The US Stock Market Is Overvalued
“The stock market is overvalued!”
That’s the concern I repeatedly hear from my clients. They say they want their investments to profit from the market’s ascent, but fear we are overdue for an inevitable correction.
Market Valuation Is Not that Simple
Any time it seems the market cannot be stopped – as though the sky’s the limit on its valuation – two demons appear on investors’ shoulders. Greed screams at us to invest as much as possible into the market, so we don’t miss this opportunity. Fear, on the other hand, demands we exit altogether in preparation of a cyclical downturn.
Neither is an angel.
A colleague of mine used to fake his way through investment conversations by playing to these demons. Specifically, I remember overhearing conversations with prospective clients in early 2014. They would ask his thoughts about the market. He knew nothing about investments – sometimes even less than they did. He knew the market had gone up substantially in 2013 (as most of the prospects were well aware). He would pontificate as to his “cautious approach, considering the market’s recent dramatic incline.”
That satisfied most clients. It’s what they wanted to hear. They were eager to get in on more gains, but deep down, they were concerned. The rep appeared savvy and disciplined.
Were his observations sage wisdom or cliché drivel? Knowing him personally, it was the latter.
Yet it worked with clients, every time. Why? Consider a roulette table in a casino. When the ball lands on black many times in a row, gamblers are more inclined to bet red than black, as if the odds are now stacked for the ball landing on red. The longer the black series, the more this becomes true. Casinos often acknowledge this irrational behavior by posting the results of the last eight or so spins. If seven or eight of those were black, they know more people will bet red (instead of the more typical and logical 50/50 red/black split).
In reality, however, the odds never changed. Past results have no bearing on the next spin.
This logic applies to financial markets, as well. The fact the market went up (or down) by a lot yesterday (or last week, last month, or last year) should have no bearing on its performance today.
Financial markets are more complex
Additionally, there is much more to a financial market than the random outcome of a spun wheel.
- Thousands of companies making hundreds of thousands of decisions
- Dramatic and unexpected shifts in domestic and international economic variables
- Political decisions of countries all around the world
- Irrational and emotional decisions of every market investor
It's a lot to track.
If you don’t know what to watch for, or have the time or means to do it, you can at least rest assured that a market climbing for a long time is in no way an indicator of things to come. Nor is a steadily declining market, for that matter. There are plenty of factors that could justify 5, 10, 15 years or more of steady growth or decline.
How, Then, Can You Know?
Cyclically adjusted price-to-earnings ratio
Of course, there is no way to predict when a dramatic market move will take place in the future.
There is, however, one measurement that stands out among the rest: the Cyclically Adjusted Price-to-Earnings (CAPE) ratio.
What does it mean?
The Price-to-Earnings (PE) ratio tells an investor how much he or she will pay for each dollar of a company’s earnings. For example, if a company’s price per share is $40 and it earns $2 per share, it has a PE ratio of 20 (P/E = 40/2 = 20). It is a quick, commonly-used method for assessing companies.
When used for the S&P 500 index, it compares the price of the entire index to the collective earnings of the 500 component companies.
The CAPE ratio was popularized by Nobel-Prize winning author of Irrational Exuberance, Robert Shiller; appropriately, it is also called the Shiller PE. It takes the calculation an important step beyond basic PE. It uses the average earnings from the last ten years to calculate the ratio (instead of the typical 12 months). This has a smoothing effect, and has been a remarkably accurate indicator of bubble-like activity in the past.
A high value might suggest we are paying too much for the market in its current state. A low value might indicate the market as a whole is undervalued.
The consequence of an elevated CAPE
Since the denominator of this equation is a 10-year average, it’s the numerator – the current price – that is the more significant driver of the rapid ups and downs, or booms and busts. The chart below illustrates the CAPE ratio of the S&P 500 for every month since January, 1881 (labeled 1881.01). I have also included a reference line (red) at today’s level.
Notice we have surpassed the levels of the 2008 Great Recession. Only two periods boasted greater CAPE ratios: the Crash of 1929 (but only by a little, at 32) and the Tech Bubble of 2000 (44).
Only two periods boasted greater CAPE ratios: 1929 and 2000
An alarming hypothetical: what if the CAPE retreated to normal levels?
For the S&P 500 CAPE ratio to come down to normal levels, one of two things will have to happen:
- Earnings will have to go up a lot, without also driving up the price of the market.
- The price (the S&P 500 itself) will have to drop substantially.
For example, if the value of the S&P 500 fell from its current level (roughly 2350) to 1320, the Shiller PE would rest at 16.5, still slightly above the historical average. This would represent a fall of 44% for the index.
If the CAPE ratio of the index were to drop to a typical historically low level of around 10 (by no means the all-time low of around 5), its price would have to fall from 2350 to 800 – a 66% drop.
Don’t get me wrong – I don’t anticipate this happening.
Whether 800 would represent the actual value of the S&P 500 is beside the point. The trouble is, investors have no interest in facing reality; it would cost them dearly.
Those “in charge” – the Fed, Congress, the Oval Office – have even more to lose: face. Nobody wants the political stain that would come with this much-needed market correction. Investors might not understand. They would definitely seek someone to blame.
Nobody wants the political stain that would come with a much-needed market correction
To avoid that stigma, the “powers that be” will inevitably derive some new machination to prop up the system yet again. Perhaps this time around, the Fed will obtain permission from Congress to purchase stocks themselves.
A government entity purchasing corporate shares to boost a falling market intentionally. Sound crazy? Sound like manipulation?
Other countries do it…
…isn’t that enough to prove we can, too? Janet Yellen, the Chairwoman of the Fed, seems to think so.
Sound terrifying and unsustainable?
What Can You Do About It?
Is the market overvalued?
Sure, most likely.
Does that mean its value will decline to a reasonable level any time soon?
Unfortunately, it does not.
There are too many factors beyond straightforward, practical valuations driving today’s markets: the investment herd’s greed (“irrational exuberance”), the Fed, foreign central banks, etc. Even if you could correctly identify its overvaluation, acting on that wisdom (by exiting or shorting the market) could prove just as devastating as staying in (a subject we’ll explore in greater detail next week).
The real problem
Traditional investment paradigm instructs investors to allocate a disproportionate amount of their savings to the United States stock market.
When the inevitable correction happens – whether it’s a 25% decline or a 50% decline, and whether it occurs in five years or five months – the average investor will be disproportionately harmed. This would represent a devastating and potentially ruinous reality for baby boomers preparing for or entering retirement.
Investors should adopt an enhanced diversification. The traditional massive stock allocation within a portfolio will not serve the average investor well in these turbulent times.
As I said in my previous post on the subject:
The US stock market is not your only, nor should it be your primary, investment option. It should be one of many. Other viable diversification vehicles include (but are not limited to):
- International markets (stock, bond, etc.)
- Physical real estate (domestic and international)
- Entirely uncorrelated alternative strategies (managed futures, market neutral, etc.)
(But since this is a blog and not a book, we will explore them all in detail in future posts.)
My goal is to help investors question these potentially damaging mainstream investment dogmas – to be unsatisfied, non-complacent, and ask questions of themselves, their advisors, and the pundits to whom they listen.
Knowing the stock market is overvalued is not a “sell signal.” That knowledge should, however, reinforce the need for a more enhanced portfolio diversification.
Don’t settle for 60/40!
Knowing the stock market is overvalued should reinforce the need for enhanced diversification
Let me know your thoughts
- Do you think the stock market is fairly valued? Please explain.
- What strategies have you implemented to diversify your portfolio better?