Is the stock market overvalued?
Is the stock market overvalued?
That’s the million dollar question for us investors; isn’t it, but the answer is not quite as easy as some make it seem. There’s a lot of articles touting one answer or another. Using some of the metrics that are used to judge value, I wanted to take a deeper look.
It’s easy to look at the graph below taken from here and draw conclusions.
The 32.33 CAPE(Cyclically Adjusted PE Ratio A.K.A. Shiller PE) has only been higher one time in the past decade. It maxed out at 44.19 in December of 1999.
That means we still have 30%+ upside so that’s it then – case closed! Just kidding!
One of things that worries a lot of people is that S&P 500 earnings have barely grown in the recent years. That means the run up has been primarily driven by P/E expansion.
The S&P 500 ended 2011 with a $95.04 per share in earnings and ended 2016 with $96.60 per share in earnings. More recent results are a bit more favorable with the current 12 month GAAP EPS near $105 which finally shows a return to growth. Despite that, the CAPE has expanded as prices outpace earnings growth.
Today’s CAPE is double the mean and median of 16.80 and 16.15 respectively. That doesn’t seem like a good sign and if history is a good metric, can be taken as a sign of poor returns going forward. Unless we see massive earnings expansion then one can expect poor returns if the CAPE has a tendency to revert to the mean in the long run.
The question lies in whether that’s a safe assumption to make and the answer to that is less clear despite how the graph looks.
The Earnings Picture
The stock market certainly looks like it’s priced aggressively but it’s important to take the CAPE and it’s relation to the historical mean in context.
The CAPE compares the current market prices to the last 10 years of corporate earnings. The value of this is that it covers the cyclical nature of the market but the risk with this metric is that it can understate the earnings if the past ten years include an event that is unlikely to reoccur in the future, in this case the 2008 financial crisis.
I don’t want to discount the earnings decline entirely as we’re likely going to have a recession in the next ten years but will it be as deep as the 2008 financial crisis?
2008 end of year corporate earnings dropped nearly 80% bringing them down to levels not seen since 1947. It was the biggest year end earnings drop on a % basis eclipsing the crash of 2008 and even the great depression.
The 2008 financial crisis had a much quicker recovery than the great depression. However, the CAPE calculation still has that massive earnings drop embedded in it. That means the earnings base is low and may have an impact on its value as a predictor if you see the 2008 financial crisis as a once in a lifetime event versus a once in a decade event.
As an example, if earnings for the next two years are static and prices don’t change, the CAPE would be 28.2 and if a recession takes down earnings in one year by 50%, the CAPE would be 29.8 which shows the impact of the 2008 financial crisis.
While we’re on the subject of earnings, the other problem with the CAPE ratio arises when comparing the current ratio versus the mean and that’s the difference between GAAP and non-GAAP EPS.
The CAPE uses GAAP EPS. I’m not going to go into the details of the differences between the two but GAAP and non-GAAP EPS have diverged more in recent years due to various changes in accounting practices. This has lead to overly conservative GAAP EPS that may understate true earnings and in turn produce a higher CAPE.
This is illustrated best by the earnings drops mentioned above. The 2008 financial crisis produced an 80% decline in GAAP EPS in a time where the GDP declined around 5% while the great depression produced smaller declines during a time where the GDP declined 25%+.
The difference in the two is largely driven by the more conservative accounting standards that emerged in the 90s around asset impairment and special charges. This has led to deviations of as much as 30% in recent years.
2016 GAAP EPS was $96.60 for the S&P while the non-GAAP(pro-forma) EPS was $127.97.
This is not to say that GAAP EPS is useless and non-GAAP EPS is the true picture of earnings as there are plenty of companies that are too optimistic around their adjustments.
The truth as with many things in life likely lies somewhere in the middle.
If you believe this to be the case then this is just another reason why comparing the current CAPE to the historical mean is potentially an incorrect way to go about it. In fact the average CAPE since the 1990s, the time where the divergence began to occur in earnest is closer to 25 which is a much smaller gap especially if you consider the impact on historical earnings of the 2008 crisis.
The Price Picture
Below I included today’s P/E ratio, the mean(where available) and the 10 yr. average based on data from factset and multpl.
|Shiller P/E||GAAP P/E||non-GAAP P/E|
|10 yr. Avg||23.3||23.89||14.2|
The CAPE P/E and even standard P/E ratios whether based on GAAP or non-GAAP EPS are high in historical context when looked at today’s ratios through the lens of the 10 year average or the mean.
I wouldn’t put too much weight in the 10 yr GAAP P/E average due to the impact of the 70+ P/E ratio in 2008.
It’s rather easy to look at this data and say that today’s ratios are not only much higher than the mean but also a good deal higher than the 10 yr. average.
However, I think it’s important to look at it in relation to other asset classes.
The reality is that our money has to go somewhere. Whether it be stocks, bonds or cash or other asset classes. Bonds offer the easiest valuation comparison as they have historically been seen as the alternative to their riskier cousin stocks.
In the table below, I’ve outlined the Schiller P/E(CAPE) for the S&P 500 from 1997 to today, converted it to a earnings yield and compared that earnings yield to the 10yr risk free treasury bond. I’ve also added a price to yield for the 10 yr treasury to better illustrative the comparison.
The concept here is simple. If we have to put money somewhere then we either put it in stocks or bonds, in this case the S&P 500 for stocks and the 10yr treasury for bonds. In assessing which one is the better investment, we take the yield of one and compare it to the other. The colors are red when it benefits bonds, orange when it’s a toss up and green when it benefits stocks.
I wouldn’t worry about the colors too much. There’s no scientific basis for what constitutes a good value for stocks or bonds. It’s just a simplified way of looking at the two asset classes and comparing them.
The idea is to illustrate how hard it really is to say that the stock market is “overvalued”. Against what should be the next question.
The assumption that stocks were overvalued in 2000 is easy to make after looking at the data. They likely WERE overvalued because an investor could get a much better yield from a risk free 10 year treasury.
It’s easy to look back at this now and say; of course the large cap stocks returned -14.6% from 2000 to 2002 while bonds returned 12.6% in that same time period. In fact 1997 to 2002 had an anemic return of 4.36%. Bonds returned 9.1% in that same time frame.
There is a simple reason why stocks generally have a better return profile than bonds. It’s the fact that they can grow earnings but that clearly wasn’t the case during that time frame. That was due to the hefty prices investors had to pay for that growth in relation for the guaranteed return they could get from 10 yr treasuries.
However, once the bond yields started to drop, that difference became smaller. Bonds started to be less attractive to investors who could get a similar yield plus growth from stocks.
That was a solid time for stocks but that ground to a halt in 2008 during the financial crisis. Once we got past that, we saw the reverse of what happened in the early part of the decade. The red turned to green.
The earnings yield in 2009 was suddenly much higher than bonds and as we know now, that offered one of the best investing opportunities in our lifetime. The opportunity to buy stocks at bargain basement prices was offered to those who weren’t scared by the market turbulence. Bonds suddenly became more expensive as money flooded into the market and yields began to fall.
It’s easy to say this now. Money kept flowing into the markets and continues flowing into the market today because the alternative is priced where it is right now.
The Market Picture
I’ve read about the upcoming crash and the how overvalued the market is for a few years. That might have been the case if you bought into the CAPE ratio argument.
While it’s true that the ratios are high, as stated above; alternative investments have to factor into the discussion somehow. Cash is almost never the right place to park your cash for long periods of time.
It might have been easy to say the stock market is over valued in 2000. You could move your money into bonds when those were yielding 6%.
It was much harder to make that argument in 2016. At that time, the earnings yield was 2% higher than the bond yield.
It makes little sense from a long term perspective to put your money into something that essentially has a P/E of 50. On top of that, it won’t grow earnings at all in the next 10 years. That’s what bonds offered. Even at a P/E of 25, the stock market was a much sounder bet because of potential earnings growth AND a higher yield.
That’s not to say that bonds hold no value in a portfolio right now because they are a risk modifier and can help smooth out losses which is important in the long run. They are there to make sure you don’t make any dumb decisions with your stocks during a recession.
It’s easy to say that 2016 looked like a prime buying opportunity in hindsight after an excellent 2017. That wasn’t all that clear in 2016 as there were many people calling for a terrible year. Risk is the game when it comes to the stock market. In the short run, sometimes you win and sometimes you lose. It’s not always reasonable but this certainly speaks to one reason why what happened in 2017 may have been reasonable after all.
The question is whether the market is still a sound investment at a time where the CAPE ratio has climbed above 30 and the P/E ratios are 25.62 and 20 on a GAAP and Non-GAAP basis respectively.
Those certainly SEEM like high numbers. The point of this post wasn’t to tell you whether they ARE but to give some context around current valuation. Now, I’ll let you make your own decisions based on your risk profile.
After all, 2000 looked like a bad time to invest. Despite a bleak outlook, stocks still ended up being the better bet then.
An investor who put 10k into the U.S. stock market on January 1, 2000 still made a return of 5.58%. That’s against a 5.43% in a 10 year treasury fund. That was at a time where yields were much more favorable than they are now and CAPE ratios were a lot higher.
The 40+ CAPE ratio shown above was just for the S&P 500 so it was likely that the total stock market was even higher as the NASDAQ P/E was floating somewhere in the 170 P/E range at that time.
The 5.58% isn’t anything amazing. It’s likely lower than investors expect. However, it’s still not a bad number when you consider how “overvalued” the market was at the time.
The other thing to consider is that most investors don’t just invest all their money at the peak. An investor who put 10k into the market on January 1, 2000 and added 1000 each year ended up with a return near 12% and $20,000 more than an investor who did the same for 10yr treasuries.
Now that I’ve said all that – we can get back to the question at hand, is the stock market overvalued?
The answer to that is who the hell knows!
No matter what anyone tells you, the truth is that it’s hard to tell whether a 32 CAPE is a good value. It’s probably not. However, there are so many things we don’t know. There’s future earnings growth, future bond yields, how far the market will expand the CAPE and more.
It’s true that a 32 CAPE and a near 20 adjusted P/E(25 GAAP) is much worse for an investor than something lower from a long term return perspective. But what are the other choices if you’re aiming for long term returns?
In my opinion, stocks still offer a better value than bonds. That doesn’t mean they’ll outperform bonds in the near term. However, there’s a pretty good chance that they’ll beat them in the long term.
We’re 9 years into a bull market and due for a recession. It’s quite possible that earnings will eventually start to slide. At the same time, ratios might start to contract leading to a big decline. Investing in stocks requires a level of comfort with that. That’s why bonds still have a place in any asset allocation even if their valuation might not be that attractive.
It’s common sense that a higher valuation at time of purchase likely means lower future returns. If I buy a stock at a 10 P/E and it grows at 10% then it’s a better stock than one bought at a 20 P/E growing at 10%.
It’s the 10% growth rate that’s the big question mark and not something anyone can predict accurately.
It’s true that a higher valuation generally means a lower potential return and a higher risk of decline. That’s the type of market we’re in right now and an investor has to be comfortable with that. The truth is that if you’re a long term investor then short term valuations shouldn’t be of concern to you. If they are then you might want to revisit your asset allocation and see if there’s something out there that jives with your risk profile.
If you knew the crash was coming next week then you should totally go be in cash. You’d be ready to buy when it hits bottom. However, countless studies and years of experience have shown us timing the market is impossible. It makes sense to just stay in it and deal with any movements.
The CAPE nearing 25 in 2014 caused many to say the market was too hot. The market has soared since then.
One thing to remember is that the CAPE ratio and other valuation metrics I talked about are generally market specific(in this case the S&P 500) and don’t mean that there’s absolutely no value in stocks whether domestic or international, you might just have to look harder than usual to find it.
Bad returns aren’t guaranteed due to this information. Earnings can outpace projections and the ratios can keep expanding for quite some time. Selling can cause one to miss plenty of upside if one were to sell.
This also doesn’t mean that the stock market can’t correct quite abruptly in the near term. All it takes is a shift in market sentiment and money can start to flow elsewhere like cash or bonds. After all, this is just one way to look at market valuation and there are others out there as well.
Personally, I think the stock market is a bit hot even if you take into consideration the points discussed above. The CAPE and P/E ratio averages have definitely trended up in the recent years. However, the current ratios are still a good deal above the more recent averages. That can lead one to assume that future returns will be worse than we’ve seen in the past few years.
Still, I think bonds are an even worse value right now. The nature of the market also means we’re due for a recession within the next 5 years. I wouldn’t fault anyone for moving into less risky assets right now.
That doesn’t mean I’m selling or changing my asset allocation. I’ll keep buying stocks. I’ll keep buying bonds. However, I’ll likely also keep some more cash on the side in case any values emerge.
The reality is that markets work in cycles. They go up and they go down. There was a savings and loan crisis in the 90s. And there was one in 2008 and there will be another one in the future. There was a recession in the 90s; one in 2000, one in 2008 and there will be another one in the future. Wars, political instability and all sorts of other things one can’t predict will impact the stock market returns.
The thing one has to remember is that people thought that the stock market was hot in the 90s. Investing in it then was a fool’s errand! However, returns since then have been great(and that was at a time when treasury yields were near 9%). They thought the same in 2000; they thought the same in 2008; and they will think the same in 2017 or 2018 or 2019 or whenever the bull market nears its end. Reward sometimes came to those who thought so in the short term. However, reward came to all those who stuck through the hard times.
After all, it pays to remember that time in the market beats timing the market.
Let me know what you think about the market. Are you holding off buying because of the prices? Are there butterflies in your stomach when you think about it? Or do you not care because any short term fluctuations are just a blip on the long term radar. After all, they will help your long term results!
Hope you enjoyed this article. Let me know if you disagree with anything or if you have any questions or comments.
Tom from Dividends Diversify
Excellent debate you have written Time. As an investor, I certainly think about valuation especially when I make a new investment. On most measures, valuations seemed stretched, but I really don’t know. Fortunately for me I started dividend growth stock investing 13 years ago. I have turned my attention more to the cash my investments pay me. I know the value of the cash my investments are throwing off right down to the dollar. No one can debate me on that. It is the same whatever GAAP or non-GAAP measure you want to use or whatever PE ratios are at by however you want to measure them. This philosophy helps me stay sane and sleep a little at night. Thanks for the post. I really liked it. Especially all the ways you looked at valuation currently and historically. Tom
Very nice article. It is indeed difficult to find value in this market. But I am in it for the long haul. Like Tom mentioned all I care about is the income (dividend). If market goes down a few years I am okay with it (as long as I keep getting my dividends). I am invested exclusively in ETFs, which provides me a wider market exposure and better sleep.
I don’t think their is fundamentally anything wrong with the market or valuations. With interest rates going up I hope to see a correction in value stocks.
It could drop tomorrow or it could keep marching towards 30,000. I will keep investing no matter what. as long as the company im invested in is good I am not worried to much about what the market does. If it does look like we are heading for a long down turn i might take some of my reits and invest them in more sound stocks but other than that just watch everything keep rising.
good piece of work – tx for sharing! – i know that i can’t predict the market (i was wrong too many times :-)..never thought that this bull market would run for so long. In my opinion it’s not easy for dividend growth investors at the moment and i have to admit that sometimes i feel uncomfortable pumping fresh money into this market. – but i can’t think of a better, safer investment in the long run.
My plan is to invest on a regular basis to let my money work as fast as possible. And on the other hand i hold a substantial cash reserve to be ready if a decent market correction or even a crash comes along. And someday it will – no doubt about that. Only fools believe the party will last forever…
Great write up TITM. The Shiller PE has been very interesting to keep an eye on recently but as you say, it’s impossible to know when the market is going to turn. Earnings growth for the ASX300 has been flat over the past 10 years, so we’re in a similar predicament. I was reading an article in the paper this week where an investor was pointing out that we either receive a return in advance from the future (and maybe have to give it back later), or receive a return from the past that took a while to sift through. I thought that was a very interesting and useful way to look at returns.
Troy @ Bull Markets
I wrote a post about this recently. Yes, the stock market is overvalued (it’s basically “overvalued” whenever its above the medium valuation). But valuation has little impact on the stock market on a 1-5 year time frame! In this post (http://bullmarkets.co/stock-market-on-december-15-2017-thoughts-and-outlook/), the r squared for valuation and stock prices is a measly 10% on a 1 year scale. THis means that valuation accounts for only 10% of the stock market’s change.
Interesting analysis and based on one metric (CAPE in this case) the market is probably a little hot. Given the multiple other variables there could be more upside. Domestically there’s the tax plan that could be an additional stimulus (corporate). Other data include PPI, CPI and my favorite TFP. My opinion is that given minimal/negative productivity increases (TFP) continuing increases by any measure is not broadly sustainable. However certain members within some industries could flourish. The key is defining which is which.