Yesterday I received information from JPMorgan in their comprehensive quarterly Guide to the Market concerning the valuation of the market at year end 2015. They note the current forward P/E is 16.1 times earnings, and suggest that it is very reasonable by comparing it to the 25 year average of 15.8%. See Figure 1. Two things immediately jumped out at me. The first was the current P/E. Barrons has the trailing 12 month S&P 500 earnings as slightly under $95. With the S&P 500 having closed the year at 2044, this puts the 12 month trailing P/E at 21.5. In order to get 16.1 times earnings, you have to believe earnings will rise to $127 in 2016, a gain of over 32%. Or you have to have a more generous definition of earnings, one that allows companies a lot of leeway as far as non-recurring charges and other accounting gimmicks.
The second thing that I noticed was the decision to use a 25 year average. I’m sure JPMorgan knows that P/E ratios going back to 1927 (when they first started keeping reliable records) have averaged a lot lower than 15.8 times. Going back 25 years just confines data to the great disinflation era, when interest rates were in a fairly steady decline and P/E ratios have been elevated. Since disinflation has to end at some point, and from current levels is unlikely to persist over the next 10 years, why is this period the only guide we should use? Why not 1948 to 1971?
I believe that the assumption JPMorgan makes is that we are in a different age – one of technology and services rather than machines and factories. I would agree with those who say that technology allows us to manage inventories so much better than we used to, so companies are much more efficient now. I’d therefore be willing to accept a higher P/E today, all other things being equal. On the other hand, perhaps we are more aggressive with financing than the companies of 50 years ago. We certainly use leverage more than they did. In fact, many companies we think of as successful today are experts in the creative finance game. Home Depot, for example, reported record profits in 2014 and 2015 but in both years suffered a decline in book value. How? By using its cash flow to buy back tens of millions of dollars’ worth of stock. Home Depot stock is not cheap at 22 times earnings and more than 10 times book, so this is hardly a move that a long term profit maximizing entity would make. It does, however, boost current earnings per share. I would argue that a company using its cash to acquire stock at a high multiple deserves a lower P/E, not a higher one, since they are weakening the balance sheet. Ask Famous Dave’s how buying back its stock at high valuations ultimately worked out for shareholders.
Analysts have traditionally been willing to pay higher multiples for organic (higher sales and cash flow) growth as opposed to financially engineered growth. 2015, however, was not a particularly good year for people who value stocks in the traditional manner. Just ask Warren Buffett (Berkshire Hathaway declined over 12% in 2015) or such value managers as Longleaf Partners (LLPFX was down -18.8% in 2015) or Yacktman (YACKX was down -5.6% in 2015). It was about “buzz” or trendiness – if lots of people use it, it must be a good business, right? We’ll see how that plays out but I have a feeling I’ve seen that movie before.
What worked in 2015 was growth and low volatility. The large cap growth style box crushed the competition with a gain of 5.7%. Seven of the other eight style boxes, including all three on the value side, were negative. Every domestic iteration of the low volatility strategy, be it large cap (USMV and SPLV), midcap (XMLV) or small cap (XSLV) performed in the top decile of its category. The EAFE Minimum Volatility ETF EFAV beat its benchmark (EAFE) by over 800 basis points. Of the two, I am more optimistic that the low volatility trend will persist than the growth trend.
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