In order to assess the level of valuation at any point in time, we typically look at a large variety of at times contrasting indicators. Our quantitatively-oriented valuation model uses all these indicators as inputs and returns a single score ranging from 0 to 10, where higher values signal more attractive valuations. This helps remove a certain degree of subjectivity from the analysis. Currently, the model is an equally-weighted average of 14 different indicators grouped into 4 different categories called P/E Measures, Non-Earnings Measures, Yield-Based Measures, and Intrinsic Value Measures. As part of the constant effort to improve on the efficacy of the model, the team is currently evaluating alternative weighting systems based on the specific explanatory power of the individual components of the model. Regardless of what system is used, since 1981 (the beginning of the sample) our valuation model has exhibited an outstanding ability to forecast future S&P 500 returns, having a roughly 50% correlation with 2-year forward S&P 500 returns and a roughly 70% correlation with 5-year forward S&P 500 returns.
Following the turmoil experienced by the stock market in the last few weeks (at the time of writing the S&P 500 is 13.5% off its April 29th high on a closing basis), we would expect valuation to have improved some. The important question is, by how much? Updating our valuation model as of the end of last week returns a score between 6.07 and 6.8, depending on what weighting system is used. This constitutes a great improvement from the score of around 5 seen at the end of July, before the worst of the latest market sell-off. Since the model’s inception, valuation scores in the 6-7 range have been associated with median 5-year forward S&P 500 returns of around 11% (standard deviation of 2%). However, the forecasting power over shorter time frames was less impressive, with 1-year forward S&P 500 returns coming in still at around 11% but with a standard deviation of 12%.
All considered, a score in the lower 6-7 range is not yet overly compelling in our view, especially given the high level of uncertainty that is pervading global financial markets as of late. In addition, the other two tenets of our investment management process suggest that the market may become cheaper before it gets expensive. As a result, we will keep an eye on the model and give it increasing consideration if valuation keeps improving.
