KOTOK: Stocks Defy Conventional Valuation Techniques

“This extraordinary stock market is driven by characteristics that defy conventional valuation techniques. I receive emails from people who tell me that the market is overextended, overvalued, and trading way above its 50- or 200-day moving average. If you look at the metrics, the market is all of those things.

I receive other emails that talk about the valuation of the market. Is it reasonably “fair?” If you look at earnings expectations and the price of stocks this year and compare them to a metric, you would say the market is reasonably priced.

The math goes something like this. The S&P 500 Index will earn an estimated $105-$110 for 2013. That puts it at a multiple of about 15 times earnings. Those earnings are being reported by companies that have minimal distortions due to inflation or accounting mechanisms. Thus the earnings are of a higher quality in terms of reporting than they have been in the past. They do not reflect the bubble of the 2006 and 2007 financials. And they are more representative of the diversity of American companies. Our metric would say the market is reasonably priced. Not a great market, but certainly not excessive.

The next metric ties the relationship between stocks and interest rates. We use a number of vehicles to make this comparison. I like the calculation of the equity risk premium that says how much you get paid for owning stocks versus riskless debt instruments. If you compute an equity risk premium against an interest rate next to zero, the valuation of stocks could be infinite. Anything compared to near-zero has a huge bulge in its multiplier.

If you compare stock valuations against the 10-year riskless Treasury note, the equity risk premium is still very high by any historical measure. Why? Because the Treasury interest rate is so low.

If you try to compare the equity risk premium against what you believe to be the normalized 10-year Treasury interest rate, you still get a fairly reasonable equity risk premium.

The math is straight forward….”

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