spx S&P 500 PE Ratio, Earnings Yield, Adjusted For Inflation And Interest Rates, At Market Troughs

S&P 500 PE Ratio, Earnings Yield, Adjusted For Inflation And Interest Rates, At Market Troughs

The trailing price-earnings ratio of the S&P 500 currently (3/16/01) stands at 23.2, 27.8% below last year's PE high of 32.2 and 36.1% below its all-time high of 36.4 in April 1999. However, some investors remain concerned that the market, although over one-third less richly valued than at its peak, is still high by historical standards. When adjusted for inflation and interest rates, the price-earnings ratio of the S&P 500 indicates that the market represents tremendous value.

The Market Has Already Declined Past Levels of Historical Troughs

We examined the bottoms of significant market declines to determine what multiple of earnings investors paid at historic market lows:

Figure One: All Market Declines Exceeding 15% Since 1960:
Date:	S&P 500:	Price-Earnings Ratio:
Oct-62	56.5	15.7
Sep-66	76.6	14.0
Jun-70	72.7	13.3
Dec-74	68.6	7.7
Sep-75	83.9	10.2
Mar-78	89.2	7.9
Mar-80	102.1	6.9
Jul-82	107.1	7.8
Nov-87	230.3	13.4
Oct-90	304.0	14.1
Aug-98	957.3	25.1
	Median:	13.3
Current:	1179.0	23.2

At the bottoms of 1974, 1978, 1980, and 1982, the PE ratio on the S&P 500 sank into single digits. By comparison, the market's current PE ratio of 23.2 seems to indicate that there is significant downside risk. But using the PE alone is misleading.

The S&P 500 Price-Earnings Ratio Is Low Relative to Inflation

Intuitively, one might think that avoiding stocks when market PEs are historically high is a good strategy. In fact, although PE ratios are inversely correlated with subsequent 12-month returns in the stock market, the relationship is weak; the PE ratio of all 12-month rolling periods from January 1945, to February 2001, is only -0.130 (-1 would be a perfectly inverse correlation; 0 would be no correlation at all). In other words, high PEs were on average followed by below-average 12-month S&P 500 performance, and the market performed somewhat better than average when the PE was low, but this relationship was inconsistent and unreliable.

Even if you could forecast next year's earnings perfectly, the resulting "forward" PE ratio would do even worse: -0.074 correlation. Clearly, PE ratios alone tell us very little about what the market will do in the future.

The PE ratio cannot be viewed in a vacuum. To get a valid picture of market valuation, we must put the PE ratio in the context of inflation and interest rates. In a low inflation environment, stocks can have much higher PE ratios, if for no other reason than that the net present value of future earnings is greater.

To adjust the PE for inflation, we first converted it to an earnings yield, defined as price divided by earnings, or the inverse of the PE ratio. Thus, higher PE ratios convert into lower earnings yields. High earnings yields indicate relatively undervalued markets.

The current earnings yield of the S&P 500 is 4.3%, below the median of 6.0% since 1960. However, when we consider the earnings yield adjusted for inflation, the market is not extremely overvalued. The earnings yield is fully 2.5% above the 1.8% year-over-year change in the core Personal Consumption Expenditures (PCE) deflator. In fact, the market has been more richly valued 38% of the time since 1960, when adjusted for inflation. By this measure, the S&P 500 is not overvalued; in fact, its valuation today is comparable to its valuation at prior market troughs:

Figure Two: Earnings Yield Versus the Core PCE
Date:	S&P 500:	Inflation (12-month change in Core PCE):	Real Earnings Yield:
Oct-62	56.5	1.2%	5.1%
Sep-66	76.6	2.3%	4.8%
Jun-70	72.7	4.4%	3.1%
Dec-74	68.6	9.5%	3.5%
Sep-75	83.9	7.3%	2.5%
Mar-78	89.2	6.4%	6.2%
Mar-80	102.1	8.6%	6.0%
Jul-82	107.1	7.0%	5.9%
Nov-87	230.3	4.4%	3.1%
Oct-90	304.0	4.7%	2.4%
Aug-98	957.3	1.4%	2.6%
	Median:	4.7%	3.5%
Current:	1179.0	1.8%	2.5%
source: Barron's, Bureau of Economic Analysis

The median real earnings yield (earnings yield minus 12-month change in core PCE) was 3.5% at significant market bottoms over the past 30 years. Note that by this measure, the S&P 500, with a real earnings yield of 2.5%, is currently much more in line with valuation levels seen at past bear market troughs. In fact, the market is much cheaper by this measure than it was in October 1990, although the nominal level of the S&P 500 is over four times its 1990 value. If one adjusts the S&P 500 for the more commonly used, albeit narrower, measures of inflation, such as the Consumer Price Index (CPI), the current market appears no more richly valued than it was at the panic trough of 1974:

Figure Three: Earnings Yield Versus the CPI
Date:	S&P 500:	Inflation (12-month change in CPI):	Real Earnings Yield:
Oct-62	56.5	1.3%	5.0%
Sep-66	76.6	3.5%	3.7%
Jun-70	72.7	6.0%	1.5%
Dec-74	68.6	12.3%	0.6%
Sep-75	83.9	7.9%	1.9%
Mar-78	89.2	6.6%	6.1%
Mar-80	102.1	14.8%	-0.2%
Jul-82	107.1	6.4%	6.4%
Nov-87	230.3	4.5%	3.0%
Oct-90	304.0	6.3%	0.8%
Aug-98	957.3	1.6%	2.4%
	Median:	6.3%	2.4%
Current:	1179.0	3.7%	0.6%
source: Barron's, Bureau of Labor Statistics

In 1974, inflation was running at an economy-crushing 12.3% rate. In this context, the PE of 7.7 times trailing earnings doesn't look so cheap! In fact, compared to the year-over-year change in the Consumer Price Index, the S&P 500 was identical in valuation to the S&P 500 of today. When one considers the economic and geopolitical backdrop of 1974 with Vietnam, the OPEC oil embargo, stagflation, and Watergate, even the gloomiest of current economic forecasts looks cheery. We have detailed major reasons why the market deserves a much higher inflation-adjusted PE multiple today than it did in 1974 (see our report titled "The Best Superbull Stock Market in U.S. History: To Double Again," October 25, 2000).

Similarly, the inflation-adjusted earnings yield of the 1980 bottom was lower than that of the S&P 500 today, meaning that when inflation is taken into account the market was more richly valued in 1980 than it is today!

Stocks Are Cheap Relative to Bonds

The bond market is arguably the most sensitive gauge of inflationary expectations. When the yield on the 10-year Treasury is low, it reflects a consensus opinion that inflation is low and stable. As we have emphasized in prior reports, in such an environment the market deserves a much higher multiple of earnings (lower earnings yield). Indeed, subtracting the 10-year Treasury yield from the earnings yield illustrates that stocks are reasonably valued compared to prior market troughs:

Figure Four: Earnings Yield Versus the 10-Year Treasury Yield
Date	S&P 500	10 Year Treasury Yield	Earnings Yield - 10 Year Yield	Return, next 12 months
Oct-62	56.5	3.9%	2.4%	30.9%
Sep-66	76.6	5.2%	2.0%	26.3%
Jun-70	72.7	7.8%	-0.3%	37.1%
Dec-74	68.6	7.4%	5.5%	31.5%
Sep-75	83.9	8.4%	1.3%	25.5%
Mar-78	89.2	8.0%	4.6%	13.9%
Mar-80	102.1	12.8%	1.8%	33.2%
Jul-82	107.1	14.0%	-1.1%	51.8%
Nov-87	230.3	8.9%	-1.4%	18.8%
Oct-90	304.0	8.7%	-1.6%	29.1%
Aug-98	957.3	5.3%	-1.4%	37.9%
	Median:	8.0%	1.3%	30.9%
Current:	1179.0	4.8%	-0.5%	??
Source: Barron's

Remember that we are comparing the market of today with historical market troughs, yet even by this extreme measure the S&P 500 today is trading at a valuation level below that of four of the 11 market bottoms since 1960. Note that the 1982 and 1984 market trough PEs no longer look so cheap when it is remembered that the 10-year Treasury yield was almost three times its current value. Any rational investor who could get 14% virtually risk-free in a government bond would demand a much higher earnings yield before buying stocks. The 10-year Treasury yield today is lower than it was in all past market bottoms except 1962. Relative to interest rates, the S&P 500's valuation is comparable with past market troughs. In today's low inflation, low interest rate environment, stocks should be trading at a much higher multiple.

Note that we are not necessarily calling an exact bottom. Markets can correct much more than anyone anticipates. However, we believe that selling stocks out of a fear of overvaluation would be misguided. The final column of the last table underscores this point: investors who bought stocks following severe declines when stocks were as undervalued relative to inflation and earnings as they are today were richly rewarded. The median stock market gain, excluding dividends, over the next 12 months was 30.9%.