A new valuation metric suggests that stocks have upside potential “despite being in the midst of the worst economic contraction of the postwar era.” This according to a recent article in Barron’s.
The metric is the brainchild of Leuthold chief investment strategist Jim Paulsen, who argues that conventional valuation metrics tend to overstate “cheapness when the economic cycle is strong and overemphasize expensiveness during downturns.” He explains that investors use a variety of adjustments to check their biases, including future estimated earnings or trailing weighted moving averages, but that these adjustments fall short.
To address the gap, Paulsen created a new metric called the Output Gap Adjusted Price-to-Earnings Multiple (OGA-PE), which “adjusts earnings based on the percent difference between the current level of real gross domestic product and its estimated potential level if the economy were operating at full employment.” While admittedly far from a scientific approach, Paulsen says his gauge gives “explicit valuation recognition to the fact that when the economy is contracting, future earnings improvements should be expected because faster economic growth will eventually return and diminish the output gap.”
According to Paulsen, his OGA-PE and the trailing P-E multiple have diverged since the first quarter of this year—with the former falling while the latter has risen. With the U.S. output gap now at an all-time low, the article concludes, “the earnings outlook for U.S. companies is probably far stronger than most investors appreciate.”