Sign in
Become a MarketWatch member today
Mark Hulbert
Sept. 3, 2010, 7:26 a.m. EDT · Recommend (6) · Post:
View all Mark Hulbert "º
"¹ Previous Column
Don't leave the bond party -- yet
First Take "º
Private-sector adds jobs, just not enough of them
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) -- Are stocks hugely undervalued?
It certainly would seem to be a big stretch to argue that they are, even to advisers who are otherwise bullish. After all, the market's current P/E ratio -- depending on how the "E" is measured -- ranges from being more or less in line with the long-term historical average to being moderately above it. ( Read my July 1 column on price-to-earnings ratios.)
The P/E ratio, the once tried-and-true market measurement, is losing its luster as a way to measure a stock's value.
Although that doesn't doom the market to dismal performance, especially over the near term, it seems to remove the valuation argument from the list of those that Super Bulls can rely on to support their case.
But over the past week or so, I nevertheless have come across a surprising number of Super Bulls who based their bullishness on the P/E ratio. Their sleight of hand is to interpret the P/E ratio in relative terms: While the market's current P/E ratio might not be below average in an absolute sense, they argue, it is once we take today's rock-bottom interest rates into account.
Should you buy their argument?
I think not. There is precious little evidence that an interest-rate-adjusted P/E ratio does any better of a job of identifying undervalued and overvalued markets than the P/E ratio itself does. In fact, just the opposite appears to be the case: Interpreting P/E ratios in the context of prevailing interest rates actually reduces its predictive power.
Consider a fascinating study conducted nearly a decade ago by Clifford Asness, managing and founding principal at AQR Capital Management, a Greenwich, Conn.-based quantitative-research firm. Titled "Fight the Fed Model," it appeared in the fall 2003 issue of the Journal of Portfolio Management. (Click here to read a copy of Asness's study.)
His findings are best understood in terms of a statistic known as the "r-squared," which reflects the degree to which fluctuations in one thing predict or explain changes in another. The r-squared ranges between 0 and 1, with 1 indicating the highest degree of predictive power and 0 indicating no detectable relationship. (The table below gives the r-squared as a percentage of 1.)
The table reports the r-squareds that Asness derived from tests of the period back to 1926 on the S&P 500 index /quotes/comstock/21z!i1:in\x (SPX 1,101, +11.17, +1.02%) . Notice that, regardless of whether you're using the P/E ratio to forecast the market's one- or 10-year return, you'll do a whole lot better by focusing just on it -- rather than interpreting (and adjusting) that ratio in light of prevailing interest rates.
What this means: Regardless of whether interest rates are high or low, high P/E ratios are bad news, and low P/E ratios are good. A high P/E ratio doesn't become any less bad just because interest rates may be low.
Furthermore, because inflation and interest rates are highly correlated, the same conclusion applies to those who are fond of adjusting P/E ratios according to prevailing inflation.
Note carefully from the table, however, that the r-squareds are markedly lower at the one-year horizon than at the 10-year horizon. That is hardly surprising, since over the shorter term, many extraneous factors can affect the stock market's returns. But over longer periods, those other factors tend to cancel one another out, enabling valuations to have a markedly greater impact on returns.
Another way of saying this: Valuations exert only a weak gravitational pull on the market over the short term and a much stronger pull on the longer term.
Given this, it's entirely possible that the Super Bulls will turn out to be right about the market over the next year. But, if they are, it will be in spite of current market valuations, not because of them.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.
The U.S. economy is still bogged down, but it's not sinking any further into the mire.
9:31 a.m. Today9:31 a.m. Sept. 3, 2010 | Comments: 24
- Offoz | 6:43 a.m. Today6:43 a.m. Sept. 3, 2010
"Mark Hulbert: Are stocks really undervalued? http://on.mktw.net/cgbmae" 7:04 a.m. EDT, Sept. 3, 2010 from MktwHulbert
"Mark Hulbert: Don't leave the bond party -- yet http://on.mktw.net/dbFKx5" 9:43 a.m. EDT, Sept. 2, 2010 from MktwHulbert
"Mark Hulbert: September by the numbers http://on.mktw.net/9B2VID" 11:54 p.m. EDT, Aug. 31, 2010 from MktwHulbert
"Mark Hulbert: Insiders' reaction to August's decline http://on.mktw.net/asFtw7" 11:34 p.m. EDT, Aug. 30, 2010 from MktwHulbert
"Mark Hulbert: Contrarian take on Dow below 10K http://on.mktw.net/cyeE2g" 11:59 p.m. EDT, Aug. 26, 2010 from MktwHulbert
Your Portfolio
Give your portfolio a confidence boost
On the Markets
Are stocks really undervalued?
Money and Power
Land of Opportunity turning barren
View from Jerusalem
Obama's postwar dividend: defense cuts
On Retirement
Health law's retiree perk won't last long
Read Full Article »