Something to consider.

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A Better Way to Think About Stock Prices

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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Traders returning to their desks after the long holiday weekend will be greeted by the continuing Greek saga, a guessing game about when the Federal Reserve will raise rates and a megamerger in the cable industry. But the debate I am much more interested in is the one taking place about U.S. stock valuations. It is more significant, and not as well understood as those other discussions.

The bears have been saying for some time now that stocks are at best fully valued, meaning there isn't much room for gains after equities more than tripled from their March 2009 lows. The ursine argument is that low future returns are a given, and an ugly crash is the worst-case scenario.

The bulls argue that ultralow inflation allows for higher valuation metrics based on price-earnings ratios or Shiller's CAPE (cyclically adjusted P/E). Compared with all historic medians, these measures are rather high. But compared with similar eras of very low rates and very low inflation, they are quite reasonable.

Meanwhile, the market keeps meandering along, occasionally reaching new highs.

I want to suggest another framework for evaluating the market's prospects. It involves future earnings growth and a range of possible outcomes. Some may find this approach to be unsatisfactory, for it is dependent upon future events that are both unknown and unpredictable. 

Have a look at the table above: It comes from Bank of America Merrill Lynch equity and quant strategist, Savita Subramanian. I have found that many investors focus on the implied 10-year annualized returns, rather than upon the range embodied by the 90 percent confidence interval.

Placing emphasis on specific expected returns embeds an assumed prediction about future earnings. But there are too many variables that affect future corporate profitability to make a specific guess with a high degree of confidence. Hence, many valuation arguments with an embedded forecast are usually binary in their outcome. The guess is either right or wrong; the correlated investment posture is either a winner or a loser.

Focusing on a range allows us to recognize that several factors remain unknown at present. These are crucial in determining future equity valuations.  

Consider these variables:

-- Will the U.S. economy slip into a recession? Begin to accelerate from its long slow recovery from the financial crisis? Or will it keep muddling along?

-- New unemployment claims are at lows not seen in a generation. Will this create wage pressure?

-- If wages rise, will consumers save or spend their pay increases?

-- Will companies expand their modest capital expenditure budgets? Will research and development spending increase?

-- Are corporate sales going to accelerate anytime soon? 

-- Will corporate profits be hurt by increased capital expenditure and wage increases? Or will a virtuous cycle raise profits?

Each of the above unknowns has the potential to affect U.S. equity valuations. This is why a range of possible outcomes is a better way to think about valuations than declaring stocks cheap, expensive or fairly valued.

Hence, when we consider valuation metrics, we should be aware that many of us build a forecast into those ratios. We don’t know what future earnings will be in 2016 or the year after, and merely extrapolating a number from present levels is at best guesswork.

To clarify, I am not suggesting stocks are especially cheap here or that equities must go up. Rather, I am emphasizing that since we have only limited ability to estimate future earnings, the reliance on valuation metrics such as P/E ratios should recognize the likely range of outcomes.

Stocks, like the Fed, are data-dependent. It is a shame we don’t hear that admission from more market participants.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net