With stocks up some 60% off their lows, one of the big questions among investors has involved the market’s current value. Are stocks now overvalued? Or are they still cheap?
The issue of valuation is one that can be looked at in a myriad of ways — currently, for example, the 10-year price/earnings ratio pioneered by Robert Shiller shows the S&P 500 to be valued at levels above historic norms. So does the more frequently used trailing 12-month P/E ratio. But one ratio you don’t hear as much about indicates otherwise — and it’s a measure that’s had a pretty good track record.
The measure is the “price/peak earnings ratio”, used by top strategist John Hussman.
On Hussman Funds’ web site, William Hester explains this measure: “Since stocks are a claim on a very long-term stream of cash flows, using temporarily depressed earnings during a recession is not a very useful way to measure stock valuations,” he says. “Several years ago, John Hussman created an alternative P/E measure called the “price to peak-earnings ratio” — the current price of the S&P 500 divided by the highest level of earnings achieved to-date. By smoothing out earnings fluctuations (the underlying peak-earnings series looks like a ‘stairstep’ that moves higher each time earnings rise to a new record), the P/E ratio becomes less volatile and more informative.”
Hester writes that, while the use of peak earnings is inherently an optimistic figure, “history tells us it’s a fair assumption. The market’s earnings power has always returned to previous levels.” (He cautions against using the metric for individual stocks, however.)
“For more than a century, the price to peak earnings multiple has fluctuated around an average near 14,” Hester says. “It was in the single digits in the 1930’s and 1940’s, as well as 1974 and 1982. It climbed as high as 33 in December 1999. A level of 20 marked valuation extremes that were followed by the price slides of 1929, 1972 and 1987.”
Hussman Funds’ site doesn’t specifically list today’s price/peak earnings ratio for the S&P. But in commentary from Dec. 15, 2008, Hussman said “the price/peak-earnings multiple on the S&P 500 is just over 10, but that is based on peak earnings of about $86 for the Index.” Presuming that that peak earnings figure still holds today (which seems a reasonable assumption), the S&P’s March 8th closing price of 1,138 makes for a price/peak earnings ratio of 13.2 — which compares favorably to that historical average of 14 or so.
For more on the price/peak earnings ratio, see this interview Hussman did with Barron’s back in the late 1990s.