It’s been a while since I’ve posted another entry in my ongoing series for Benjamin Graham’s excellent book, “The Intelligent Investor”. My previous articles have covered chapters 1 & 2. Today I’ll be covering the topics Graham discusses most prominently in chapter 3 — more specifically, a detailed look at the overall state of the market today in 2013.
There are really two trains of thought in the investing world at the moment, with the market now making all-time highs on a daily basis. One is that the market is being irrational and has become overvalued. Investors who share this view are staying away. There are others however that believe the recent run-up over the past few months is just the beginning of an extended bull market. Let’s use some Graham-style logic to assess the situation for ourselves.
Graham’s focus in this chapter was to evaluate the attractiveness of the market at the time of the book’s writing in 1972. We will use the same thought process in an attempt to evaluate where we’re at currently in early 2013. The first thing Graham noted was the fact that there had been over 19 distinct bear-bull market cycles over the prior 100 years – usually occurring every 3 – 5 years on average. We see this same pattern today with extreme market downturns over the past decade in 2001/2002 and again in 2008/2009. The rates of growth in each of this periods varied wildly however.
Graham’s analysis ended in the early 70’s when the book was last published. Let’s pick up where he left off and look at the period between 1970 and 2013:
There were nine bear-bull market cycles during the last 43 years, or one complete cycle every 4-5 years on average. Secondly, we notice that market advances last longer than downturns — 4 years vs. 1 year on average respectively. Finally, gains during advances outpace declines during bear markets quite handily. The average advance in the table above was about 120% while the average decline was about 33%.
This is all fine and dandy, but what can we infer about the market today? First we should note that it has now been nearly four years since the last major market decline ended in 2009 and we’ve seen gains of nearly 130% over that period. Comparing against the historical data above, on average our bull run should be coming to an end soon. We are pretty much bang on as far as the usual length and size of market advances go. This lends some credibility to the train of though that says we’re in for a downturn soon.
Now let’s ignore market cycles and look at the past four decades individually, as summarized in the following table:
Graham noted that only two decades of the entire century prior to 1972 showed a decline in average earnings and stock prices. We can see from our table that the market is as predictable as it was previously, with none of the last four decades showing a decline in either. In fact, both earnings and price have increased at an accelerated pace over the past 40 years.
Let’s compare two very simple gauges of market valuation to the past: the average PE ratio and average dividend yield. These two are not mutually exclusive as they are both affected by changes in the stock price, but it is interesting nonetheless.
Prior to 1970 the average PE ratio for the entire market typically ranged from a low of 10 to a high of 17. Take a look at the 1990s… an average PE of 20! This would have been a good indication of the crash to come in 2001. It’s interesting to note though that from 2001-2010 the average PE ratio remained at the historically high level of 17.
Average dividend yield was much higher on average in the past as well. Before 1970 dividend yields typically fell in the 4% – 6% range. From 1970 – 1990 dividend yields were at the low end of this range at around 4%. More recently however, yields have averaged under 2% at all time lows. This is due in part to companies not paying as much of their earnings out in the form of dividends, as evidenced by the lower average payout ratio shown in the table. Higher prices are equally to blame however.
At the time of this writing, the S&P 500 index is making all-time highs at a level just below 1,600. Let’s try to determine whether this is overvalued, fairly valued, or undervalued, using the analysis Graham uses in table 3-3 in his book. The following table presents today’s picture, along with representative data every 5 years since 1970:
The S&P 500 is currently trading at 16.4 times earnings over the past twelve months, and about 17.2 times the average earnings over the past 3 years. This is toward the upper end of the spectrum, leaning towards being overvalued. It isn’t a solid indication however. Just look at the PE ratios in the 90s — a high PE didn’t stop the market from engaging in the largest bull market in history. Another way to look at valuation is the inverse of PE, called earnings yield. Earnings are currently yielding about 5.8% against a historical range of 4.3% – 12%.
Dividend yields are below average as well, returning just 2% currently. This is an improvement over the prior decade, but much less than the 3-5% yields that were the norm previously. Again, this is an indication of overvaluation.
Finally, let’s compare stock yields to bonds. High grade bonds (10-yr treasuries used in the table above) are at all time lows, yielding just 1.86% today. The earning’s yield from stocks are over three times bonds and even dividends alone are slightly higher. This is very interesting, because despite stocks appearing to be overvalued at the moment, their potential return compared to bonds is at an all time high as well!
Jason Zweig raises an interesting point in his commentary following chapter 3, paraphrased here:
Stock market performance is really driven by only three factors: i) Real growth in earnings & dividends, ii) Inflation, and iii) Speculation by investors which drives prices higher or lower.
Jason postulates that real EPS growth has historically averaged about 2% per year. Inflation over the past decade has averaged about 2.5%. The S&P 500 is currently offering a dividend yield of 2%. Adding these together, we can therefore expect that on average over the long term, the stock market should increase by about 6.5% per year. Fear and greed obviously cause substantial deviations from that average, and that is our goal as value investors to identify those periods (and which one is which!).
In conclusion, I believe that we are due for a market correction based on valuation and the historical duration and size of market cycles. On the other hand, just because the market is overvalued doesn’t mean it is going to suddenly become rational in the near future – especially considering the relative yields of stocks and bonds at the moment. The question arising from all of this is how to change your investment strategy based on this information. My strategy will be to remain conservative, only choosing stocks that appear to be undervalued, and to also be prepared to liquidate a good portion of my portfolio at the first signs of a major correction. There are plenty of potential catalysts for this correction on the horizon, including a financial crisis in Europe, a war in North Korea, and a major economic slowdown in China.
- The Intelligent Investor Chapter 3, by Benjamin Graham
- S&P 500 Yealy Charts 1970 to 1979, on the Examiner
- S&P Earnings Data, on Damodoran Online
- Selected Interest Rates, at the Federal Reserve
- Wholesale Price Index Historical Data, at Trading Economics