An economist and a portfolio manager discuss today’s U.S. valuation in the context of interest rates, prior bear markets and investment strategy.
Matt Miller: Darrell, speaking of valuations, on the home front, lots of conversation about where U.S. valuations are. I know you’ve thought about this in terms of some of the concerns people raise. What’s your point of view?
Darrell Spence: Any discussion about whether a market is cheap or expensive is a little fraught with risk, but the most basic form of valuation, or measure of valuation, is the price-to-earnings ratio. There’s a lot of other ones out there, but I always come back to the price-to-earnings ratio, because earnings are what we buy companies for. And certainly the price-to-earnings ratio on the U.S. market is above its historical average. A lot of people point to that fact as a sign that it’s overvalued, but you can’t look at P/E ratios in isolation. You need to look at them in relationship to where interest rates are. And one of the reasons that P/E ratios are above the long-term average is because interest rates are below the long-term average, and how that translates into the discounting mechanism that ultimately determines the price of stocks and markets matters.
The market is roughly, let’s call it, 18½ times on trailing earnings right now. That’s certainly on the higher side of things, but, again, think about where interest rates are, and it starts to make a lot more sense. It starts to look a lot more consistent with other historical periods where we’ve had low bond yields. In any bear market, it’s always difficult to know what caused it. But if you went back and looked at the post-war history and picked out the ones that arguably were caused by a market that perhaps got a little overvalued — 1961, 1987 and, of course, the Internet bubble in 1999-2000 — the market was trading well in excess of 20 times in the former two of those episodes and then in excess of 30 times in the Internet bubble.
So we still aren’t at levels of valuation — even though we may be above the longer term averages — that at least arguably you could say caused some of the market declines in the past.
Gerald Du Manoir: Can I just add something? I think what Darrell said is quite important, put into context of how we look at companies at Capital. We, as we’ve been saying, do not invest in markets, and we tend to take advantage of mispricing. Mispricing can sometimes be on the upside where markets tend to be expensive, and historically we’ve done quite well in markets that were expensive, because we have no attachment to indices or obligation to be invested in the entirety of the market. So we actually move money where valuations are more attractive, more defensive, where the dividend yield is more attractive, where we know that the money that we allocate to these companies will be rewarded appropriately with the right governance and the right fundamentals. It’s really important to put that in context.
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