Market Valuation

With much of the stock market reaching new highs there’s been a lot of discussion recently about the market’s valuation and the possibility of a bubble. Generally people seem to fall into two camps- those focused on valuation measures such as CAPE and Market Cap/GDP who find the market expensive and those who argue it is reasonable primarily based on trailing or forward price/earnings ratios.

With the market at its current level, I’m in the bearish camp. Many of the valuation metrics that I like reveal a market trading at lofty levels. While stocks may not be in a bubble, they are priced for a lot of blue sky.

I’ll break down why I don’t buy the bulls argument in the future but for now I’ll present a few of the metrics showing overvaluation.

The Shiller Price Earnings Ratio:

Recent Nobel winner Robert Shiller’s market valuation metric compares the current price of stocks to their inflation adjusted earnings of the past ten years. The idea of this metric is to normalize earnings for boom/bust years in order to get a more accurate picture of the current market valuation. The historic average of this ratio is ~16.5 versus its current level of ~25. Mr. Shiller was recently quoted in the Wall Street journal saying the market is “a concern” and it “could be a bubble, but it might not be…it will take a little time to tell.” Either way it’s clear that investing when the Shiller P/E has hit these levels has been a losing proposition in the past.

Shiller PE Ratio

 

Market Capitalization to GDP:

Described by Warren Buffett as “probably the best single measure of where valuation’s stand at any given moment,” Market Cap/GDP compares the valuation of the overall market to the amount of goods and services we produce. As the chart below from Vectorgrader.com shows, we’re entering territory only seen in the tech bubble of the late 90’s.

MKT Cap to GDP Market Cap to GDP

Tobin’s Q Ratio:

Tobin’s Q ratio compares the market capitalization of the market to its replacement or reproduction cost. It’s currently sitting over 1 compared to its historic mean of .68.

Q-Ratio

Median P/S:

One of the scariest charts I’ve seen is the median price/sales ratio for non-financial companies in the US since 1989. Although this is a much shorter dataset, the median company is now more expensive relative to its sales than it was in the tech bubble.

AE Price Sales Median

Conclusion:

Valuation metrics such as the Shiller P/E and Market Cap to GDP have flashed warnings signs at key levels of overvaluation in the past. Both urged caution in 1929, 1966, 1999, and 2007. The talk about whether this market is a bubble misses the key takeaway that I think investors should have – equities priced at these levels in the past have done poorly.

Investors with some of the best track records over the past 15 years (and who generally preached caution during the tech bubble and ’07) are out warning about equity valuations again. Seth Klarman, Bob Rodriguez, Jean-Marie Eveillard, Steven Romick, Donald Yacktman, and other value investors have all professed varying degrees of concern over current market valuations.

Of course just because the market appears expensive today does not mean that it can’t go higher. Valuation metrics help determine the attractiveness of the market in general at a given moment but they don’t work as timing indicators. Indeed even some bearish investors such as Jeremy Grantham have said we could easily see a speculative run up from here.

Nevertheless I believe investors should heed Ben Graham’s wisdom and focus on limiting their downside risk. With equities priced dearly, prudent investors should raise cash and remain patient for better opportunities in the future. That may be painful in a zero-interest rate world amid rising equity prices, but I’m confident that will allow investors to take advantage of better opportunities at some point in the future.

 

Scott Caufield, CFA, CPA

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