Is The Stock Market Overvalued? (2017)

Is The Stock Market Overvalued? (2017)

How overvalued is the market? Everybody seems to want to know. Whilst the overall market valuation isn’t of primary concern for a value investor, it will test our decision-making if the market dropped by 50%. Remember, undervalued stocks can still lose 70%. Therefore it would be dangerous of me to sit here and preach that you should not care if the market falls because I haven’t experienced such a drop yet.

People are fretting about the S&P500, Dow Jones & FTSE valuations everywhere so here’s my take!

Is the S&P 500 overvalued by historical standards?

By Robert Schiller’s CAPE ratio calculations – absolutely. Is that a worry? absolutely not.

What is the CAPE ratio? It stands for cyclically adjusted Price to Earnings ratio also known as the Schiller PE or P/E 10.

Prof. Robert Schiller of Yale University invented the Schiller P/E to measure the market’s valuation at any given point in time.

The Schiller P/E is a more reasonable market valuation indicator than a P/E ratio alone because it eliminates fluctuations of the ratio caused by the variation of profit margins during business cycles. Essentially it looks back at profits for the last 10 years. Read more about the P/E 10 here.

 As you can see in the graph below, as of today the CAPE ratio for the S&P is at 30.7 times. It’s only been higher twice before – 1929 and 1999.. so you can see why alarm bells are ringing.
CAPE overvalued in USA

Is the FTSE 100 overvalued by historical standards?

The FTSE is fairly valued and has a CAPE ratio of 16. John Kingham from UK Value Investor built the below graph. You can read his analysis here. I’m going to be a contrarian now and intellectually speculate that the S&P 500 is fairly valued and the FTSE 100 is therefore a bargain.

Why would I speculate that? Because I think Robert Schiller is wrong this time.

FTSE 100 fair value 2017 07 v3

Could Prof. Robert Schiller be wrong?

I read about the CAPE ratio in Schiller’s 2014 revised edition book, Irrational exuberance.  It’s a fantastic read because it makes a lot of sense and his arguments on bubbles and investor psychology are spot on – if only people listened to him in 1999 & 2005!

Schiller released the latest edition presumably because he expected/expects another crash soon. He spells out the reasons why we will see another crash and I don’t wholly disagree but there is one large oversight – interest rates.

CAPE ratio weaknesses

The issue with CAPE analysis in today’s world is its oversight of interest rates which leads me to think that we are ripe to see a melt up similar to 1999 when everyone realises (intellectually or not) that the markets are acting differently this time – and for good reason.

Investors and professional analysts use discounted cash flows and NPV analysis to price assets and many of the hurdle rates have fallen due to the lower risk free premiums (10-30 year bond rates). Many asset prices are therefore historically higher than usual for that reason.

Look at the options you as an investor have:

  1. Leave your money in a bank and receive 0.25% interest rate.
  2. Purchase short-term UK bonds for 2.26% return.
  3. Buy long-term USA bonds for 2.76% return.
  4. Bet on Iraqi bonds for 6.25%. Yes this is real (scary)!
  5. Property offers an average yield of between 4% (in London) to 7%.
  6. Buy stocks for an average yield of 3-7%

As time has gone on and interest rates remain low the higher risk yield premiums have been falling because investors are chasing the yields.

The FED model

On the other hand, valuation measures that adjust for inflation and interest rates, both of which are near record lows, suggest that the S&P isn’t overvalued – it is fairly valued. Stocks are mostly in the Goldilocks range: Not too cold, and not too hot. Goldilocks is pretty happy.

I read Dr. Ed Yardeni’s blog which might be a new area of interest for you because he follows this line of thinking – it’s called the FED model.

This is why Buffett says stocks are relatively cheap! He values businesses using DCF analysis and uses 30 year bond yields as the discount rate for his asset purchases to set a benchmark.

Let me demonstrate with a simple DCF:

Present Value of Cash Flow in Year N = CF at Year N / (1 + R)^N

CF = Cash Flow

R = Required Return (Discount Rate)

N = Number of Years in the Future

Suppose we have a £1,000 cash flow five years in the future with a 7% rate of return. The present value of that cash flow is:

£1,000 / (1 + .07)^5 = £712.99

You wouldn’t be willing to pay more than £713 today for £1000 in 5 years otherwise you will lose money in real terms after you deduct your required rate of return.

Low-interest rates has forced investors to naturally reduce their R or required rate of return. Now look at the PV if we reduce it to the S&P 500’s current CAPE ratio return of 3.33%.

£1000 / (1 + .0333)^5 = £849.92

I would now be willing to pay up to £850 today for £1000 in 5 years. 20% more than before!

Ray Dalio’s Market View

Like Schiller, Ray Dalio also predicted the crashes and actually made money in 2008! I like him because he takes the FED model into consideration. This was his latest view in May 2017.

Big picture, the near term looks good and the longer term looks scary. That is because:

  1. The economy is now at or near its best, and we see no major economic risks on the horizon for the next year or two,
  2. There are significant long-term problems (e.g., high debt and non-debt obligations, limited abilities by central banks to stimulate, etc.) that are likely to create a squeeze,
  3. Social and political conflicts are near their worst for the last number of decades, and
  4. Conflicts get worse when economies worsen.

So while we have no near-term economic worries for the economy as a whole, we worry about what these conflicts will become like when the economy has its next downturn.

You can read his full Linkedin post here and he’s worth following on Linkedin too. I’ve also linked one of his videos at the bottom of the page which really helps you consolidate your understanding on the subject and the economy as a whole – if you are wondering where we sit on that timeline it’s 1937 according to Dalio.

A warning from History

The obvious issue here is what will happen as low inflation and low-interest rates come to an end? That is where Schiller’s CAPE comes in handy because we all know where the normalisation of asset prices sit if they do increase. The conundrum is not how expensive the market is but when will things normalise?

We only have to look at Japan who has fixed rates for 10 years to know that it might be a long way off. Therefore we shouldn’t speculate that it’ll be December, next year or 10 years from now.

How do we invest in today’s market?

My opinion is to keep investing in the stock markets regardless of the current CAPE and justify asset prices on the basis of their individual fundamental analysis. If the asset is below fair value in the US with a discount rate of 8-12% then why wouldn’t you buy it? Just look at how that price action moves as you reduce the discount rate to 4-7% which may technically happen if this extraordinary situation continues.

Admittedly I don’t condone low rates but I really think that we should take this into consideration in our portfolio allocations going forward. We may miss opportunities if we hold back. I think the FTSE is very cheap and I wouldn’t be surprised to see it become as overvalued as the S&P500 based on historical standards in the next few years all things equal.

It’s important to keep eyes wide open and allocate capital appropriately. Keep calm and carry on – our opportunity is where the worry is. Ensure you have cash to deploy if things do go belly up.

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