Saturday, October 1, 2011

Diary: Is the market cheap?

Equity Premium
A statistic that I'm slowly accumulating is the "equity premium", which measures the premium that equities have in relation to 10-year gilts. I obtain an earnings yield by inverting the median PE ratio of the Footsie, and subtracting it from the 10-year gilt yieild ( At the moment, the median PE is 12.07, which is below the historic average. This gives an earnings yield of 8.29%. The gilt yield is 2.42%, so the equity premium is 5.87%.

Despite this suggesting that the Footsie is slightly undervalued, a poster on the yahoo group macgicformulainvesting pointed to a couple of statistics that the market (at least the US stock market) is still expensive.

This is the ratio of the total market value of a firm to its total asset value. According to this link, the historic mean is 0.71, and the current value is 1.01; suggesting the market is currenlty overvalued. I've heard elsewhere that the Q-Ratio (aka Tobin-Q) is not necessarily a particularly reliable predictive statistic, though. The link concludes:
The mean-adjusted charts above indicate that the market remains significantly overvalued by historical standards ? by about 42% in the arithmetic-adjusted version and 54% in the geometric-adjusted version.

CAPE (Cyclically Adjusted PE), aka PE10, is a ratio of the price to 10-year average inflation-adjusted earnings. It is a way of adjusting for earnings cycles. According to this link, the PE on a TTM basis is slightly undervalued, but according to the PE10 ratio, it is near the top of the 4th quintile, suggesting an overvaluation.


John Kingham said...

Do you have the link or data for the CAPE being in the 4th quartile (overvalued)? My data says the opposite so something's wrong somewhere!

Mark Carter said...

John, the link it provided in the post, but here's a shortened version:

The data is for the S&P. The second graph shows a PE10 of 19.7. The 3rd quintile (i.e. the middle range) is 14.3-17.2, so the S&P is in the overvalued range. It is in the 4th quintile, nudging the 5th (highest) quinitle.

Admittedly, the graph isn't for the UK market, but I'm assuming that the pattern will be vary similar.

John @ said...

Thanks Mark, must have mis-read the article originally and not spotted the link. Also I thought you said 4th QUARTILE, not QUINTILE. I'll have to read more slowly in future!

So at 19.7 or whatever it was, the S&P500 is about 20% above the long run average PE10, which makes it perhaps mildly expensive. From my chunky dataset I think the FTSE 100 is at a real PE10 of around 12 (at the 5,000 level) which is a bit more than 20% undervalued.

Whether that's the whole euro thing or not I don't know, but it shows that the S&P and FTSE 100 aren't entirely tied at the hip! Not just yet anyway.

Happy hunting...