Is the Market Cheap? Three things you need to know about valuation, but don’t

There is a general consensus that valuation indicators are not very useful for market timing. Despite this, the financial media and the blogosphere feature an avalanche of articles warning that the market is seriously overvalued. Your retirement account might drop 50% at any moment. There are countless worries in the world.

Many investors have been “scared witless” (TM OldProf) by this, missing out on a great opportunity. Is it now too late? What is the current potential for market gains?

Here are three things you do not know about valuation:

  1. The oft quoted indicators are not currently endorsed by their developers, only by those of the bearish persuasion.
    1. Warren Buffett described his “favorite valuation indicator,” the stock market cap to GDP ratio, in 2001. The current high readings are gleefully cited by many. Warren Buffett himself, while not specifically repudiating the indicator, has often noted that it does not work when interest rates are so low. He has repeatedly said that investors should prefer stocks to bonds in the current market climate. Charlie Munger has said the same thing. There have been many stories about this, but they are mostly ignored.
    2. Prof. Shiller’s CAPE ratio shows an overvalued market and is frequently cited. No one ever mentions that Prof. Shiller himself is more than fully invested in stocks for someone of his age. He cut exposure a bit last fall, but does not recommend the “all-in, all-out” approach of many who quote him. Whenever he is asked in an interview he explains that young people should certainly own and hold stocks. He never advocates using CAPE for market timing. He has endorsed CAPE for sector selection. Barclay’s seems to have pulled the page with the Shiller endorsement, although the CAPE Fund is still trading. My article explains the methodology.
    3. Tobin’s Q was invented in the 50’s by a great economist. It emphasized the replacement cost of major companies. If he were alive today, this brilliant man would be revising his methods to explain modern technology companies, as well as stocks like Amazon, Google, and Facebook. It is not fair to apply methods designed for a world with more manufacturing to one so different. No one uses this method for individual stock analysis. Only a few people profit from writing about this aged and obsolete indicator.
  2. There are many experts whose methods show that stocks are attractive. Whenever these people – Laszlo Birinyi, Brian Wesbury, Jeremy Siegel, Jim Cramer, and me, to mention a few – suggest that stocks are undervalued, someone plays the “perma-bull” card. I don’t know for sure about the others, but I am perfectly willing to shift positions as the evidence changes. No one should be embarrassed about being right. I find the name-calling unhelpful for both bullish and bearish viewpoints.
  3. There is a bias in valuation coverage. Because the bearish concept has such a grip, and predicts huge declines like 50% or so in stocks, it grabs headlines and page views. If you do not believe me, do a little personal poll or else a Google search on stock market valuation. Look at the headlines. Those who are comfortable with current stock values expect 10% gains or so. For the average investor, the risk-reward seems dangerous. The key is that the big declines are low probability, while the expected gains are pretty normal.

Conclusion

The bearish valuation theme has persisted for many years. It is usually invoked to claim that all indicators show an over-valued market. No other choices or ideas allowed! This is not a balanced analysis.

The consensus that valuation methods are not good for timing came years too late. It was only after the various bearish valuation indicators did not signal a buy in 2009. How many years will it take before investors catch up? Forget about changes in pundit opinion. They are all “locked in.”

The single greatest reason for the valuation error is the level of inflation and interest rates. And not the Fed-controlled rates, but the longer end that reflects market forces. Mr. Buffett, as usual, nailed it in his commentary, but few paid any attention. In an interview last August, he stated:

Buffett reiterated that he was a long-term investor, saying he expected prices to be “a lot higher” 10 years or 20 years from now.

He likened owning stocks to owning a home, saying that if homeowners expected prices to fall 5%, they wouldn’t sell their homes in hopes to buy it back for 5% less. They are locked in for the long haul.

He also stated, as he has on many other occasions:

What you can say now — [it’s] not very helpful – but the market against normal interest rates is on the high side of valuation. Not dangerously high, but on the high side of valuation. On the other hand, if these interest rates were to continue for 10 years, stocks would be extremely cheap now. The one thing you can say is that stocks are cheaper than bonds, very definitely. We’ve seen low interest rates now for six years or so, rates that we really wouldn’t have thought possible, particularly in Europe where they’ve gone negative. And that’s continued a long time, and of course we saw them continue for decades in Japan.

Do you think you should pay attention to What Mr. Buffett said fifteen years ago, or what he says now? Can’t he interpret his own indicator? Can you or I do better?

The same argument applies to Prof. Shiller, who is poorly served by the uber-bearish applications of his work.

My conclusion? Earnings prospects are important and remain my own principal focus for stock valuation. Stocks remain moderately attractive, despite the scary stories. Specific names are quite cheap, with low PEG ratios and great prospects. Develop a good shopping list!

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4 comments

  • Jeff Partlow May 12, 2016  

    Jeff,

    I agree with you that “Earnings prospects are important and remain my own principal focus for stock valuation.” But I strongly disagree that current prospects are “moderately attractive” since current P/E of S&P 500 (based on average of operating and as-reported earnings for the past 12 months) is historically high at 22. And profit margins are also historically high. Isn’t it likely that both P/E and profit margins revert-toward-the-mean? Please share your thoughts on this.

    • oldprof May 12, 2016  

      Jeff — My own approach is to look at earnings expectations. I expect these to increase even as profit margins fall and the ten-year rate rises.

      There are many reasons, which you know well, for the poor earnings performance of the last twelve months. Neither of us really bases our stock choices on what happened last year, so why extrapolate that thinking to the entire market?

      I expect profit margins to shrink even as overall earnings increase. I am not yet ready to plunge into oil….

      Thanks for sharing your thoughts with us!

      Jeff

  • Mitchell Langbert May 12, 2016  

    Thanks, Oldprof. A few points: First, the Japanese stock market is currently at less than one-half the 1990 high despite 25 years of low interest rates. Second, the Fed might raise interest rates. Third, Buffett might be right for the long term but wrong for the short or medium term. While you’re right that low interest rates spur stock price increases, what will happen to interest rates if Donald Trump defaults on treasury bonds? Do you really believe that the Fed can continue to reduce rates as they have since 1983? Negative interest rates may not work, and if they do work, do you expect rates to fall to -10? -20? What is the limit before depositors remove their money from banks. What happens to interest rates then? What happens to the stock market when the limit of interest rate subsidization is reached? Can America’s welfare-for-Buffett strategy work forever as it has since World War II?

    • oldprof May 12, 2016  

      Mitchell — I can see that I was not completely clear on that point. I believe that failing to account for interest rates is the reason the popular indicators do not work. I don’t expect them to fall farther. I just think that things are more attractive now than most others believe. If the ten-year went to 4 or 4.5%, stocks would be fine as long as it was accompanied by economic growth and better earnings. That is actually my favorite scenario.

      Good question, and thanks for helping me clarify my position.

      Jeff