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Thursday, January 30, 2020
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One valuation metric never tells the whole story
It’s no secret that stock market valuations are high.
According FactSet, the forward 12-month price/earnings (P/E) ratio is at around 18.6, well above the market’s 5-year average of 16.7 and its 10-year average of 14.9. And these elevated valuations have caught the attention of Federal Reserve Chair Jerome Powell.
"We do see asset valuations as being somewhat elevated,” Powell said during his post-FOMC press conference on Wednesday. “Risk spreads: they're narrow. P/Es: they're high.”
But it’s ill-advised to consider valuation metrics like P/Es in a vacuum. Powell understands this.
“One way to think about equity prices is what's the premium you're getting paid to own equities rather than risk-free debt,” Powell added. “That's also at fairly low levels, but not extremely low levels. Valuations are high, but not at extremes.”
With interest rates at historically low levels (which means bond prices are high), valuations look relatively more reasonable.
Powell’s brief discussion of stock market valuations — which was part of a broader discussion about financial conditions — echoes what his predecessor Janet Yellen said during her tenure as Fed chair.
“The fact that [stock market] valuations are high doesn’t mean that they’re necessarily overvalued,” she said in December 2017. “For starters, high valuations don’t portend lackluster returns in the near term. History shows that valuations provide no reliable signal as to what will happen in the next 12 months.”
(For a longer conversation about how valuations don’t predict next-12-month returns, check out the Jan. 3 Morning Brief.)
Yellen continued: “We are in a...low interest rate environment. Lower than we’ve had in past decades. That’s a factor that supports higher valuations.”
And it’s not just Fed chairs who think this way. Warren Buffett, arguably the greatest investor of all time, will also tell you that valuation metrics must be considered in the context of interest rates.
“Everything in valuation gets back to interest rates,” Buffett said to Yahoo Finance’s Andy Serwer in April 2017. “[Valuation metrics] can be very important. Sometimes they can be almost totally unimportant. It’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.“
It’s something to keep in mind the next time someone points out how high stock market valuations are.