Current market valuations

I try to avoid thinking too hard about market valuations as I firmly believe you can make good money by simply judging what you see in front of you.  There is no reason for me to care that Vodafone looks overvalued if the company’s I’m looking at appears attractive.  However, even the most undervalued portfolio will show a degree of correlation with the market as a whole, so I think you should always be aware of how attractive current markets are and how they are likely to do over an extended period – say 10 years - as there is little to prevent your own portfolio becoming even more undervalued. 

Which is why the following charts worry me.  Below is the Cyclically Adjusted Price to earnings (CAPE) for the US.  It shows that current valuations are around 50% higher than their long-term average of 15. 

 Another way of looking at the same problems is using Tobin's Q.  This compares the replacement value of a company's assets compared to the price it fetches in the market:

Again the story is similar, with valuations around 40% above the long-term average. 

As a relative novice to the investment game, I was surprised by these results.  Valuations don't look stretched on a P/E basis, with the market as a whole on around 14x at the moment.  So why do both CAPE and q suggest equities are so overvalued? 

The answer lies in profit margins, which are extremely elevated relative to historical norms.  The chart below illustrates this clearly: 

The absolute levels are higher than operating margins because depreciation is excluded from the results, but the trend is clear.  Margins are around 7% higher than normal, and this is a relatively recent phenomenon.  Note that on this chart a 7% increase on 30% margins implies companies are only earning 25% more than 'normal', but if we include depreciation the increase is probably closer to 50%. 

The upshot of all this is that future returns on the S&P are likely to be mediocre.  Hussman (link on the right) projects just a few percent per year over the next decade. 

I'll address why margins are high, and why I think they will eventually come down, in a subsequent post.  But for now, I'll be especially careful not to get too enthused by low P/Es if they are supported by supernormal profit margins (resource stocks anyone?).