Part One: Stocks are too Expensive
I.C. Angles Investment Post
The stock market is too expensive. This is what valuation methods that have been proven to work are showing. And at some point prices will decline significantly, in order for stocks to become fairly priced. Expensive valuations are just one reason, the current bull market is likely to end particularly badly, with a price decline that could very easily surpass either of the last two major bear markets. Given how high valuations have currently risen, a fall in the stock market of well over 50 percent is a very real possibility.
Valuations that Matter are Expensive
To consider current market valuations the work of John Hussman of Hussman Funds is worth serious consideration. The below chart is one I posted earlier, courtesy of Hussman Funds, and shows seven different methods for valuing the stock market: the forward operating earnings model; dividend model; market-cap to GDP or the Buffett model; revenue model; Tobin’s Q model, and the traditional Shiller price-earnings ratio, as well as the profit-margin-adjusted cyclically-adjusted price-earnings ratio model. The reason for choosing these valuation methods is that when back tested they work more often than not in discerning whether stocks are priced too high. In the below graph their predictive value is shown by plotting the actual ten-year subsequent return of the stock market, as measured by the S&P 500.
Today, these valuation methods are unanimous that stocks are expensive and as a result are predicting ten year returns going forward of under two percent rather than the long-term average of ten percent. As a result, a substantial price decline is the most likely path for stocks to get back to more reasonable valuations with average expected forward returns. All this comes with the caveat that these valuation models are not market timing tools, as their correlation to ten-year rather than one-year returns illustrates. The S&P 500 could become more expensive, as it did in 2000, before the market then collapsed. John Hussman has received a lot of criticism for being overly negative on stocks, partly based on this type of analysis, even as the stock market has risen to new heights. In my opinion the work Hussman has done on valuations deserves serious consideration, and multiple posts are available on his website to read about his methods. But they should be studied with the caveat that they are not particularly useful in timing the market; only in determining whether it is a good long-term value for investors or not. Right now it’s not.
Source: Hussman Funds
Another Look at Valuations
Another excellent resource for studying the value of the stock market is the Advisor Perspectives financial website dshort.com. The below chart shows four methods for valuing the stock market, including the S&P 500 from its regression, and three ratios (two of which are also included in Hussman’s chart) plotted against their arithmetic mean: Crestmont Research’s Crestmont P/E; the Cyclical P/E 10 a.k.a. the Schiller P/E; and Tobin’s Q ratio. This chart again demonstrates that reliable methods for valuing the stock market indicate the current market is very expensive and does not represent a good value for stock investors.
Regression to Trend
Unlike the other valuation methods in the above charts, regression to trend is an indirect, but still very useful method, for valuing the stock market. Over very long periods the economy, corporate earnings and stock prices tend to grow at steady and consistent rates. When stock prices rise too high they eventually regress back to their long-term trend line oftentimes overshooting well below. With the current stock market well above trend, history suggests it is simply a matter of time until a major price decline brings the market back to or below trend.
Q Ratio without IP
The Q Ratio is the price of the stock market divided by its replacement cost or the cost to buy or replace the assets of the public companies composing the market. The below chart shows a modified Q ratio that does not include the replacement cost of intellectual property, based on the premise that the IP that is one company’s competitive advantage is another’s disadvantage and in terms of total market value a zero sum premise. With either calculation method, the Q Ratio shows the stock market presently overvalued, but excluding IP implies an even more expensive market.
CAPE to Baa Yield Ratio
Below I have included a chart I recently posted, showcasing another modification of one of the aforementioned valuation methods. Here the Cyclically Adjusted P/E ratio, popularly known as the Schiller P/E, is divided by the average yield of corporate bonds with a Moody’s credit rating of Baa, signifying moderate risk of default. Linking earnings to bond yields alleviates one criticism sometimes leveled at P/E based methods that stock earnings do not exist in a vacuum and an investors willingness to pay for earnings will be influenced by what they could earn by instead investing in bonds. Unlike the other valuation methods, this one also has some use as a timing tool. When the ratio rises above 5.0, as it has currently, a major market top is usually not far off. My well documented personal view is that while there is good reason for caution in the current market environment, I will not even seriously consider calling a market top until the S&P 500 has broken support of its 125-day simple moving average.
Buffett’s Favorite Indicator
Some of these ratios, including the Buffett Indicator below (a favorite of legendary value investor Warren Buffett that compares market capitalization to the worth of the economy as measured by gross domestic product), showed stocks overvalued, during the last major top in 2007. Others, referenced here did not. But investors should not focus on whether these methods work all the time. Nothing works all the time. But when so many valuation ratios that work more often than not are all pointing in the direction of an overvalued stock market then it is safe to say the stock market is too expensive and a very large decline from these levels is simply a matter of time.
Simple P/E Ratio is Simply Misleading
The case for stocks currently being too expensive is in my mind very compelling. However, this has not prevented many from arguing stocks are not expensive. Such arguments are largely based on using valuation methods without predictive power. The most popular of these is the price to earnings ratio. The below chart shows just how useless an exercise it is attempting to predict whether the stock market is fairly valued using the P/E ratio. Yes, in terms of its P/E ratio the stock market isn’t expensive.
In other words in terms of a valuation method with little correlation to stock prices rising or falling and little connection to whether stocks are a good or bad long-term investment, the market isn’t expensive. This should not be any more reassuring to investors than valuing dotcom stocks without earnings in 1999 based on the number of visitors to their website, the so called market cap to eyeball ratio. Ironically, because the earnings part of the P/E ratio often falls the most during recessions, this ratio shows stocks to be most expensive when they are actually priced at their lowest levels around stock market bottoms, during recessions. The lack of utility of the P/E ratio is exactly why people like Professor Shiller created P/E valuation methods modified to have predictive worth in valuing the stock market.
Reason to Worry
Looking beyond the trailing P/E some investors point to the Fed model valuing stock earnings in relation to ten-year Treasury bond yields or the use of forward operating P/E ratios, as better methodologies that show the stock market reasonably priced. Unfortunately, historical analysis shows these methods also ineffective. The bottom line on valuations is that methodologies that work, show this stock market to be too expensive. Beyond valuations, there are other reasons to believe that things are not going to end well for investors buying stocks at today’s prices. But market valuations alone, are reason enough for investors to be very worried about future prices of stocks.