A Strong Rally

Equity markets have enjoyed a strong rally off the low base that was set in the early part of this year. In the case of the US market, for instance, the S&P500 Index has risen more than 55 percent since the low reached in the first quarter of 2009. In a similar vein, the Johannesburg Stock Exchange’s (JSE) All Share Index (ALSI) is up just over 35 percent since March.

Importantly, these instances are not exceptions: since March developed markets have gained about 65 percent, whilst emerging market equities, measured by the MSCI Emerging Markets Index, have almost doubled.

This dramatic recovery in equity prices poses the critical question: “Are equity markets still attractively priced?”

One way to answer this question is to use the market’s price-earnings ratio as a guide. Taking the case of the US, the S&P500 is trading on a trailing price-earnings ratio of 120 times, which is more than six times the market’s long-term average of 18. This figure is exceptionally demanding, and suggests that equities in the world’s largest stock market are very expensive. That said, it is essential to recognise that the price-earnings measure has two elements to it, namely the numerator, price, and the denominator, earnings. And on this front, whilst the price recovery noted above explains some part of the stretched price-earnings ratio, earnings over the past 20 months have collapsed (to 75% below their peak level). Thus, the demanding rating is as much a consequence of lower earnings as it is a result of higher stock prices.


This last point is a key consideration, because relying on a single year’s earnings to assess investment merit is fraught with danger. The reason for this is earnings are temporal and cyclical, often highly so as has been the case of the past year. Similarly, earnings in the middle years of this decade were extremely inflated, which using single year earnings made stock valuations appear cheap, while the market overlooked the unsustainably high levels of earnings.

For this reason, it makes greater sense to use a number of years’ earnings when assessing the price-earnings ratio for a company or a market. As long ago as the 1930s, Benjamin Graham and David Dodd argued in favour of using between seven and ten years of earnings data to arrive at a normalised earnings figure for a company or a market. In turn, Graham and Dodd argued, by using normalised earnings, investors afforded themselves some protection from reading too much into recent events, such as a collapse or ballooning in prior year’s earnings. Thus, the Graham and Dodd price-earnings ratio, (which in recent years has come to be known by some as the Shiller ratio, after Robert Shiller of Irrational Exuberance fame), is a more sober measure of the attractiveness of equities.


Returning to the question, then, using the Graham and Dodd price-earnings tool, it is evident that the S&P500 is expensive, but not nearly as expensive as suggested by the one-year price-earnings ratio. To be more exact, the 10-year price-earnings ratio for the US stock market is 18.7 times. This is slightly higher than the historical norm of 16.3 times. As shown in Figure 1, the US equity market is neither extraordinarily expensive nor extraordinarily cheap, despite the growling of some noted bears.

Source: Cannon Asset Managers (2009), data from Shiller adapted from The Pragmatic Capitalist

Value aside, what is more interesting in this data is not the exact price, but the action surrounding overshoots and undershoots. In each of the instances where the S&P500 approached an extreme overshoot of, say 20 or 25 times ten-year earnings, the market undershot over the course of the following five years, falling to a price-earnings ratio of between 5 and 10 times. This over-reaction on the upside and downside will be unsurprising to disciples of value investing.

To demonstrate the extent and implication of over-reaction, Figure 2 shows the deviation of the Graham and Dodd price-earnings ratio, measured in terms of the percentage move above or below the long-term average.

Source: Cannon Asset Managers (2009), data from Shiller adapted from The Pragmatic Capitalist

Notwithstanding the one-year price-earnings ratio of 120 times, adopting a longer-term investment perspective, it appears that the world’s largest equity market is not overly expensive or inexpensive. Yet, it is interesting to note that the S&P500 has not collapsed to the downside despite the largest overshoot in the history of the market. This suggests that there is much more work to be done on the downside as price-earnings ratios contract and the US equity market digests the excesses of the last decade.


Repeating the above analysis in the case of the JSE, the current one-year trailing price-earnings ratio measures 14.5 times. This represents a sharp increase from the recent low of 8.4 times that was recorded in March, and the rise is a result of the combined forces of price gains and falling earnings. To be more exact, the market’s earnings fell a little over 25 percent over the past eight months, whilst prices have risen 35 percent. In any event, whilst the JSE’s one-year price-earnings ratio of 14.5 appears extremely cheap compared to the S&P 500’s ratio of 120 times, the figure is above the domestic market’s long-term average of 13.0 times one-year earnings.

By using the Graham and Dodd price-earnings ratio to strip away the noise of the past year, it becomes apparent that despite the strong recovery in domestic equity prices, the domestic stock market continues to hold investment merit. As shown in Figure 3, the ALSI currently trades on a Graham and Dodd price-earnings ratio of 14.4 times. This is modestly below the long-term average of 16.5 times (since 1980).

Source: Cannon Asset Managers (2009)

Putting valuation aside for a moment, it is evident from Figure 4 that the JSE exhibits the same pattern of mean reversion. That is, expensive markets collapse to become cheap, whilst cheap markets, with strong momentum behind them, rise to become expensive.

Source: Cannon Asset Managers (2009)

It also is clear from Figure 4 that the JSE has experienced the type of correction that still is absent from the US market. Read against this backdrop, and notwithstanding the strong price recovery seen since March, the Graham and Dodd toolkit suggests that the JSE continues to display value.