On May 6, Fed Chair Janet Yellen threw markets for a loop when she said “equity valuations at this point generally are quite high.” Is she right?
At first glance, valuations do look high, whether using trailing operating or GAAP EPS. As of May 8, the S&P 500 traded at a P/E of 17.8X trailing operating EPS, which is a 2.3% premium to the median of 17.4X since 1988. Prior to 1988, The Street looked at GAAP results. Today, the P/E on trailing GAAP EPS is 21.3X, which is a 9.1% premium to its median P/E of 19.5X since 1988 and at a near 34% premium to the median of 15.9X since 1936. Therefore, on the surface, trailing P/Es do indeed look “quite high.” On an inflation-adjusted basis, however, history says stocks are either slightly underpriced or modestly overpriced.
Looking at Next 12-Month (NTM) EPS estimates, P/E multiples also look pricey. Since the start of this millennium, the average NTM P/E is 16.2X and the median is 15.4X. Today, the S&P 500 is trading at a P/E of 17.6X on NTM EPS, which is a premium of 9% to the average P/E and 14% to the median P/E. Looking at estimates for 2016, however, valuations look less expensive. S&P 500 EPS estimates are expected to show 0.5% growth for 2015, as Capital IQ aggregate estimates point to S&P 500 EPS of $118.56 versus the $117.95 recorded in 2014. However, EPS estimates for 2016 are significantly more optimistic (as they usually are that far out) at $133.16, indicating 12.3% growth.
So there you have it. Even though some on Wall Street have said “Janet Yellen is no strategist,” she’s not out of line saying that valuations are stretched. Whether looking at trailing or projected operating or GAAP EPS, valuations are above long-term averages. Only when these P/Es are viewed with a negative inflation overlay do they appear “fairly valued” rather than “richly valued.” But don’t sell all of your stocks just yet. Should S&P 500 operating EPS shift into overdrive next year, as currently projected by aggregate analyst expectations compiled by S&P Capital IQ, the market may be able to close 2015 at an all-time high and eclipse the 2300 mark by year-end 2016, based on the market-valuation metric known as “The Rule of 20.”