Is the Stock Market Too Expensive?
Asked another way: Do stock market valuations matter?
Yes.
And no.
Well, it depends.
Now that we are clear on that, what are we talking about here? Investors tend to draw conclusions about the stock market based on the current level relative to where it has been in the past and on relative valuation metrics such as a price-to-earnings (P/E) ratio. What sort of information can be gleaned from this and does it even matter?
Highlights:
- The scariness of all-time highs
- How to value the market
- Timing based on valuation
All-time Highs
A common (and recently persistent) objection I receive when discussing the investment of money currently in cash is the proximity of the market to all-time highs. As in, do we really want to be buying at these high prices? The objection is understandable – nobody wants to feel like the sucker that bought at the very top. The problem is that for every top there are many more all-time highs so avoiding the pain of buying the top causes people to miss out on the market steadily marching upwards. For example, as you can see in the chart below from S&P, there have been a whopping 313 all-time highs made since 2013. At every one of these, there was a reason to worry that sounded very smart at the time.
There exists a somewhat misguided notion that stock markets obey physics and “what goes up must come down.” Sorry, that is just plain incorrect. Stocks go up as a result of human innovation and progress that translates into corporate profits – Newton’s law of gravity does not apply here. This isn’t to say that stocks will continue to rise indefinitely. For example, also illustrated in the chart is the 12-year period where stocks (specifically, the S&P 500) produced a measly nine all-time highs, right before the biggest crash of many of our lifetimes. Luckily, the S&P 500 is not the only game in town and proper diversification and monitoring can alleviate the pain of these stretches of time.
The great investor Peter Lynch once said, “Far more money has been lost preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.” Think about the investor in 2013 who wanted to wait until things cooled off because the market was at all-time highs.
So what’s an investor to do if still wary about the level of the market? Dollar cost averaging is a process of systematically investing a flat amount on a regular cadence to mitigate the risk of market timing. Most people are inherently familiar with this due to their regular contributions to their retirement plans from payroll deductions. If you are sitting on a big pile of cash from an inheritance, a lottery win (congrats), or from selling out of the market, consider implementing this strategy to get the money back to work. The math says you have a higher probability of success putting it all in at once, but regret aversion is a powerful force so this is the next best option.
Valuations
Now that we have covered absolute levels, what about relative metrics like the P/E ratio we mentioned earlier? We will first cover techniques for valuing the market and then look to answer the question of whether or not they matter.
Let me start by saying there is not a best way to value the market. Probably the most commonly referenced is the P/E ratio which represents the price paid by an investor for every dollar of a company’s earnings. For example, a P/E ratio of 40 means that investors are currently paying $40 for every $1 of earnings of that company or, in the case of the S&P 500, a combined amount based on the index’s constituents. As previously mentioned, P/E is the most popular, but it is far from the only way to value a company or market. All ratios typically have price in the numerator and a figure from the company’s financial statement in the denominator (Price-to-Sales, Price-to-Free Cash Flow, Price-to-Book Value, etc.). No matter which metric is used, the idea is the same: how much is being paid relative to the fundamental business value of the company?
How expensive is the market now? The chart below from J.P. Morgan has the answer:
First reaction? Wow, that’s really high! Last time we saw this level was in 1999, right before the market crashed. We will get into using valuations as a timing mechanism in the next section, but for now let’s answer the question at the beginning of this blog: do valuations matter? Yes, absolutely. It is a mathematical truth that the higher price paid for something lowers the future expected return. If you buy a stock at $11 that was previously at $10, the 10% return was recognized by the person who sold you that stock, not you.
From a relative standpoint, Jim O’Shaughnessy has an entire book devoted to this subject called “What Works on Wall Street”. There are chapters devoted to different valuation metrics and the lesson is clear: the higher the ratio, the lower the probability of success in the long run. That last part is key – sometimes it takes years for markets to “normalize.”
A quick aside about normal markets. What represents normal in regards to things like volatility and P/E ratios? Is it the historical average of things? Are we to believe that today’s market and industries should be compared to averages incorporating nearly a century of data? I believe today’s market is fundamentally different. Whereas in the past there existed frictions to invest in the stock market like high brokerage commissions, virtually none of those frictions exist today. However, this is a debate for another time.
Timing Based on Valuations
This is where I get into my “no” response to the question of valuations mattering. If you are trying to time the market based on valuation, my simple response is: don’t. Markets can correct through time or price. I will say that again because it is so important: markets can correct through time or price. What looks like an expensive market can move sideways while the fundamentals catch up - or the fundamentals can catch up as the market continues to grind higher. There does not always have to be a bear market to reset valuation levels back to that elusive normal level. The time spent on the sidelines can be costly from an opportunity cost standpoint (remember that quote from Mr. Lynch?). Additionally, what if current levels are what will be viewed as normal in the future? Simply put, valuations are a very blunt instrument with which to time the markets. Selling or sitting on the sidelines because of a high P/E is not something I would recommend.
Conclusion
It is easy to turn on the business news channel and get fed a multitude of reasons why the market is too high (Tip: turn it off). When it comes to your portfolio, there are three things you need to worry about: saving, diversification, and compounding. The more you save, the higher your probability of success, regardless of the market environment. Diversification helps you avoid having all your eggs in one basket. Albert Einstein reportedly said, “compound interest is the eighth wonder of the world. He who understand it, earns it. He who doesn’t, pays it.” Micro-managing a portfolio satisfies the urge to do something to protect our money, but counterintuitively, we risk missing out on the long-term effects of compounding.
Author: David Rath, CFA
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