10 Charts on the PE10 Valuation

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!

Global equities PE10 chart

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.

PE10 valuation quartiles across markets

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.

PE10 cohorts cheap vs expensive chart

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.

PE10 valuations country market table

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).

PE10 10yr returns and PE10 valuations scatter plots

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.

chart of S&P500 blended PE valuation

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 subt