A Tale about Market Valuations

Talking Points

  • We would see a 25% decline in the S&P 500 if the P/E ratio contracts from 22.0 to 16.5.
  • 3 sectors had negative EPS growth in the past 3 years: Energy, Materials, and Telecommunication Services.
  • The consensus 2017 EPS estimate is 128.52 per share, a 21.0% increase from 2016 EPS in the S&P 500.


Note: Data last updated as of June 8, 2017.

Once upon a time, there was a bull and a bear.  Both had conflicting viewpoints.

The Bull saw greener pastures.  He even wrote a book titled Stocks for the Long Run.  The premise was simple; stocks delivered the best total returns of any asset class over the long-term.  His outlook remains positive for stocks with solid returns for the long run.

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Meanwhile, the Bear thought the greener pastures were fertilized with bullshit.  His book, Irrational Exuberance, says what goes up must eventually come tumbling down because business is cyclical.  The S&P 500 has been trending up since 2009, reaching new highs, and turning bears into bulls.  This above average performance must eventually revert back to average says the Bear.

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With the stakes so high, who will prevail in this raging battle between Bull versus Bear?

By the Numbers

The Bullish Stats

In the green corner, we have the Bull.  He’s optimistic because historical data shows positive and consistent trends.

Let’s look at the S&P 500 closing price from 1960 to 2016.  It started from 58.11 and climbed to 2,238.83, a nice 6.7% compound annual growth rate (CAGR) during that time period.

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Also, the returns remained consistent across different rolling time periods.

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Since the Great Recession in 2008, stocks have done even better than the historic 6.7% CAGR.  However, investors shouldn’t expect double-digit returns going forward.  Still, 6-7% CAGR is good long-term!  That’s average, and apparently being average is amazing nowadays.

What about dividends?  It gets better.  If you would’ve reinvested the dividends from 1960 to 2016 then the closing price on the S&P 500 would’ve skyrocketed to 12,131.20, or 9.9% CAGR. 

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Again, the returns remained consistent across multiple time periods.

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The dividends added an extra 2-3% onto the S&P 500’s returns.  That’s a huge difference over the long-term.  I can see why investors are hyped about the dividend growth strategy!

The Bearish Stats

In the red corner, the Bear thinks today’s investment environment is abnormal.  We operate in a historically low interest rate environment.  Valuations are above their historical averages.  This doesn’t seem normal at all.  I hear from folks that this is the most hated bull market in history.  Eventually, valuations will revert back to normal.  The problem is we don’t know when.

Currently, the S&P 500 trades around 22.0 times earnings.  The historical average P/E ratio is between 16-17 times.  Across different rolling time periods, the P/E ratio averages have been consistent, with a trend of higher P/E ratios in recent rolling years.

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If tomorrow, the P/E ratio contracts from 22.0 to 16.5 then we would see a 25% decline in the S&P 500.  People freak out if stocks are down 1%, just imagine if we get drop over 10.0%!  CNBC would run Markets in Turmoil specials 24/7 and have Dr. Doom and Gloom as the host.

The P/E ratio is even higher if you look at the Shiller PE Ratio.  It’s around 30 times.  The historical average Shiller P/E is between 16-17 times as well.

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You would see a 45.0% decline if we revert back to the average.  That’s a scary thought.  Then again, I don’t think the Shiller PE Ratio is a good valuation metric for the S&P 500.  The disagreement is because taking the average of an increasing value, EPS in case, would make the ratio inflated.  That’s why the trailing-twelve-month PE ratio is lower than the Shiller PE Ratio.  EPS has been growing faster than inflation.  10 years from now, EPS will likely be higher than today.  That’s a discussion for another day.

More Data to Digest

The S&P 500’s returns aren’t generate out of thin air.  Returns are powered by EPS growth.  This trend has been a positive for the Bull.

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Take at a look at the EPS growth over various rolling time periods.  From 1960 to 2016, EPS grew 6.5% CAGR, which closely mirrors the 6.7% CAGR of the S&P 500, excluding reinvested dividends.

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EPS growth has been robust for the past 15 and 20 years.  Excluding P/E multiple expanding and contracting, EPS growth mirrored S&P 500’s returns pretty closely.

The Bear argues that EPS growth in the past 5-10 years does not justify the current valuations.  EPS grew 1.9% CAGR in the past 10 years.  We had the Great Recession during that time frame.  However, EPS grew a healthy 10.0% CAGR since 2008.  It’s only in the past 3-5 years that EPS growth is slowing down again.

There’s a good explanation for the EPS growth slowing down, and even turning negative!

Here is a breakdown the EPS of the sectors in the S&P 500.  3 sectors had negative EPS growth in the past 3 years: Energy, Materials, and Telecommunication Services.

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The obvious standout is Energy.  Oil and natural gas prices just plummeted.  It’s hard to make money when prices are down more than 50%.

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Luckily, there is light at the end of the tunnel for Energy.  Analysts forecast EPS will turn positive for 2017 and 2018, which will contribute to robust EPS growth for the S&P 500.

For what it’s worth, I think Energy earnings will remain depressed going forward.  The world isn’t constant; it’s changing rapidly and new innovations are changing how businesses operate.  Before, the world ran on fossil fuels and industrial production.  Going forward, the trend shows we’re shifting to more renewable energy and service orientated offerings.  Commodity prices can stabilize and Energy earnings can be positive again.  It’s difficult to see +$100.00 oil again unless there’s a huge supply disruption.

Another interesting observation is negative EPS growth.  It has happened in the past.  I counted 12 times EPS growth went negative since 1960.  Over 56 years, that’s about 20% of the time.

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Coincidently, the S&P 500’s total returns went negative 12 times too.

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My takeaway from analyzing the EPS trend is EPS growth is pretty consistent over the long-term.  Yes, there will be setbacks because of recessions and whatnots.  Those appear to be temporary.  At most, EPS growth turned negative for 2 years straight and turned positive again.

For those who are hoping for a bear market, the past shows it’s temporary.  Of course, past performance is not a guarantee of future returns.

The Trend is Your Friend

Warren Buffett said interest rates act has a gravity on valuations.  If interest rates are low then multiples will be higher, and vice versa.

Let’s compare the S&P 500’s earnings yield to the 10-year treasury.

The 10-year treasury peaked at 14.6% in 1981.  The yield has been trending downward since then.  We now operate at historically low interest rates.

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Here are the average earnings and 10-year treasury yields over various rolling time periods.  Both yields are trending downwards.  The 10-year treasury average 6.2% since 1960 and is now 2.2%.  The S&P 500’s earnings yield average 6.8% over the same time frame and is now 4.6%.

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What’s interesting is the spread between the earnings and 10-year treasury yields is widening in recent years.  We can see a few different scenarios can play out.  The first is the spread narrows.  This requires either bond yields increasing or stock multiples going up.  The other scenario is the spread widens.  This requires either bond yields declining or stock multiples coming down.

Looking Into the Future

With all of that said, what really matters are future returns.  The billion dollar question is “Will the S&P 500 go up or down from here?

Bull Case

Analysts are quite optimistic about the future.  The consensus EPS estimate for 2017 is 128.52 per share.  That’s a 21.0% increase from 2016 EPS!  2018 consensus estimate is 145.80, or 11.9% higher than 2017 EPS.

Let’s assume the estimates are accurate.  Analysts are really good at their jobs and predicted the future accurately.  It would definitely make my job easier.  If we assume the P/E ratio contracts from 22 to 20 then the S&P 500 closing price for 2017 and 2018 will be 2,570.40 and 2,916.00, respectively.

With dividends, we can expect an upside of 7.5% and 22.0% returns for 2017 and 2018, respectively.  That’s not too bad.

Also, it’s interesting to note future valuations in the bull case.  If the EPS estimates are accurate then the S&P 500’s forward P/E looks actually reasonable.  Valuation revert back to normal if the S&P 500 remains flat going forward.

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Bear Case

Now, let’s assume analysts are human like the rest of us and their estimates are wrong.  It’s okay, we all make mistakes.  Double-digit EPS growth for the next 2 years sounds pretty optimistic, especially in the later stages of the business cycle.  We’ll say EPS growth will average 6.5% for 2017 and 2018, which is the historical average EPS growth.  The multiple will revert back to average to 17.0.

With dividends, the down size is -19.2% and -14.0% returns for 2017 and 2018, respectively.  Ouch, that doesn’t look too good.

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In the exercise above, the bull case is we get above average returns if the estimates hold up.  There are good catalysts in the near-time to generate strong EPS growth. We have the Energy sector possibly rebounding, tax reforms, clarity on health care reform, new infrastructure spending, low unemployment, and increasing wages.  All of this can contribute to healthy EPS growth.

However, the bear case is we lose money.  If most of the catalysts don’t happen then valuations can begin to revert back to normal.

Base Case

Those viewpoints are on opposite ends of the spectrum.  If we look somewhere in the middle then things look meh.  Let’s say EPS growth reverts back to normal to 6.5% CAGR.  However, interest rates remain low so the P/E ratio stays elevated at 20 times.  Then future returns would be below average going forward.

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There are 3 possible scenarios: we make money; we lose money; or we break even.  This little exercise shows that investing is difficult, especially at the macro level!  It’s all about probabilities and there are a lot of scenarios that can happen. 


Who won the battle of the Bull versus the Bear?  And the winner is… I’d say it’s a draw.  There are too many external factors to consider.

For now, markets are above their historical averages.  In the United States, the low-hanging fruits have been picked and it’s harder to find opportunities nowadays.  However, I run a pretty concentrated portfolio and make a few investments per year.  There’s no excuse not to find a few ideas to invest in.  I just have to flip over more rocks and kiss more frogs.

The investing game isn’t supposed to be easy as Charlie Munger would say.  As investors, sometimes we just have to play the game on hard mode and refine our skill sets.



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