July 2014: Is the Stock Market Overpriced, Fairly Valued, or Cheap?

 

The stock market has reached record high levels this year.  Has it become overpriced?  Or, is it fairly valued—or even undervalued?  More importantly, is this a good time to be heavily invested in stock investments, or is this a good time to lighten up on stock investments? 

Measuring Valuations

There are a host of metrics to assess stock market valuations.  Based on those findings, it is best to increase your stock holdings when stocks are cheap (buy low) and reduce your stock exposure when valuations are high (sell high).  Although none of these metrics are definitive, and none can predict the very near-term direction of the stock market, they offer valuable insights to guide a prudent investor.  Sure, anything can happen, but sensible investors know it is a dangerous proposition to ignore history, hoping to buck the odds when those odds are stacked against you.  

Historically, it has repeatedly been observed that richly priced markets, like now, have provided poor returns in the following years, although not necessarily starting right away.  Keep in mind that an overpriced market, regardless of how overpriced, can rise even higher before correcting.  (Conversely, underpriced markets can go even lower before heading higher.)

Risk-Return Tradeoff

Riding the upward momentum of an already overpriced stock market, hoping to squeeze out a bit more profit, is similar to a car racing a train to a railroad crossing to save a little time.  The consequences of being unsuccessful are disastrous and far outweigh the minimal benefits of crossing the tracks without incident.  That’s a very poor risk-return tradeoff: a small potential upside coupled with a huge potential downside.

Current Valuations

Two of the most reliable, broad measures of stock market value were discussed in our last two Commentaries:

1. Market Capitalization to GDP (January 2014 Commentary). This tool shows the relative price of the total value of the stock market (total stock market capitalization) compared to the amount of goods and services produced in the economy (Gross Domestic Product, or “GDP”).  In 2001, Warren Buffett referred to this ratio as “probably the best single measure of where valuations stand at any given moment.” At the beginning of the year this ratio stood at 1.25 compared to a median of just 0.65.  It is currently 1.27. This indicates the stock market could decline about 50% from today’s levels to get back to an average valuation.

2. Shiller Cyclically Adjusted Price/Earnings Ratio (April 2014 Commentary). This tool provides an historically sound indication of likely future returns based on current stock market valuations. When the ratio is low, future returns are high; when the ratio is high, future returns are low.  The historical average of this ratio is about 16. In the past 130 years of stock market history, a ratio of 21 or higher marks the top 10% of historical valuations. It is currently 26.3, indicating extreme overvaluation in the stock market.  The stock market would need to decline about 40% from today’s levels for this ratio to return to an average valuation.

By any standards, these two metrics are at alarming levels worthy of the attention of every investor concerned about the preservation of their capital. 

There are those who deny that today’s stock market valuations are excessive; they argue that stocks are cheap in comparison to valuations in 1999.  We find little solace in that kind of “reasoning.”  Only three times in the last 130 years has the Shiller P/E been higher than now — in 1929, 2000, and 2007.  In each instance, the major declines that followed speak for themselves. Overvalued is overvalued, even if there are other instances in which stock market valuations were even more extreme. 

The “New” Tech Bubble: Déjà vu all over again

We’re not sure if we should laugh or cry when we look at the following chart.

The proliferation of money-losing IPOs (Initial Public Stock Offerings) now rivals the frenzy of the great tech bubble and IPO frenzy of the late 1990’s.  That’s right, 83% of companies going public this year are unprofitable, as in losing money.  Cool ideas are nice, but profitability is essential to survival.

With slight modification (and a thank you to Grant Williams, author of “Things That Make You Go Hmmm…”), we present a humorous description of a typical business plan of these heretofore unprofitable companies:

This is a classic case of too much money, with too little concern for risk, chasing half-baked ideas.  This is the embodiment of a frothy market.  And, as always, it never ends well.

 “Those who cannot remember the past are condemned to repeat it.”  -- George Santayana

How can this occur again just 14 years after the calamitous “tech wreck”? A great part of this speculative froth can be attributed to five years of Quantitative Easing (money-printing) that artificially lowered interest rates, thereby making capital cheap and inducing the reckless misallocation of capital.  

Another factor is that the founders and CEOs of today’s new IPO companies are 36 or younger.  What does “36” have to do with it?  Well, when the last IPO and tech stock bubble burst in 2000, they were still living in the insular world of college, high school, middle school, or grammar school.  They were largely unaffected. They have no personal experience or historical perspective from which to cause them to be wary now.

As in the 1990’s, many of today’s newly public companies will not be around in 10 years.  But, some will.  Make no mistake, some of today’s new companies, similar to the 1990’s newbies, will reshape the way we use and benefit from technology.  And, like the tech darlings of the 1990’s, the survivors’ stock prices 14 years hence may very well be lower than the lofty levels reached during their heyday.

Investing Today

Navigating today’s financial markets entails obvious challenges. Worldwide central bank intervention, including that of our own Federal Reserve, has greatly distorted financial markets.  In a world of ultra-low interest rates and ongoing money-printing (a.k.a. Quantitative Easing), investors are saddled with ever-increasing amounts of zero-interest cash.  Desperate investors have cast aside concerns about risk, attempting to capture returns, however meager, if they think the returns will be more than zero.  They have tried to unload their cash, buying investments and bidding up the prices of stocks, bonds, real estate, and anything else that offers a hope of getting a positive return.  However, cash cannot be “used up.”  It can only change hands. Every person attempting to “use up” their cash by buying an investment merely trades places with the seller.  So, the game of hot potato continues until investors become indifferent to holding zero-interest cash or over-priced investments.

While we can easily see pockets of froth and excess in the stock market, it’s not so easy to find solid values that are worthy of your and our hard-earned dollars.  Accordingly, we are maintaining lower than normal stock allocations in portfolios. We have chosen a more conservative and prudent path, holding above-average portfolio allocations of cash and bonds in lieu of higher stock allocations.

What if the stock market continues to rise, becoming even more overvalued?  We will continue to participate in market gains, although to a lesser extent than if we held a larger portion of your portfolio in stocks.  On the other hand, what if the stock market retreats and returns to average valuations or lower?  We will participate in that to a lesser extent, too.  Given today’s lofty stock market valuations, we believe this is an appropriate trade-off for investors seeking both profits and the protection of their capital.

Our position will change when prices become more reasonable.  We will add to your stock holdings when the prospect of capturing greater returns with less risk becomes available again. We believe this is not a matter of “if,” it is a matter of “when.” Patience is essential for prudent investors who want to preserve their capital and capture solid gains without taking undue risk.***

                                                                        --- Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2014