US stocks are cheaper than they look – but are they cheap enough?

Adjusted for low interest rates, US stocks are not as pricey as they seem. But you may still be better off elsewhere, says John Stepek.

One of our favourite valuation ratios here at MoneyWeek is the cyclically-adjusted price/earnings ratio (Cape). The Cape – also known as the Shiller Cape, after Professor Robert Shiller, who popularised it – is similar to a standard p/e ratio (see below) in that it looks at how expensive a company or index is relative to the earnings it generates. But rather than a single year of earnings, the Cape takes average real (inflation-adjusted) earnings over ten years. This smooths out cyclical ups and downs and gives a clearer picture of whether a market is truly cheap or not. History shows that buying an index when the Cape is low (ie, it’s cheap) will deliver the best returns, while buying when the Cape is high (ie, the index is expensive) is a bad idea. 

However, in recent years there’s been a bit of a fly in the ointment – the Cape doesn’t seem to be working. The S&P 500 index in the US in particular has looked massively overvalued for many years (not just on the Cape, but on plenty of other measures too). Yet it keeps hitting new highs. 

What’s going on? One obvious factor stands out as significant here: interest rates have never been this low before. All else being equal, when rates are low, asset prices should rise, because low rates make any future income stream more valuable to investors today. And this is what Shiller and two colleagues, Laurence Black and Farouk Jivraj, have tried to adjust for in a new measure, the Excess Cape Yield (ECY), which they revealed on Project Syndicate last week.  

The calculation is simple. Invert the Cape, to express it as a yield (so today’s US Cape of 33 becomes 3%). Then subtract the ten-year real interest rate. In the case of the US, that’s negative 1% (that is, the ten-year US average inflation rate of about 2%, subtracted from the yield on the ten-year US Treasury, which is around 1%). That gives a US ECY of 4%. The higher the ECY, the more appealing equities are compared with bonds. At a 4% ECY, markets have historically returned around 5% a year (after inflation) for the next decade. As John Authers notes on Bloomberg, “that would not hurt at all”. And if we are entering a period of financial repression (where central banks and governments hold rates down) then real rates might fall even further, propping markets up. 

Yet it’s still not a sound reason to favour the US, because most other regions are even cheaper on this basis – the eurozone and Japan are both trading on ECYs of around 6%, while the UK is more like 10%. Indeed, the latter, says Shiller, is the only major market whose Cape remains “well below its pre-pandemic level and longer-term average”. In short, even if US equity valuations can be justified at current levels, you’ll enjoy a far greater margin of safety in the UK.

I wish I knew what a p/e ratio was but I'm too embarrassed to ask

Many investors use the price/ earnings (p/e) ratio as a measure of whether a share is cheap or not. That’s because it’s one of the simplest valuation measures out there. You just take a company’s share price and divide it by its earnings (profits) per share (which you can read in the accounts). So a company with a share price of 50p and earnings per share (EPS) of 5p would have a p/e ratio of ten. 

A p/e ratio that is based on forecast earnings is often referred to as a “forward p/e ratio”, while one based on past earnings is sometimes described as a “trailing p/e”. P/e ratios are also sometimes referred to as “multiples”, as in “Acme widgets is trading on a multiple of ten times its earnings”. In effect, a p/e of ten means you are paying £10 for each £1 of earnings, while a p/e of 20 would mean you are paying £20 per £1 of earnings. So in theory, the lower the p/e, the cheaper the share. 

However, a lower p/e does not always mean that a company represents good value. If investors are only willing to pay £5 for each £1 of current earnings, say, then this implies that they don’t really believe current earning levels can be sustained. Instead, there may be serious problems that will hinder future growth or lead to falling profits. Meanwhile, those trading on higher p/e ratios might look expensive – but in fact might be expected to grow exceptionally strongly (for example, high-flying tech stocks typically trade on relatively high p/es). 

Also bear in mind that some industries (eg, mining and housebuilding) are extremely cyclical – their profits fluctuate sharply with the economic cycle, as opposed to remaining relatively stable over time. Companies in these sectors tend to trade on low multiples at the high point in the cycle (when they are very profitable) and high p/es at low points (when they may be loss-making). The Cape ratio offers one way to correct for this.

Recommended

Just how green is nuclear power?
Energy

Just how green is nuclear power?

Nuclear power is certainly very clean in terms of carbon emissions, but what about the radioactive waste produced as a byproduct? It’s not as much of …
22 Jan 2022
Why GSK should turn down Unilever’s billions
UK stockmarkets

Why GSK should turn down Unilever’s billions

Unilever has offered GSK £50bn for its consumer division. But while the cash will be a temptation, the deal is not in the interests of shareholders or…
22 Jan 2022
The charts that matter: the start of the big crash?
Global Economy

The charts that matter: the start of the big crash?

US tech stocks fell further this week, more than 10% down on their November high. There’s what happened to the charts that matter most to the global e…
22 Jan 2022
Cryptocurrency roundup: authorities tighten the screw
Bitcoin & crypto

Cryptocurrency roundup: authorities tighten the screw

Saloni Sardana looks at the cryptocurrency stories that caught our eye this week.
21 Jan 2022

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
Interest rates might rise faster than expected – what does that mean for your money?
Global Economy

Interest rates might rise faster than expected – what does that mean for your money?

The idea that the US Federal Reserve could raise interest rates much earlier than anticipated has upset the markets. John Stepek explains why, and wha…
6 Jan 2022