The current market valuation is expensive by historical standards. Some say it’s overvalued but others don’t.
If you’re lean on the side of expensive, a question worth asking is what would make our current high market valuation “not expensive”?
Jeremy Grantham asks the same question in the latest GMO letter. He has some decent answers worth thinking about:
Along the way there were early signs that things had changed. First was the decline from the greatest bubble in US equity history, the 2000 tech bubble. Compared to the previous high of 21x earnings at the 1929 bubble high, this 2000 market shot up to 35x and when it finally broke, it fell only for a second to touch the old normal price trend. And then it quite quickly doubled. Compare that experience to the classic bubbles breaking in the US in 1929 and 1972 (Exhibit 2) or Japan in 1989. All three crashed through the existing trend and stayed below for an investment generation, waiting for a new crop of more hopeful investors. The market stayed below trend from 1930 to 1956 and again from 1973 to 1987. And in Japan, the market stayed below trend for… you tell me. It is 28 years and counting! Indeed, a trend is by definition a level below which half the time is spent. Almost all the time spent below trend in the US was following the breaking of the two previous bubbles of 1929 and 1972. After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months. So, we have actually spent all of six months cumulatively below trend in the last 25 years! The behavior of the S&P 500 in 2002 might have been whispering in my ear, but surely this is now a shout? The market has been acting as if it is oscillating normally enough but around a much higher average P/E.
We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “This time is different.” For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.
Grantham goes on to list two reasons why market valuations deviated from the “norm” over the past 20 years: higher profit margins and record low interest rates. His views around those two are worth reading because neither seems to be in a rush to revert to a more historically normal level.
I don’t know how right Grantham is. The stock market isn’t what it used to be but that doesn’t make it less expensive either. When dealing with valuation you have to consider interest rates. Lower rates allow for a higher fair valuation (it’s up to the market to accept it or not).
That doesn’t mean that the current valuation is right or fair or undervalued or overvalued. It is what it is. We’ve never been here before (compared to previous periods where rates were this low, it’s happened exactly once before in the 1940s and market valuation never came close to these levels).
But if interest rates rise, then the allowable fair valuation will shift down (higher rates will hit profit margins too). Going down this path means trying to predict interest rates. That’s not easy. Harder still, you have to predict the market’s reaction to your interest rate prediction. In other words, you need to be right twice.
To me, that’s a waste of time.
So is the market expensive or cheap? I lean towards expensive. If I’m right, we can expect less than stellar returns going forward. If I’m wrong, then returns would possibly be better.
Of course, the market doesn’t always follow the logical path. I could be right and the market continues to get more expensive (with better than expected returns) or wrong and the market corrects despite a fair valuation (less than stellar returns).
None of that makes the process easier. That’s why market valuations are poor timing tools. They give you a point of reference to compare with the past but tell you little about next year.
The great thing about investing today is not being limited to the S&P 500 i.e. “the market”. Just because the market appears expensive, doesn’t mean that every stock is expensive. And just because the U.S. market appears expensive, doesn’t mean every stock market is expensive.
Regardless, your strategy dictates what you do in this situation. So if you lean towards value, you have options. There are still pockets of value in the U.S, there are value opportunities outside the U.S, and also the option of cash or bonds.
Grantham may be right that “this time is different”. But this time is always different. You and your strategy should be ready for that.
This Time Seems Very, Very Different – GMO
- Watch the Berkshire Hathaway Shareholder Meeting on Saturday – Yahoo!
- Why I Lost My Bet With Warren Buffett – BloombergView
- Shareholder Yields Are Higher Than You Think – B. Carlson
- Peter Lynch Explains His Process (video) – Institutional Investor
- Stories vs. Statistics – M. Housel
- Why You’re Biased About Being Biased – Nautilus
- To Make Better Decisions, Ask Yourself ‘What,’ Not ‘Why’ – Science of Us
- Our World Outsmarts Us – Aeon
- Algorithmic Accountability – Tech Crunch
- Programming as a Way of Thinking – Scientific American