Valuation Compression Masks Economic Gains

There’s a good article in today’s Wall Street Journal by economist John Cochrane which reminds us that cheap valuations have historically been a very good predictor of future stock market performance (not a guarantee, of course, just a historical correlation: this time it may be different).  One outgrowth of the fact that stocks having gotten “cheaper” is that share prices have not reflected the real economic gains that companies have achieved.  To look at the stock market, where 10-year returns are flat to negative, one would think that no progress was made over the last decade.  This simply isn’t true.  Obviously we are going to have a setback, but even a severe recession is unlikely to undo the bulk of the real advancement.  The following 10-year chart of IBM tells a typical story:

IBM

IBM

The top panel shows the price of IBM as well as both trailing and expected earnings.  The bottom panel calculates the Price/Earnings ratio based on forward earnings expectations.  Looking at the share price of IBM alone, one could infer that this is a company that has not advanced in a decade — yet, over the same period, earnings have more than doubled!  The disconnect, of course, is that valuations, as evidenced by the Forward PE chart have steadily declined. 
The point is that investors have to be very careful in drawing lessons from the past decade’s stock market, particularly if they focus on share price alone.  Certainly one lesson to learn is that valuations are important — and if high valuations should make investors wary, low ones should encourage them to look for opportunities.  A common lament in the wealth management industry is that, “this is the only industry on earth that, when prices are ‘on sale,’ buyers run away!”
An important question to ask is why valuations have declined.  At the extremes, one can argue that coming down from the dot-com euphoria is reasonable, and the recent sharp drop is in anticipation of lowered earnings expectations.  Yet there is a multi-year trend beyond these extremes.  One cannot help but wonder if the overspeculation in the financial world — an unhealthy diversion of too many assets away from traditional investment strategies and into more trading type strategies — has played a role.
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