No matter how many times we hear "stocks are trading right around their average valuation levels of the past 15 years" and this chart is trotted out as evidence that stocks are "fairly valued", we cringe a little bit.
By every measure that we look at stocks have flown by fairly valued and have entered into richly valued territory. We hinted at this fact yesterday as well when we showed that most stocks around the world are trading at a premium to book value.
Today, we are going to try and dispel the idea that stocks in North America, at least, are fairly valued. We are going to use the MSCI North America Index as this is the data we subscribe to instead of the S&P 500 for our analysis. Now, before we are accused of comparing apples to oranges we contend that we are comparing Red Delicious apples to Golden Delicious apples. Or put another way, the MSCI North America Index and the S&P 500 are very similar, especially for the largest weightings in both indices, which is important since the largest 20 names in MSCI North America account for 23.84% of the index and the largest 20 name in S&P 500 account for 27.42% of the index. To give the reader an idea of how close these indices are, let's look at the largest 20 stocks in each index. Out of the top 20 names in each index, they are exactly the same except for two names (figure 1). The 20th largest company in the MSCI North America Index is Coca-Cola (which is the 22nd largest in the S&P 500) and the 6th largest company in S&P 500 is Berkshire Hathaway (which is the 22nd largest in the MSCI North American Index).
If we look at the next 20 largest, which account for another 12.56% in the MSCI North America and account for another 14.14% in the S&P 500, 18 out of the 20 names are the same. The two that are different are Royal Bank of Canada (53 basis points of the MSCI North America Index) and Toronto-Dominion Bank (48 basis points of the MSCI North America index). So yes, the comparison isn't perfect but we think it is close enough.
Back to valuation levels. Let's begin by looking at the differences between average and median valuation levels. Average valuation levels are well below median valuation levels which implies that there are more companies trading at higher valuation levels at first blush. As the charts below show, this tends to be true most of the time. Currently, the median price to cash flow ratio is at levels seen from 2005-2007 and the median price to sales ratio is above 2000 and 2007 highs.
We also like to look at valuation breadth. We analyze breadth in a few ways. We look at the percentage of stocks trading above 3-year, 5-year, 7-year averages as well as the percentage of stocks trading with 25% of their 3-year, 5-year, 7-year max valuations. We also like to look at the percentage stocks trading at important absolute levels such as 1x book value or 10x cash flow. When we analyze our breadth data points, we find that breadth is at or above levels seen in 2000 and 2007. For example 67% of stocks are trading above their 3-year average price to book ratio. This is below highs hit in 2006 (86%) but well above the average (44%) over the past 15 years. From a price to earnings perspective, the percent of stocks trading above their 3-year average is right at the same level as it was in 2006 and 2007. When we look at 5-year and 7-year averages, we find that all valuation ratios have more stocks trading above their averages than in 2007.
Currently, 65% of all stocks are trading with 25% of their max P/S valuation level which is higher than it was in 2007. Also higher now than it was in 2007, is the percentage of stocks trading within 25% of their 7-year max P/E ratio. As the charts below show, similar trends emerge when looking at shorter time periods as well.
Finally lets look at the percentage of stocks that are trading above (or below) various absolute levels and compare the current situation to how it was in the 2007-2009 period. Currently, 64% of all stocks are trading above 10x cash flow which is slightly higher than in 2007. Perhaps more telling is the fact that only 7% of stocks are trading below 5x cash flow compared to 45% at the bear market low. Currently, 89% of all stocks are trading above 10x earnings while only 6% are trading below 5x earnings. And lastly, just over half (53%) of stocks are trading above 2x sales while only 16% of stocks are trading below 1x sales.