5.1%.
5.1% and the growth rate of this basket of stocks is something that you can use to compare to other investments.
If the PE is 14 times, the earnings yield is 7.1%.
The price of the basket of stocks can go up or down, the earnings can go up or down as well. But taken together, a review of PE and earnings yield, relative to history can give us an idea of whether this basket of stocks that are ever-changing in the index is lean towards cheaper or dearer.
If the PE gets down to 10 times, the earnings yield is 10% which will be very attractive relative to history and people will bid up for it. And that may not have factored in the future growth of the earnings.
You will get a PE expansion and the market price adjust upwards as people bid up a basket of business that is able to help them hedge their inflation risks.
The opposite is true as well.
If the PE is 25 times, the earnings yield gets to 4%. If future growth has reached a peak (meaning earnings have been growing so much in the past years that it has to pause or decline in the future), this makes the basket of stocks look relatively expensive if the risk-free treasury moved up to 3% a year.
There is no incentive to hold this basket of stocks relative to the risk-free treasury. This is why this rate move up is difficult for stocks.
The market constantly reprices the worth of this basket of stocks.
A Review of the PE of the Market
Edward Yardeni at Yardeni Research constantly publishes a report on the forward and historical PE ratio.
If you Google “Yardeni PE Ratio”, you should hit a PDF that gives you a report that shows where the PE ratio relatively to history.
So where are we now that the prices have fallen by roughly 17%? Let us take a look at the S&P 500, which forms 60-65% of the MSCI World.
The yellow shaded areas show bull markets, the pink show bear market (20% correction and above) and the blue area show correction between 10-20%.
At its peak in 2020, the forward PE did not reach the height of dotcom. However, there are many stories that we can tell from this data.
We can see how long it took for the PE to compress from the height in 1999. The PE basically compressed for like 12 years before the PE expanded. PE compressed due to the price falling or earnings increasing over time, or a mixture of both.
The PE basically compressed through the 2000 to 2002 bear, then the subsequent recovery, then the GFC bear as well as the recovery after that before expanding in 2011.
If we draw a line from 2007 to 2012, the PE then is about 12 times or if we invert it the earnings yield was 8.3%. If you can buy a basket of high-quality blue-chip businesses that self rejuvenates for 8.3%, with the possibility of increasing earnings growth that looks very attractive.
You may be able to understand why the US market ran so well from 2010 to where it is currently.
Quantitative easing does help (a lot), but the business needs to earn well for this growth to sustain.
Currently, Yardeni has the larger capitalization companies at 16.7 times or 5.9% earnings yield. They have definitely compressed a fair bit and look like we are back to 2017, 2019, and 2003 levels.
The difference between today’s and the dot-com period is that these larger firms are also throwing out a lot of cash flows. The question is what happens when liquidity is taken away.
Yardeni also presented a chart showing the median forward PE of the S&P 500 and also over a longer time frame starting from 1982 instead of 1998. Median forward PE should show the PE based on the firm in the middle of the S&P 500, which should take away the contribution of the larger capitalization firms.
The PE is 18 times, higher than the large-cap. This tells me that if we take out the larger firms in the S&P 500, the smaller firms are either dearer or they don’t have as good earnings as the largest businesses.
In this regard, we are still rather far from the average from 1992 to 2022 of about 16 times. The average company may have to fall 12.5% more from current levels before things become fair.
It is also kind of crazy how low the PE was at the start of the secular 1982 bull and where it ended at the 2000. PE expanded from 7 to 22.
Yardeni constructed an even longer PE chart going back to 1960 and that would factor in the high inflation period.
The worrying thing is that the risk-free rate got up to a very high percentage of 10-14% and in order for the stocks to look attractive, the earnings have to grow like crazy and prices have to drop a fair bit.
A PE of 7 times is a 15% earnings yield, which gives us an idea that interest rates do have an effect on risk assets.
The Cheapness of the Smaller US Companies
The chart above shows the PE of the medium-capitalization companies in the US, relative to the history.
Mid Cap companies are pretty big. They are at least 7-11 billion.
We can see that the chart looks rather different from the large-cap one.
It looks like it is oscillating more not between high extremes but there seems to be a mean of around 16 times PE or 6.2% earnings yield.
If it goes above 16 times eventually it corrects downwards and if it goes below that, it reverses upwards. The question is how long it takes.
Currently, the PE is 12.1 times or 8.2% earnings yield. This is lower than the lowest in 2002 but not as bad as 2008. Quite close to Covid and 2018 lows.
I think it is cheap enough.
Factoring in forward earnings, the small-cap are cheap.
It should be noted that there is a difference between S&P 600 SmallCap and the Russell 2000 index in that S&P consider adding businesses that have earnings and other criteria so I would expect the PE chart of a Russell 2000 index to look rather different.
This chart should give you a better idea.
The PE of the Russell 2000 index always looks higher than the S&P 600. This is weird to me because if the businesses are higher quality, I would have thought they should trade at a higher valuation on average.
But you can see how crazy the PE of Russell 2000 got. Yardeni had to cap the PE to 35 times due to extreme values. It is even higher than the 2002 period. Even with the correction, its not as low as the 2008 and Covid bottoms, unlike the S&P 600 SmallCap.
The World Relative to the US
The world relative to the US is cheaper.
One thing I noticed is that within each line, there is some sort of mean reversion, but for the past 10 years, the US has been more resistant to it.
If there is one thing that we learn, it is that markets have a long history and it gyrates between periods of cheaper, less cheap, expensive, and very expensive.
If you do not wish to buy things that are too expensive or wish to find opportunities where things are more attractively valued, yet with fundamentals that held up, then perhaps it is to search for opportunities not in the large-cap companies.
You don’t have to play the same game as the MSCI World or S&P 500.
There seems to be a value premium there to be captured. How do you capture the value premium?
Either prospect cheaper companies that you think are mispriced and buy them as a basket, or invest in a value fund.
Or you could invest in a value-tilted exchange-traded fund.
If you read my article on Smart Beta ETF, we have the opportunity to invest in the cheaper companies.
The MSCI World Value UCITS ETF (IWVL) currently trades at a trailing PE (using the last 12 month’s earnings not forward) of 9.4 times, compared to a PE of 17 times for the MSCI World ETF (SWDA).
Even the MSCI World Multifactor UCITS ETF (IFSW) trades at a PE of 11.3 times.
So the world is open if your investment philosophy is different.
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Saturday 14th of May 2022
Hi, If inflation is eroding the value of cash/cash equivalents while companies with moats are able to pass on cost increases to consumers, wouldn't this make stocks more attractive to hold than cash?
Monday 16th of May 2022
it may be but it is very hard to see. the best hedge for inflation seem to be 1-month treasury bills because once they mature they can adjust to the new rates easily. when interest rate keeps hiking, this puts somewhat of a dampener on stocks. certain stocks can still do well but it is a mix bag.
Saturday 14th of May 2022
I have a question for you, do you believe in efficient market hypothesis? i.e. if something is well known, then it is already in the price. Right now, there is expectation of FED going to raise interest rates to atleast 3% by the end of the year. This is already priced in the rates market. The 2 year yield is like 2.6%. So does that mean that the equity markets already have this FED tightening priced in? Then why do people still want to keep selling, expecting markets to go lower because FED is raising rates?
It would be great if you could do an article about this EMH concept and using previous data about how how markets react when FED clearly telegraphs that they are raising rates. In the past did market bottom out when rates peaked or did market bottom out much earlier?