Market Valuations: Are Stocks Cheap?
Updated: Oct 21, 2019
I rarely watch financial news on TV. But this week I had it on at lunchtime and during one of the segments someone said something to this effect: “Stocks are cheap relative to where interest rates are.” Are they?
There are a few different ways to look at the valuation of the stock market. Buffett’s favorite methodology is to look at the market cap of all equities divided by GNP. Similarly, you can look at a version of Tobin’s Q and divide the market cap by the net worth outstanding. The St Louis Fed provides the data for both and I’ve included the code below to calculate. (I have charts of these in my investment reports.)
These two measures basically look at valuations from a balance sheet perspective. Pre-1970, before the monotonic rise of computing power, this was a fantastic way to value the overall market. But as our economy has become more technology and service oriented, the true value at most companies is in their employees’ intellectual and institutional knowledge. How do you capture on a balance sheet the value of what’s in someone’s head? Or the value of some lines of code? Measures of balance sheet valuation do a poor job of capturing these intangibles and frequently overvalue the market.
Shiller’s PE ratio looks at earnings, which better captures the intangible intellectual property that exists today. Looking at this ratio, perhaps the market is slightly expensive, maybe 10% to 20% depending on where you want to place your long-term average. But certainly nowhere near as expensive as Tobin’s Q or Buffett’s measure would represent.
That leaves us with the question of where do valuations stand versus interest rates? To examine this we’ll use the trusty standard linear regression. The plot is below; the regression has an adjusted R2 of .42, not too bad. You can see there is some convexity to the relationship (curve), so we could use a higher order fit or a more sensitive model to be more accurate. If we did that it looks like the market might be slightly cheap. But, all in, I’d say the stock market looks reasonably priced compared to the current level of bond yields. I mean, who really wants to buy a 30y bond at 2.2%?
Taken all together, the market may be slightly above fair value, but not excessively so, and seems spot on given the level of rates we have.
# get data and clean
pe <- fGetShillerPE() # left to the reader
yld <- getSymbols('DGS10', src='FRED', return.class = "xts", auto.assign = FALSE)
dat <- na.omit(na.locf(merge(pe, yld, join = 'left'))); names(dat) <- c('pe', 'yield')
datDF <- as.data.frame(dat)
pointDF <- tail(datDF, 1)
ggplot(data = datDF, aes(x = yield, y = pe)) +
xlab('10y Rates') + ylab('Shiller PE') +
ggtitle('Rate Level vs Stock Valuations, 1962 to Present') +
geom_point(color = 'darkgreen') +
geom_smooth(method = 'lm', formula = y ~ poly(x, 1)) +
geom_point(data = pointDF, aes(x = yield, y = pe), colour = "red")
# Simple model
lm_mod <- lm(datDF$pe ~ datDF$yield)