Valuation Indicators

Both research and experience have taught us that popular methods of valuing the stock market, such as the ubiquitous price-to-earnings (P/E) ratio, are actually very poor predictors of the future direction of prices. In fact, the latter stages of several major bear markets have seen astronomically high P/E ratios, since earnings tend to fall even harder than stock prices during the worst downturns. A better way to determine relative value in the stock market is to turn the P/E ratio on its head to get an “earnings yield” – earnings divided by price (E/P). Because ownership of a stock represents a claim on future earnings, and because stocks compete most often with bonds for portfolio capital, comparing the earnings yield of the overall stock market to that of risk-free Treasury bonds paints a much more meaningful picture of the market’s valuation than does a P/E ratio in isolation. Historically, large negative spreads between the market’s earnings yield and Treasury yields have immediately preceded periods of significant downside volatility, including the crash in October 1987 and the 2000-02 bear market, whereas positive spreads have been indicative of undervalued markets with tremendous long-term upside. The earnings yield is also an effective tool for determining the relative valuations of foreign equity markets – for example by comparing the spread between the earnings yield of the Nikkei and the yield on the 10-year JGBs with the spread between the earnings yield of the DAX and the yield on 10-year Bunds.

Another good way to evaluate the relative value of equities is to watch for unusually high levels of buying or selling by insiders (company directors, CEOs, etc.). We have found that extreme levels of aggregate insider buying and selling exhibits a strong positive correlation with intermediate-term changes in trend. This makes sense intuitively, since the upper management of any given company is likely to be the first to know about developments that will later take the market by surprise, and as a group, corporate insiders have exhibited an uncanny ability to dump their own shares near market peaks and buy the stock back around market bottoms. Our favorite source for insider selling and buying data is Vickers Stock Research, which publishes weekly insider sell-buy ratios for the major U.S. stock exchanges.

The relative attractiveness of overall equity valuations can also be inferred from the trend in stock buybacks and M&A activity versus IPOs and spin-offs. When the market value of future earnings is cheap relative to bond yields, companies will leverage their balance sheets by using cash and debt to finance stock buybacks and acquisitions (private equity players will also be very active in removing shares from the public market, and hot start-ups will be more likely to agree to an acquistion by an established company rather than doing an IPO). Conversely, when the market value of future earnings is expensive relative to bond yields, companies will seek to monetize their stock by issuing new shares, spinning off entire divisions, and using shares (not cash or debt) to fund expensive mergers and acquisitions (venture capital and investment banker players will also be very active in bringing new shares to the public market via IPOs - and it is always important to remember that companies tend to go public en masse whenever they can get cheap money by selling overpriced shares to undiscriminating investors).

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