Valuations Are Higher, but So Are Margins

Median price-earnings and price-to-sales ratios are currently higher now than they were near the height of the last two bull markets. Though this may seemingly be a reason for caution, there are underlying factors to consider before making a judgment about their significance.

I ran numbers looking at valuations near the height of the previous two bull markets and at the bottom of two bear markets. Since we are in the sixth year of a bull market, I thought it would be interesting to compare the valuation ratios now to what they were at the peaks of the previous two bull markets. Doing so provides comparisons, but it is important to realize that they are only comparisons. Just because valuations were at a certain level when a previous bull market peaked does not mean the same level implies a peak now. Neither bull nor bear markets come with expiration dates attached.

The median price-earnings ratio for stocks in our Stock Investor Pro database currently is 20.2 (as of May 1, 2015). This compares to 14.3 on February 25, 2000 and 18.4 on September 28, 2007. The median price-to-sales ratio is currently 1.97, versus 1.33 near the end of the tech bubble (February 2000) and 1.69 near the end of the housing bubble (September 2007). The price-to-book ratio is currently 1.97 versus 1.90 and 2.01, respectively.

Median yields are 0.0% for all periods. This is because the majority of companies do not pay and have not paid dividends. When the universe is restricted to dividend-paying stocks, the current median yield is 2.5% versus 3.0% and 2.3% respectively. Keep in mind that yields and valuations are inversely related, with higher yields implying lower valuations and lower yields implying higher valuations. (As a quick aside, there are currently 2,587 stocks with a yield above 0.0%, versus 2,444 at the end of February 2000. In other words, the total number of dividend payers in the U.S. has not changed significantly over the last 15 years.)

One factor cited as playing a role in the higher current valuations is the very accommodative monetary stance by the Federal Reserve and other central banks. The benchmark 10-year Treasury ended last week with a yield of 2.12%. According to data pulled from Yahoo Finance, the benchmark note yielded 6.34% at the end of February 2000 and 4.58% at the end of September 2007. Put another way, borrowing currently remains at historically low levels and lower borrowing costs boost profitability. Cheap money can also spur merger and acquisition activity—and this year has so far been a busy one for deal making—which contributes to higher valuations. It should be noted that even if the 10-year Treasury note’s yield were to jump by a full percentage point, the yield would still be below levels seen throughout most of the last decade. 

Reduced borrowing costs also helps operating profit margins. Median operating margins are currently at 8.3%, versus 3.6% in February 2000 and 4.9% in September 2007. While there is debate about how much more companies can cut costs, I want point out that median gross margins are currently at 41.1% versus 36.6% and 40.8%. Inflation, as opposed to interest rates, more directly impacts gross margins. As long as inflation remains low, it seems likely that gross margins will remain at higher levels (assuming, of course, that companies can exert enough pricing power to pass along the cost increases they do incur).

The big question, of course, is: How long can valuations stay at current levels? Since neither bull nor bear markets come with expiration dates, nobody really knows. Market analysis is good for telling us where we are, but it’s not always good for telling us where we’re going to go over the short term. The danger with acting on information about prevailing valuations (or similar market data) is the possibility of missing out on future potential gains or not getting back into the markets in a timely fashion after a pullback (or a bigger drop) has occurred. For most investors, it far better to embrace the uncertainty than to try and pick the best times to get out and back in.

(A point of interest: I chose to use the median numbers instead of average numbers because the median represents the midpoint of values. For instance, the current median price-earnings ratio for all U.S.-traded stocks in our Stock Investor Pro database is 20.2, meaning half of all stocks trade at or below this number and half trade at or above it. The current average price-earnings ratio is a much higher 34.5. The average is skewed upward by stocks with extraordinarily high price-earnings ratios.)

Table 1. Median Valuations Over Time

*Median dividend yield is only for dividend-paying stocks; all other data is for all stocks in the Stock Investor Pro database.
**10-year Treasury note; actual closing yield for each date.
Data from AAII’s Stock Investor Pro/Thomson Reuters and Yahoo Finance.

Come to Las Vegas for Great Investment Insight

As is often the case, our Investor Conference is selling out fast. The good news is that there is still time for you to sign up. The even better news is the list of speakers we have for this year’s conference.

Best-selling author Carl Richards will be one of our our keynotes. I’ve seen Carl twice and he is a great speaker. Not only does he give good insight into behavioral finance and portfolio management, he has the unique ability to convey complex concepts with sketches. (The New York Times, which publishes a regular column by Carl, calls him “the sketch guy.”) It’s entertaining to watch him draw while speaking in front of a large audience.

Also new to our conference is Jack Ablin. You might recognize the name from CNBC, Bloomberg or other financial media. Jack is the chief investment officer for BMO Private Bank. Jack interacts regularly with individual investors and understands their needs, desires and worries. Equally important, he can explain how individual investors can navigate their way through the ever-changing macro landscape.

Those of you who follow our Piotroski Screen will want to see Wesley Gray’s presentation. Wes, who explains his modifications to Joseph Piotroski’s strategy in this month’s AAII Journal, will discuss his quantitative approach to investing.

We’ll also have several popular speakers from past conferences returning this year, including CBS MarketWatch’s Market Hulbert, Morningstar’s Christine Benz, AFAM Capital’s John Buckingham (who discusses dividend investing in this month’s AAII Journal), former AAII Journal editor Maria Crawford-Scott and Computerized Investing editor Wayne Thorp.

I think you will find the conference to be both rewarding and informative. Visit AAII.com for more information and to register. I’m looking forward to seeing you there.