Stock Market Valuation
By Spencer,
At month end the S&P 500 PE on trailing operating earnings was around 24. In my model that is expensive, but not massively so.
Except in the irrational exuberance market of the 1990s, a PE of over 20 has never been sustained and always signaled a major bear market.
Trailing earnings does include the fourth quarter when EPS was minus $0.09 and as the low 2008 earnings roll out of the comparisons the PE could fall while the market rises as it did in 1993. But 1993 appears to be an exception to the rule that the market generally moves in the same direction as its’ PE. The correlation between the change in the market and the change in earnings is essentially zero, and one of the most dangerous times in the market is when EPS growth first turns positive.
Tobin’s Q
see thishttp://en.wikipedia.org/wiki/Tobin%27s_q
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Tobin’s q[1] is a ratio comparing the market value of a company’s stock with the value of a company’s equity book value. The ratio was developed by James Tobin (Tobin 1969), who called it “‘q’, the ratio between two valuations of the same physical asset.”
One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for the newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.[1]
Tobin’s Q is quite useful for evaluating large manufacturing firms or other firms with large investments in physical capital.
But it is much less useful for evaluating institutions when their capital is the institutional knowledge lodged in its workforce. This means things like financial firms, service, drug or high tech firms like software companies where physical
capital is not that important. So it is much less useful for the entire economy than when it was developed some 50 years ago.
I presume by cyclical adjusted PE they ae using some estimate of “normalized” or trend earnings to calculate the PE. I calculate a “trend earnings” PE that eliminates cyclical swings above and below trend EPS, but I am not really sure how to use it. In some situation like last year when EPS was massively distorted by large scale write-offs a cyclically adjusted Pe makes senseas an estimate of “normalized” earnings.