In my discussions there has been a lot of debate and interest around valuations, particularly Price vs Earnings type valuations (given the uncertainty around the Earnings side of the equation).
Indeed, with the corona-crash, in a number of situations valuations have either gone from expensive to cheap, or from cheap to even cheaper. And in this type of environment where some of the valuation metrics have reached extremes you want to pay more attention than usual to valuation signals.
But back to issue of earnings, it's true there is fundamental uncertainty on the path of earnings through the pandemic. Probably the only thing people can agree on is that earnings will likely plunge. But for how long? and to what extent? and what will the recovery look like?
I don't have all the answers, but I do know one thing - eventually life will return to some version of normal. This is a new and unsettling event, but it also has many parallels or echoes in past events.
Indeed, there are actually analytical tools designed specifically for this type of situation.
Enter the PE10:
PE10 = Price / Average (trailing 10 years earnings)
The PE10 helps investors look through the cycle/swings in earnings by using the rolling 10-year average of trailing earnings; providing a consistent and less volatile anchor.
As I will highlight below, the PE10 is a useful indicator for asset allocation and global equity strategy, and there are some really interesting signals right now, and a few important facts and caveats to pay attention to. So check out the 10 charts on the PE10 below and let me know what you think.
n.b. all of this analysis is conducted at the index level (hence "top down" !!), and the conclusions and commentary while maybe useful/interesting - won't necessarily hold for any one individual given stock (for instance I can say with high confidence that there will be an equity market one year from now, but I can't say which companies will survive vs thrive!)
1. The Classic Chart: This chart has been in my investment strategy tool kit from the early days, and it is both simple and powerful. It shows the PE10 valuation indicator for the major chunks of global equities: USA, Emerging Markets, and Developed Markets excluding USA. The upshot is after trading to expensive levels, US equities have returned to more neutral levels (but more on the US market later in this article). Perhaps more interestingly though is the valuation gap that existed previously between US and global ex -US, which has persisted through the crash (and is something I have documented extensively. The other key observations to note are 1. how the EM PE10 briefly traded as low as 2003 levels; and 2. the DM ex-US PE10 almost broke to a new all time low. For investors who use valuation in their process, things are getting interesting!
2. Global PE10 Quartiles: Sticking with global equities, the next chart shows the upper/lower quartiles and median PE10 valuation across countries. The sharp reset in the median country PE10 (across 47 countries) is stark, significant, and should not be taken lightly.
3. Global PE10 Cohorts: Taking a similar but slightly different angle, the chart below maps out the breadth of PE10 valuations across countries, with the red line showing the proportion of countries trading on "expensive" valuations (in this case the point of delineation is 25x) and the green line showing the proportion of countries trading on "cheap" valuations (which for arguments sake is 15x). Clearly there was a major spike in the proportion of countries trading on cheap valuations, and a swift dissipation of countries trading on expensive valuations. The last time in recent history that we saw something like this in terms of speed and magnitude was 2008/09.
4. PE10 Table: The logical question flowing from the previous couple of charts is probably "who's who?", and the table below answers that by showing the rankings across countries from the EM + DM universes. It's a pretty interesting list, and I'm sure there will be a few surprises on there (albeit perhaps except for the one in the no.2 spot!). Naturally, there's more to it than just looking at valuations, but it tends to be a good starting point.
5. PE10 Predictability - Scatter Plots: Leveraging off the country PE10 data set, the below scatter plots map out the PE10 vs subsequent 10-year CAGR (Compound Annual Growth Rate), while the R2% is not the highest I've ever seen, there are obviously some linkages here (and it makes sense: the higher the valuation you pay for an investment the higher the valuation or cash yield you need to justify that, and the reverse is true... in fact some say you make your money when you buy - that is if you buy at a good price/valuation). Back to the charts, I would say they highlight 2 things: 1. valuations are a useful signal for medium-longer term investing; (but) 2. as useful as they are we probably still need to bring in other factors. In practice what I find is that valuations offer a useful actionable signal primarily when they are at extremes (and then other factors become more important as you move through the range/market cycle).
6. US Blended PE: For all the talk of the PE10, I would not call it the be all and end all, and in fact all of the main PE ratio variants: the PE10, Price to Last 12m earnings, and Price to Next 12m earnings each have their own set of advantages/disadvantages. So one avenue is to combine the 3 into one (giving each an equal "vote" in hopes that the common signal drowns out the individual noise). Pictured below is a graph of this blended PE ratio for the S&P500. Against recent history, the S&P500 briefly went from significantly expensive to slightly cheap (or at the minimum we can say it fell below the period average). Again, this is a key chart in my tool kit, and has served me well on a few occasions.
7. PE10 vs Trailing 12m vs Next 12m -- the E (EARNINGS): Digging into the components behind the chart above we can start to fairly clearly see some of the subtle and not so subtle differences between them. Note on the first chart below I decided to show them as z-scores rather than absolute values (because as you can probably gather from the earnings chart, the PE 10 is just about always higher than the other two and the NTM PE is just about always lower than the other two). As you can see in times like 2009, the trailing PE can swing violently around (without really offering any useful/accurate signal). Forward earnings begin to move more rapidly both up and down (as you can see already there has been some significant movement there). Meanwhile trailing 10yr average earnings don't swing around as much, yet still offer a good/accurate generalization of where earnings have been - which is in most circumstances a useful best guess for the market as a whole. So while in times like now people can argue that the E will get decimated, it really is times like now that the PE10 shines -- basically what it was designed for.
8. US Small vs Large Cap PE10: Sticking with the US equity markets, but applying the same PE10 methodology to small caps (the S&P600 index) and large caps (the S&P100 index), we can see how this valuation indicator can be used not just for the big picture equity allocation decision, but also in helping finesse allocations within equities. For instance, some of the sharp underperformance in small caps was arguably foreshadowed by the sharp run up in the small cap PE10 ratio. Of course it becomes all the more interesting now that the small cap PE10 has dropped below that of large caps. Charts like this certainly make me want to go and do more work on the space! (which is a good side-point: as is clear, valuation is not the be-all and end-all but it is a very useful anchor and indeed many times is a sound trigger to go and do further research and fill out the rest of the picture (e.g. with cycle factors, flows/positioning/sentiment, technicals, and so-on).
9. Longer Term Shiller/CAPE: I wanted to also include this chart, leveraging off the data of one of the masters of finance; Robert Shiller, for two reasons: first the CAPE is a slightly different version of the PE10 in that the CAPE includes an adjustment for inflation, but in terms of signal they are virtually identical. But more importantly, Shiller has compiled a long term data set, and this helps bring in a longer term perspective on valuations. Because there are clear "regimes" of structurally lower/higher valuations, it's useful to blend the long term average with a rolling 20-year average to provide a dynamic neutral/anchor point (but even then it's not perfect, though it does help frame the ranges). Much like chart number 6, it showed US equities moving to extreme expensive levels in the last couple of years, and then moving down to neutral/"not expensive" (can't exactly call it cheap: especially after the sharp rebound) levels in the last couple of months. Much like in the early 2000's those waiting for the CAPE to fall to the green line (which would imply a drop in the S&P500 of -40% from here [SPX 2700 at the time of writing]), they could be waiting a while. But setting aside the bands for the time being, there is an elephant in the room, and that's the extremely extraordinary policy and interest rate backdrop we are living through right now...
10. PE10 Based ERP: That logically brings us to the Equity Risk Premium, which in this case I have calculated using the inverse of the CAPE so as to present a less noisy version of the earnings yield (and then subtracting the 10-year real treasury yield, and again I am using a 10-year rolling CAGR of CPI to present a less noisy signal vs the sometimes weird and wrong signals you might get if using YoY CPI). I have seen a lot of different versions of the ERP, and aside from the forward-looking prospective ERP implied from my Capital Market Assumptions data set, I would say this is the most pure/useful/accurate method, from a signal/strategy standpoint. The key takeaway form the chart right now is that the ERP actually rose above it's long term average (and well above the more recent period average). This is basically telling you equities are likely to outperform bonds over the medium/longer term. In other words, when you adjust the CAPE for the level of interest rates, US equities look good value here.
Final Thoughts and Bottom Line
Bottom line: the PE10 is a useful investment strategy tool, and as a result of the corona-crash is showing a significant improvement in valuations for global equities (especially global ex-US), but also for US equities - in that they are no longer expensive as such (especially small caps).
As outlined, valuations are a key signal for medium/longer term focused investors - particularly at extremes. The PE10 and related indicators are an especially useful lens for this signal, but as with most indicators there are strengths and weaknesses that need to be accounted for and investors should be aware of. That also leads me to the other key point: valuations are just one piece of the puzzle (along with factors like monetary policy, cycle, sentiment, and technicals). My preference is to bring in as much information as possible to build out the picture and raise conviction levels. Naturally this also means understanding how these factors evolve through the cycle and hence the mental or explicit weight to give them. When it comes to valuations, history tells us to give greater weighting to this signal at extremes, such as those reached in recent weeks.
For more detail on this this topic or any other specific questions get in touch...
Head of Research at Topdown Charts Limited