Thursday, April 22, 2010

Valuation: Not Cheap, But No Bubble Yet

At Pinnacle, stock market valuation is one of the three main pillars of our investment process, and we follow it religiously. The importance of valuation can’t be overstated at market extremes, so it must be constantly monitored. However, we realize that valuation is often a very poor timing indicator, so when it’s not at extremes it tends to receive less weighting in our asset allocation decisions.

Currently, we live in a world where depending on what you read, you could get the impression that the market is anywhere from ultra cheap to extremely expensive. While that might seem contradictory, the reality is that any one data point in isolation could look dramatically different than another simply due to how it is calculated.

For example, if you want to argue that the market’s expensive, you could use the 10-year normalized price-to-earnings ratio, since it currently uses a lower earnings figure. If you want to argue that the market’s cheap, you could calculate the P/E using forward earnings, which are being upgraded at lightning speed as the economy continues to expand. The point is, the data is available to make any case you want, and it’s got to be awfully tempting to mine the data that best fits your point of view, especially if you are a perma bull or bear.

We don’t have an extreme view of valuation one way or the other at the moment. Instead, we’d characterize overall market valuation as being slightly elevated. That is not to say that there aren’t certain indicators that might be pushing towards levels that are very elevated, but to us the weight of the evidence shows the market to be modestly overvalued.

One of the ways that we track this is through our Pinnacle Composite Valuation Model (in red), which is shown measured against the S&P 500 Index (in blue) on the chart below. The composite is a simple equally-weighted model that includes 10 different valuation indicators, including price-to-earnings ratios, price-to-sales, several yield-based measures, and an intrinsic value calculation on the S&P 500.

At present, the model’s score is 4.8 (with 10 being cheap and 0 expensive). Currently, a slightly elevated market valuation means very little as we construct our overall portfolio. At some point the model will move far enough to really grab our attention, and when it does, we’ll act accordingly.