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Is the Stock Market Overvalued?

The price you pay to buy stocks largely determines the future returns you will receive. If you pay more than the true (intrinsic) value of the companies, you over-pay, resulting in poor future returns. If you pay less than the true value, you get a bargain, potentially increasing your future returns.

How do you know if you are buying stocks at bargain, premium, or fair prices? Just because the market had a 10% correction, does that automatically mean you are getting bargain prices?

Investors have been reading about the market being overvalued for years. Of course, the tacit assumption is that the stock market is poised for a big “drop”. While there are many valuation metrics, the most popular is the CAPE Ratio popularized by Robert Shiller (also known as the Shiller P/E Ratio). A P/E Ratio determines the price (P) investors are willing to pay for earnings (E).  When P/E ratios are high, the stock market is considered overvalued (as prices are expected to decline to get the P/E back to average). The long-term average of the CAPE Ratio for large U.S. companies has been 17. However, the current CAPE Ratio is about 32 (the top quintile). Most academics consider a CAPE Ratio of 20+ to be overvalued - however, there is much debate over this.

There are other valuation methods, many of which also point to the U.S. stock market being overvalued. This makes sense given the huge outperformance of U.S. stocks over the last five years. If stock prices rise without the full backing of solid fundamentals (e.g., earnings), valuations increase. This typically occurs when investors bid up prices due to their excitement over the future. So, assuming we are buying now at a premium, what might our future returns look like?

Should I Sell or Try to Time This?
Armed with this newfound valuation information, do you conclude “stocks are overvalued” and begin to dump your stock holdings in order to buy them back at lower prices in the future?

Trying to move in and out of stocks is unlikely a winning strategy as you would need to perfectly time your moves in and out of the market (over and over) to actually benefit. This is easy to grasp with an example.

An Eye Opening Example
Take a look at the table at the bottom of the page which shows actual returns over the ten-year period from October 1998 through October 2008.  Note the 10-year compounded annual growth rate amounted to 3.1%. Let’s assume at the beginning of this period you decide to sell all of your stocks since the CAPE P/E was well over 30. After the first year, you end up missing out on a return of 28%. How do you feel? Then the second year, you miss out on a return of 13%. Are you kicking yourself? At what point do you “crack” and buy back in? Two years of envy is more than any human investor can stand! If you did crack and buy back in, you would not only have missed the gains of the prior two years, but jumped back in just prior to a 12-month drop of 27%, then another 12-month 20% drop! Now how do you feel about using valuations to time the stock market?

As you can see, even if you knew the market would provide low 10-year returns, the ordering of returns varies dramatically each year - even over a 10-year low return period – thus making it a maddening endeavor to attempt to time these swings in returns.

Valuations are indeed a major factor in 10-15 year stock returns, so people desperately want to use them to predict short-term stock returns. They can’t!

Is the U.S. Stock Market Overvalued?
The U.S. stock market may be overvalued when compared to historical valuation data. This is something we should expect after one of the biggest bull market runs in history and in our ninth year of an economic expansion.

Valuations have dropped a bit in the last few months, not due to a correction, but due to higher earning estimates. Projected corporate earnings have increased due to analyst’s recognition of the positive effects on earnings as a result of the tax cuts. Adjustments in expected earnings (the E in P/E) will lower the CAPE Ratio.

Even if many experts agree that the U.S. stock market is overvalued, this does not mean you will have success in using this information to outperform the stock market. When you read about high stock valuations, resist the urge to react because you feel the market is overvalued and poised for a drop.

If you are a long-term investor, enjoy the recent returns, curb your expectations for the future, stay globally diversified, and let your advisor take valuations into account when designing your asset allocation.

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