By Jack Forehand, CFA, CFP® (@practicalquant) —
2023 has been a great year for the market so far. Despite the negative sentiment coming into the year, falling inflation and interest rates coupled with decent earnings so far have provided fuel for a nice market run to start the year. Whether the good times will continue is still up for debate, but given the strong recent run and the fact that it has been a while since I have looked at it, 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.
Earnings-Based Valuations Have Risen, But Are Still Reasonable
When I last looked at the median PE ratio of our universe, it was around 14.5 and was in the 10th percentile of our full history. After the recent market run, it is up to 16.3 and the 31st percentile. That is more expensive than it was before, but still below the average for the full period. The median stock isn’t as cheap as it was, but it doesn’t look expensive either.
Sales-Based Valuations Remain More Expensive
As I noted in my last article, the median Price/Sales for our universe paints a very different picture than the median PE. With profit margins near all-time highs, sales-based valuations are much less reasonable.
When I wrote my previous article, the median Price/Sales was in the 75th percentile and it has now risen to the 85th percentile. If you are looking for evidence that the median stock is cheap, sales-based valuations are not the place you want to go.
Value Still Looks Very Cheap
The good news for value investors is that value stocks still look very cheap both on a standalone basis and relative to growth.
The chart below shows the valuation of the bottom decile of our database.
On a standalone basis, value is currently in the 8th percentile relative to its history. That is only slightly up since I last looked at it 6 months ago.
And relative to growth value currently sits in the 12th percentile. So no matter how you look at it, value still looks very good.
As I mentioned at the beginning, none of this tells us anything about where the market is going in the short-term. It also tells us nothing about when value will finally have the huge multi-year run many of us have been expecting. But for long-term investors who invest outside of market cap weighted indexes, there is reason for optimism.
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.
