Stock Market Valuation

It is conference season, which means we’ve been on the road lately meeting with fund companies and hearing about their latest research.

One point that virtually everyone is making these days is that traditional asset classes (stocks and bonds) are richly valued, and likely won’t generate the same level of returns in the future that we have experienced historically.  The punchline at most of the conferences is that investors will need to seek out other asset classes, beyond stocks and bonds, in order to meet their return objectives.  We agree with that to some degree, and we have indeed incorporated various “alternative” investments into our portfolios.

However, let’s turn to the issue of valuation, particularly in the stock market.  It is true that stocks trade at lofty levels by many metrics, but we’re not sure we agree with a lot of the pronouncements in the media that we’re on the eve of another major downturn.  Certainly, that conclusion cannot be reached by stock market valuation alone.

As an example, many articles have been written recently about the CAPE ratio, its predictive powers, and what it is telling us today.  The CAPE ratio was developed by Nobel Prize winner and Yale economics professor Robert Shiller.  CAPE stands for cyclically adjusted price/earnings ratio.  It simply takes today’s price and divides by the average earnings over the past ten years.  Rather than measuring valuation at a particular point in time when earnings may be skewed one way or the other, the CAPE ratio tries to smooth out short-term influences.

There are a lot of important academic achievements in the world of finance, but most of them never make the headlines.  The reason the CAPE ratio has become so famous is that Robert Shiller has used it to predict bubbles in the stock market previously.  He accurately called the technology bubble and the real estate bubble in 2007.  The fact that he is now a Nobel Laureate doesn’t hurt his credibility either.

Today, the CAPE ratio has the third highest reading ever, and the data goes back to 1871.  The previous higher readings were in 1929, just before the great depression, and in early 2000, just before the dot com bubble burst. The natural inclination then is to assume another damaging crash must be just around the corner.

The problem with that assumption is that valuation has been a poor market timing tool.  That is, even when valuations have been quite high, the market does not necessarily respond.  For example, I was working on Wall Street in 1996 when the stock market’s price/earnings ratio was quite high.  Many of the more seasoned analysts and strategists were recommending that investors sell out of the market.  However, the stock market continued to rise for the next four years, earning returns of over 20% each year.  The market did decline in 2000, but even at its lowest, it never went down to the levels in 1996.  So, what seemed like a forecast based on prudent analysis actually turned out to be a money-losing call.

While valuation has been somewhat indicative of future returns, the relationship is not as precise as one might like.  Historically, when stock market valuations were at the low end, prospective ten-year returns have been fairly high.  Conversely, high valuations historically have led to lower future returns.  However, that hasn’t always been the case, and even when high valuations do lead to lower long-term future returns, it can take years to play out (as in 1996).

Another problem with the thesis that a market crash is just around the corner is that not all valuation metrics are in agreement.  Other valuation indicators, such as dividend yield or price-to-book value, show that the stock market is roughly in-line with its levels of the past 25 years.

Even Shiller’s CAPE ratio is open to debate.  Another academic, Wharton professor Jeremy Siegel wrote a paper a year or so ago that showed the CAPE ratio is likely over-stated today versus its historic readings.  This has to do with the way corporate earnings have been calculated, and how that calculation has changed over time.  Jeremy Siegel’s work shows that if a more consistent measure of earnings is used in the CAPE ratio, the reading is nowhere near as high as Robert Shiller suggests.  I should note that even using the adjusted numbers, the CAPE is still higher than it has been historical, just not in the ridiculously overvalued range.

Where does this leave us?  Unfortunately, none the wiser.  No one has ever come up with a reliable method of timing the market.  It may make sense to diversify into other asset classes, but getting out of stocks certainly is not a good idea for long-term investors.  Interestingly, even Robert Shiller agrees.  In a CNBC interview in February, he said “My general thought is that I think it’s quite reasonable to have an investment in U.S. stocks as part of a diversified portfolio. Just don’t go overboard on it.”

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