By Jack Forehand, CFA, CFP® (@practicalquant) —
It looks like the 2022 bear market might be with us longer than many of us had hoped. A study of history would have told us in advance that the 2020 bear market was an anomaly based on how fast things turned around, but you still can’t blame us for hoping for a repeat. We just didn’t get it.
With the S&P 500 now close to 20% off its highs, I thought now might be a good time to look to our market valuation tool to see where things stand.
But before I do that, I wanted to first cover two caveats I always put in articles about market valuation. The first is that market valuation has essentially zero predictive power over short-term market returns. So the fact that the market is expensive (or cheap) tells you nothing about what it will do in the next year and very little about what it will do in the next three. Where valuations can have some predictive power is in providing an indication of the long-term returns we can expect. Above average valuations typically lead to below average long-term future returns and vice versa.
The second caveat is that we use median figures when we look at market valuation. A median is calculated by simply ranking all stocks based on each valuation metric and then selecting the valuation that ranks right in the middle of the distribution. Since our models select from a universe of all stocks, we like to use data that looks at the valuation of the average stock in that universe and how that changes over time. But this type of data offers no value in looking at the valuation of market cap weighted indexes like the S&P 500 or the market as a whole. For those types of indexes, the large companies are much more important to their valuation than the small ones, so median data is not useful.
With that all being said, let’s look at the current valuation data.
Hosted by Jack Forehand and Justin Carbonneau
Earnings Based Valuations Have Come Down a Lot
The median PE of our investable universe using current year EPS estimates is now down to 14.6. That is 15% below the average value of 17.2 for the period since 2006. That certainly isn’t a bargain basement valuation, but the median stock has only been cheaper 9.2% of the time in the period.
The big caveat with this data, though, is that it assumes earnings estimates are correct. If we are on the brink of an earnings recession, as many experts think, then the denominator of that ratio will fall and the PE will rise.
But either way, there certainly are more cheap stocks than there were last year.
Sales Valuations Look Less Good
Before you get too excited, it is important to keep in mind that sales valuations don’t look nearly as good. The median stock still looks overvalued using this measure. But at least valuations have come way down from the peak they reached in 2021. Which metric makes more sense really comes down to the issue of profit margins. The earnings-based valuation is lower because profit margins are near all time highs. If you think that will continue, the earnings approach makes sense. If you think margins will mean revert, it does not.
Negative Earners Are Way Up
One potential issue I didn’t mention with the previous PE chart is that there has been a shift behind the scenes that has a big impact on it. When you rank stocks based on their PE ratios, you have to figure out what to do with companies that lose money because the ratio cannot be calculated for them. Typically, they are just excluded, which is what the first chart in this article does. But if the percentage of negative earners is rising over time, it can also potentially make the calculation misleading. And that is exactly what has happened.
Here is the percentage of negative earners in our investable universe (using current year earnings estimates) and how it has changed over time.
| Year End Date | Negative Earner Percentage |
| 12/30/2005 | 9.8% |
| 12/29/2006 | 8.4% |
| 12/31/2007 | 9.7% |
| 12/31/2008 | 9.5% |
| 12/31/2009 | 15.6% |
| 12/31/2010 | 10.9% |
| 12/30/2011 | 8.9% |
| 12/31/2012 | 10.2% |
| 12/31/2013 | 13.2% |
| 12/31/2014 | 13.5% |
| 12/31/2015 | 15.0% |
| 12/30/2016 | 15.0% |
| 12/29/2017 | 16.1% |
| 12/31/2018 | 14.5% |
| 12/31/2019 | 17.8% |
| 12/31/2020 | 28.3% |
| 12/31/2021 | 25.3% |
As you can see, it has been on an upward trajectory for a while now and has risen from 10% to 25%.
If we take this into account by taking the negative earners and treating them as expensive in our median calculation, we end up with a much less positive valuation based on earnings.
Whether making that adjustment paints a more or less clear picture is the subject of debate and beyond the scope of this article, but I think it is at least interesting to look at things both ways.
Value Still Looks Cheap
Finally, as a value guy, I can’t help but look at value stocks when I write an article like this. And the news for value investors still looks very positive (subject to the earlier caveat that this tells us nothing about when things might change).
Relative to its own history, value is currently in the 4th percentile on an absolute basis since 2006
And relative to growth, it is in the 10th percentile.
This is actually up since last year when value was in the 1st percentile relative to growth, but that is not an indication that value has gotten more expensive. Instead, it is an indication that the top growth decile has been decimated. It is a testament to how expensive growth stocks were last year that even after that huge decline, value still looks very cheap on a relative basis.
As I mentioned earlier, none of these charts tell us anything about what might happen in the short-term. But at the very least, we can say that the average stocks looks much better from a valuation perspective than it did last year. And value stocks look even better than that.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
