As follow up to my last post regarding cost of equity and valuation multiples for the S&P 500, here is a chart showing the implied steady state PE versus the actual PE for the index since 1961.
The actual multiple typically plots above the steady state estimate. This is to be expected since the market is typically assigning some value to future earnings growth, and for simplicity’s sake my steady state multiple calculation does not factor in future growth.
By calculating the steady state multiple in this way you can easily visualize how the market is valuing future growth at a point in time. When the actual multiple is far above the steady state multiple, as in the late 1990s, the market is assigning a high value to future growth. Obviously the value of future growth can swing around violently depending on investor sentiment. In fact, exploiting this tendency for the market to overvalue and undervalue future growth is the lynchpin of Ben Graham style value investing. If you buy a stock at a low steady state valuation, yet have correctly discerned there are future growth opportunities not reflected in the market price, you get a free call option on the future.
The impact of ultra-loose monetary policy shows up very clearly in this chart in 2009. The steady state multiple shoots up dramatically in 2009 as interest rates (and thus discount rates) hit historic lows. What is interesting to me about this chart is how long the actual multiple remained below the steady state multiple, almost as if the market “realized” the discount rate had been artificially manipulated and refused to play ball. Again, that speaks to the power of investor sentiment.
Superficially, it appears as though the market valuation has finally “caught up” with its steady state value and has room left to run (remember, the steady state model isn’t pricing any growth). However, as discussed in the previous post, the steady state multiple has risen due to a low discount rate. So what I think investors need to think long and hard about today is whether we are systematically mispricing risk (spoiler alert: I think we are).
That said, I don’t think investors are mispricing risk because they are stupid, or even because they are greedy. In fact, I think they are acting rationally in the face of unappealing alternatives. But that is a subject to explore in future posts.