A Different View of Valuation
The Shiller PE says the stock market is overvalued, but the Shiller PE adjusted for profit productivity suggests it is still cheap!
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Judging the valuation of the stock market has become increasingly difficult during the last 35 years. Valuation is a relative concept. Something is only cheap if it sells below its “normal range” and becomes expensive only when it trades above conventional norms. That is, unless “normal” changes which is precisely what investors have faced since 1990. The stock market’s valuation – based on its price-earnings (PE) multiple – has seemingly risen to a permanently higher territory since 1990 compared to its stable conventional range from 1900 to 1989. This has left investors in a quandary. Is a PE multiple higher than at any time before 1990 expensive, or is it still cheap since the stock market has sold at higher multiples with some regularity during the last 35 years? This conundrum may force investors to take a different view of valuation.
A History of U.S. Stock Market Valuation
Chart 1 shows the celebrated Shiller CAPE PE multiple for the U.S. stock market since 1900. Other popular earnings-based valuation methodologies – like the price to trailing 12-month earnings per share – show similar results.
The U.S. stock market traded in a stable range from 1900 to 1990. Its 10th percentile PE ratio was about 8, the 90th percentile about 21, and its median valuation was 13.5. An almost 100-year consistent range of stock market valuations made the job of assessing valuation risk rather easy. A PE below 10 was a buy and caution was warranted as PEs approached 20. The stock market regularly oscillated between periods of over and undervaluation. Overvalued in 1900, undervalued in 1920, overvalued again after the roaring 1920s, cheap after the Depression collapse in the early-1930s, still reasonably priced after WWII, expensive again by the late-1960s, and a raging buy in the early-1980s. By 1990, veteran investors used the stock market’s prolonged and stable valuation history to easily appraise periods of contemporary risk or smell a bargain.
This tried-and-true valuation gauge began to fall apart in the 1990s. By 1994, the PE had reached the 90th percentile of its old valuation range and then proceeded to more than double before peaking in 2000 near an unprecedented level of 45! Initially, the dotcom boom was perceived as a one-off event where irrational exuberance pushed values to absurd levels. Most expected sanity to again prevail and for U.S. stock market to return to its historic valuation range. But this never materialized.
At the worst of the dotcom collapse, the PE only declined to the 90th percentile of the old valuation range. And since, only briefly during the worst of the 2009 crisis, has the PE returned to its historic range. Overall, since 1990, the PE has traded above the 90th percentile of the old range almost 78% of the time. Based on its old valuation range, the U.S. stock market has been extremely expensive nearly 80% of the time and at an above average valuation 100% of the time during the last 35 years. Since 1990, the median PE has been 26, its 90th percentile PE has been 36, and its 10th percentile has been 20. The 10th percentile valuation in the “new valuation range” is nearly equal to the 90th percentile of the old valuation range. Clearly, the historic valuation range between 1900 to 1990 has been retired!
The shattering of the stock market’s traditional valuation gauge has created an uncomfortable quandary for investors. Bears have chosen to believe this period of extremely excessive valuation will ultimately be corrected by a day of reckoning. Bulls meanwhile have mostly ignored valuation considerations believing conventional metrics are broken and other factors like momentum or new-era growth will continue driving the stock market.
Neither Bear nor Bull are comfortable without a valuation speedometer, but what choice do they have? Nobody really understands why a 100+ year old valuation range suddenly disintegrated or what the “new” valuation range is or will be? However, the market waits for no one, so investors have adjusted as best they can. Many now limit PE valuation judgements only on comparisons since 1990. Ignoring earlier times, cheap or expensive has increasingly been defined as “since 1990”. Indeed, the popular metric for valuation has become price to “estimated EPS” which really have only existed since about 1990.
After 35 years, it seems pretty clear the old valuation range no longer works, and a new valuation range is being established. But what is still uncertain is whether valuation data only from 1990 to date yields a useful valuation gauge or not? Perhaps, as suggested in chart 1, a new valuation range has already been established during the last 35 years. Or maybe, a future stable valuation range – which is required to make reliable investment judgements -- is still being established and is not yet useable? In many ways, the investment community, including this humble investor, have been forced to soldier onward by deciding individually how best to judge value in a world without a working contemporary methodology.
Thoughts on Changing Valuation Metrics
You have entered the editorial section of this post. Perhaps there were a few editorial comments above as well. Why did a 100+ year stable valuation range suddenly shift beginning in 1990? And how should investors gauge the stock market’s valuation today? While I do not know the answers to these questions, I have never been shy offering opinions.
There are a few key reasons why the old valuation range has changed in recent decades. The first is the frequency of recessions. From 1854 to WWII, the U.S. was in recession 42% of the time. Since 1980, it has had recessions only 11% of the time. Arguably, when one of the biggest risks for stock investors, recessions, occur less frequently, valuations can and should expand.
Second, innovation cycles have quickened over history. Since the 1980s, the U.S. has enjoyed a rapid pace of modernization including fiber optics, mobile phones, the PC, the internet, social media, streaming services, and now AI to name just a few. Historically, innovations have always received higher multiples as much of their value is based on future business growth.
Third, the U.S. economy has evolved from an industrial economy (cyclically based) to a service-based, technology-driven (growth-oriented) economy. Simply, the S&P 500 Index has become growthier. And growth stocks have always received higher PE multiples compared to cyclical stocks.
Fourth, liquidity for the U.S. stock market has improved significantly in recent decades. Not only has individual participation improved substantially, but international investors have also expanded. Technology advances have also improved liquidity as electronic trading now makes investing so much easier. Similar to any individual stock, when liquidity improves, volatility diminishes, and valuations rise.
Certainly, these factors have helped boost the valuation range of the stock market in recent decades. In my opinion, however, a surge in profit productivity has probably played the most important role leading to a permanently higher U.S. stock market valuation range.
Profit Productivity & U.S. Stock Market Valuation
Chart 2 overlays the Shiller PE multiple with U.S. profit productivity since 1940. Productivity is traditionally defined as real output per worker. Profit productivity is defined as real profit per worker. What matters most for companies and for investors is the profitability of the workforce or the degree of profit productivity.
Since 1940, there has been a close relationship – a correlation of +0.69 -- between the stock market’s PE multiple and profit productivity. What is most striking about this relationship is when the stock market was in its old stable valuation range, profit productivity was also in a stable range. When profit productivity broke this range in 1990 and surged higher ever since, the valuation of the stock market also broke its old valuation range and remained higher. Prior to 1990, the Shiller PE averaged 14.2 and the profit productivity ratio averaged 0.53. Since 1990, the average PE has almost doubled to 26.7 while profit productivity has slightly more than doubled to 1.11!
It is highly likely the success companies have had in improving the profitability of their workforce since 1990 is tied directly to new-era innovations. For fifty years between 1940 to 1990, real profit per worker remained largely unchanged and then shortly after the introduction of PCs and iPhones, worker profitability has continued to advance. Seemingly, real profit per worker is driven by past innovation cycles and is closely correlated with the valuation range of the stock market.
Is the new valuation range for stocks since 1990 stable? Doubtful. A doubling in the real profit per job ratio since 1990 has led to an almost doubling in the average PE multiple of the stock market. And profit productivity is still trending higher, so perhaps average PE valuations will also continue trending higher? Similarly, it’s probably also inappropriate to judge today’s valuation with how something traded on average since 1990. For example, currently the Shiller PE is about 33x. Is that comparable to 1997 when it also traded at 33x? Probably not. Today, the stock market is at a 33 PE when profit productivity is above 1.6, whereas in 1997 when the PE was 33, profit productivity was only about 0.92. The current valuation is much more reasonable today than it was in 1997 because each employee generates about 75% higher real profitability.
Although the Shiller PE has been in a seemingly stable (but higher) range since 1990, because profit productivity has persistently trended higher since 1990, one could argue overall valuations have actually trended lower in the last 35 years.
A Different View of Valuation … The PE/PPJ Ratio
Since its old stable valuation range was eviscerated, everyone has struggled to interpret whether they are operating in a cheap or expensive stock market. I share that struggle. However, I think incorporating real profit per job (PPJ) into the valuation metric provides useful insights every investor should consider and monitor.
Chart 3 shows the Shiller CAPE PE multiple adjusted for profit productivity – the PE/PPJ ratio -- since 1940. While far from perfect, this valuation metric has done a fairly good job of highlighting the major cheap and expensive periods in stock market history. Based on its indications, the stock market was very cheap in 1942, was at a below average valuation from the end of WWII until the mid-1950s and was extremely cheap both from the late 1970s until the later-1980s, and again from 2009 to 2014. This gauge also designated 1940, 1946, much of the 1960s, and from 1998 to 2002 as extremely expensive eras. The advantage of this valuation barometer is it has a stable valuation range throughout the entire 84-year period. Currently, based on the PE/PPJ ratio, the stock market sells at a valuation level which is cheaper than 72% of the time since 1940. It trades at a ratio of 21 today compared to an average ratio of 26.2 since 1940. The PE/PPJ ratio suggests the stock market is no longer as cheap as it was in the early-1980s, or after the Great Financial crisis in 2009, but is still attractively priced compared to most of the post-war era.
It appears that the stock market’s valuation was recovering nicely after the 2009 crisis when the pandemic of 2020 and its inflationary aftermath in 2021-22 significantly paused the revaluation revival. However, from its lows in 2022, the valuation of the stock market is again recovering and still has a considerable way to rise before reaching even average valuations.
Many can reasonably disagree with the merits of this new valuation metric, and I am not suggesting it is “the” solution when interpreting contemporary stock market valuations. However, in a world without a reliable guide for valuing the stock market during the last 35 years, this metric is worthy of consideration alongside other barometers when sizing up potential valuation risk and reward. It incorporates a variable –profit productivity -- which could be the primary reason market valuations rose out of their 100+ year range to permanently higher levels. It reinstates a “stable” valuation range for the U.S. stock market over the entire time period since 1940. And finally, it currently suggests the stock market remains relatively cheap at a time when most believe at best it is at an average valuation and many think an excessively high valuation.
In my view, the degree of widespread economic and financial market anxieties evident today simply are inconsistent with a stock market supposedly selling at an exceptionally overvalued level. For example, the Shiller PE is currently at one of its highest levels in its history dating back to 1870, the trailing S&P 500 PE multiple is currently higher than 85% of the time since 1990, and the S&P 500 forward 12-month PE multiple is higher than 83% of the time since 1990. Do these valuation assessments jive with so much current angst over what the Fed may do, whether a recession looms nearby, whether another round of inflation is pending, what will be the impact of runaway federal deficits, and the uncertainty associated with who may win the upcoming election? Can today’s supposed record high valuations coexist with consumer and small business confidence measures continuing to hover near recessionary low levels? And are they consistent with businesses and consumers hoarding a record high $6 trillion in money market funds, 50% higher than they clung to at the worst of the 2009 crisis?
Today’s PE/PPJ ratio is consistent with the level of caution and fear currently evident throughout the economy. Perhaps it is time to consider a different view of valuation. Should contemporary widespread angst ease in the coming years, the stock market may possess much more upside potential (i.e., the current PE/PPJ ratio at only 21 is still significantly below its average of 26.2) than is suggested by conventional valuation metrics.
Thanks for Taking a Peek! Jimp
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There was (I thought) very insightful analysis of this question more than 10 years ago, from Jeremy Siegel and especially the Philosophical Economics blog.
For instance, that accounting changes around 2001 reduced earnings and made them more volatile due to treatment of goodwill. This lifted acceptable P/E ratios, which on pro-forma earnings were more similar to past periods.
https://www.philosophicaleconomics.com/2013/12/shiller/
Has his thinking become wrong-headed or unfashionable?
Another thoughtful data based analysis, thanks. A big question must be whether the high level of profit per employee is structural or cyclical. If structural, then your new measure seems well backed, but if cyclical then I fear we’re in for a double whammy of lower multiples of lower profits. Is there an ‘elastic limit’ to how much companies can squeeze employees? My inner Marxist fears social pushback on high corporate margins, industry concentration and low corporate taxation.