Monday, May 11, 2009

Is the TSX Fairly Valued?

Canada's stock market has been on somewhat of a roll lately, rising about 35% to 10,238 from a 2009 low of 7,566. In this post I'm going to attempt something fairly pointless - trying to figure out whether the TSX/S&P is overvalued, undervalued, or valued about right.

A common methodology used to make broad stock market calls involves assigning a multiple to a forward estimate of TSX earnings. TSX composite earnings as of December 2008 were about $830 and the forecast range for corporate earnings for 2009 is a decline of between 15%-31%, suggesting a 12 month forward estimate for 2009 of between $575-$699. The former seems much more likely to me.

What is the right multiple? Hard to say. Earnings multiples tend to get compressed in recessions before increasing as the economy recovers and investors regain confidence in equities. The TSX is currently trading at around 12x current earnings, which is similar to multiples observed in the beginnings of previous recessions.

The average TSX P/E ratio since 1956 is about 20x. Applying this long-run average P/E to the range of forward earnings estimates gives a market valuation at the end of 2009 of between 11,484 and 13,980 which implies that the market is currently between 11% and 27% undervalued.

I'm more sympathetic to the low-end of the corporate earnings forecasts so i'll conclude with a market call of 11,400-11,500 by the end of 2009.


Stephen Gordon said...

Forecasting a stock market index?!?

You are a brave, brave man.

Nick Rowe said...

You have become a lot more optimistic since your 2 January 2009 forecast of TSX: 8780 by year-end ;).

I keep getting reminded of the equity premium puzzle though. A P/E of 20 means a 5% real interest rate, so about 7% nominal, at 2% inflation. Plus capital gains and stock dividends are taxed lower than other interest income (except paying down your home mortgage, which is a tax free investment).

Shock Minus Control said...

Stephen - Thanks, if I'm way off, I'll blame the unpredictability of markets, If I'm right, I shall declare myself a genius prognosticator.

Nick - My expectations at the time must have been overly influenced by my RRSP balance. (actually, I think I took the market value at the time and lopped off 5%, highly scientific).

I had originally attacked the post thinking that I would decompose the PE into its component parts (dividend and earnings growth, real rates and the equity premium) but decided instead to look at averages through time, primarily because it was easy and since this is all guesswork, a more efficient allocation of my resources (time and energy).

It was particularly interesting to see how the market reprices earnings coming out of a recession, the PE expands quite quickly - I would guess the same pattern will follow the current recession, unless extreme risk aversion prevails.