Is The Market Overvalued?

It’s time to take a serious look at our investments.  The Dow Jones Industrial average just hit an all time high.  Are we in bubble territory now?  Should we be investing at these high prices?  Heck, maybe we should be selling!

Rarely have I heard comments in the last few years that suggest the market is undervalued.  More often than not, I frequently see the media suggesting the market is overvalued.  Could it be true?  Are we investing our hard earned dollars at the apex of a frothy market, only to be crushed again by the popping of yet another gigantic bubble?  

Fellow early-retirement blogger and stay-at-home dad (Joe) over at RetireBy40 is hording cash.  He’s pessimistic about returns this year.  The bull market has been on a very long run since 2009, and we might be overdue for a bear market.  I can’t say I blame him.  Stock returns have been very good the last handful of years, but the economy is only just doing OK.

How can savvy investors tell if we should be hording cash, or tossing it all into the market in one big lump?  Efficient market proponents will say “you can’t time the market”, and they’ll usually be right.  I left my crystal ball in my other pants today…so you’ll get no prognostication from me.

I’m not big on the Efficient Market Theory (EMT) either.  In my experience, I’ve found the EMT is just as frequently false as it is true — meaning some times markets are going to be efficient and other times they are not.

Anyone who suggests to me that turning off your brain and “trusting the market” is the smart move is going to get the cold shoulder from me.  Actually thinking about business valuation might be able to give us some insight toward good investment behavior.

Let’s dig in…

The Traditional Metrics

The traditional valuation metric often touted when the prognosticators are prognosticating, are PE ratios relative to historical values.  PE’s are high today.  Earnings yield is another one frequently used (which is merely PE inverted).  The prognosticators aren’t wrong either — when we look at this lovely graph their story gets mighty convincing:

S&P500 PE Ratio
S&P 500 historical PE Ratio.  As of this writing, the S&P500 has an average PE ratio of 24.70.

Historically, yes, a PE of 24.7 is pretty high.  That’s an earnings yield of 4.05% — Meaning, if you look at your investment as a business, an investment in the S&P 500 will only earn 4% on your money.  

Even if we look back to previous boom/bust times, valuations were not usually this high.  If you’re planning on living off the 4% rule for the remainder of your days, only earning 4% is a tricky proposition.  That’s one of the reasons why I like the 3% rule.

What about those giant spikes we see on the graph for 2002 and 2009?  Those are distortions in the data.  Valuations were declining quickly at those times (due to recessions), but earnings declined faster.  This created abnormal spikes in the data.  Most of the time the S&P 500 sits under a PE of 25.

If we ignore those abnormally high values, we can see the market is highly priced.  Nearing the peak against historical numbers.  Too rich for my blood.

What’s Different This Time?

So, is anything different this time around ?  Anything that might justify high stock market valuations?  

There might be one reason — Interest rates are at something of an all-time low.  Never has money been this cheap.  To give you a idea, here’s the historical yield from a 10 year treasury bond:

10 Year U.S Treasury Rates
10 Year U.S Treasury Rates. Currently, a mere 1.43%

By comparison the 4% earnings yield of the S&P 500 looks pretty good compared to a yield of 1.43%, right?  

Treasury bonds are considered “risk free” or zero risk, because it’s highly unlikely the U.S. Government will ever default.  Stocks are another story though, companies sometimes go bankrupt!

The difference between the treasury rate and stock earnings yield is called the risk premium.  That’s the extra money you might make by taking risk instead of taking no-risk.

The higher the risk, the greater the premium.  Or at least that’s how it’s supposed to work if the market is acting rationally and efficiently.  Risk premiums appear to have actually improved in recent years, to around 4%.  

Risk Premium
Risk Premium of S&P 500 Earnings Yield vs. 10 Year U.S. Treasury Rates.

This data runs counter to the “overvalued” arguments.  If the market were over valued, supposedly the risk premium would be shrinking instead of growing.  Instead, what we have is slow earnings growth, and declining treasury rates.  This increases the risk premium.  Stocks becoming a *better deal* relative to the risk involved.  That’s the theory anyway.

I could view it entirely the opposite way too — It’s just as likely that earnings are inflated.  We could be in a bubble period that’s giving us abnormally high risk premiums.  If that’s the case, we’re in big trouble when the earnings bubble truly pops.

It’s All About The Earnings.

Ultimately, it all depends upon business earnings.  Earnings support the stock prices (either high or low).  Can earnings continue to grow in the coming months?  

We’ve been in something of a earnings recession in recent quarters — Five consecutive quarters of year-over-year declines in earnings.  That doesn’t bode well for a general upward trend to the market.  The uncertainty caused by the Brexit will likely cause business managers to take a cautious approach to business spending, thereby making all those concerns a reality.

The probabilities seem high for continued low earnings growth, or possibly even earnings declines.  High enough that I’m going to be cautious about investing in the general market.

Specifically, for my long term retirement plans, I’m going to need a earnings yield higher than 4%.  While it is possible that the S&P 500 could stay at this high level for the next 30 years, I find it unlikely.  It’s more likely that stock valuations will approach the same long term returns seen by American business.  This works out to be about 7%  (12-14% returns on equity, and prices at 1.5 to 2 times book value).


Pockets of Value

Despite the difficult earnings environment going forward, there are pockets of value out there.  Places where stock valuations are much closer to normal, or possibly even undervalued.

These pockets of value exist in places that have already seen significant earnings declines — Namely, in the energy industry and agriculture.  These are commodity businesses suffering due to the low-price oil environment, and agricultural price collapse.  In general, commodity-based companies are hurting because of low prices.

PE’s can be found in the single digits in these sectors.  Will things get better?  Will they get worse?  I have no idea!  Ultimately, their stock prices rise and fall in the short term based on commodity pricing and market sentiment.  

I won’t be gambling my retirement on unknowns, but if there are good investments to be found in U.S. Markets, that’s where I’d be looking.


The Well Known Energy Company

In fact, we are investing!

We’ve already invested around $240,000 of our own money into a single “Well Known Energy Company”, and we’re still putting money in!  It’s a company that (despite the low price environment) continues to show good Returns on Capital.  Its earnings were relatively unaffected by the oil price drop, and there is even a significant growth story in the works!

If energy prices improve, we’re bound to do well with this investment.  If they stay the same (or even decline!) we’re still going to do OK.  Better than the 4% earnings yield of the S&P 500.  ‘Heads’ I win, and ‘tails’ I don’t do too bad! 


What do you think? Are stock valuations too high?

[Image Credit: Flickr, Multpl]

22 thoughts on “Is The Market Overvalued?

  • July 12, 2016 at 6:51 PM

    I have had some worries about 1 year ago with valuations being so high and a year later, they are still at the same level. If you look at pricing the S&P500 with a risk premium compared to bonds, as bonds go down, it can drive prices to crazier levels. But when you look at earnings, they are barely higher than they were in 2011, when the S&P500 was at 1400.

    I don’t like to time the market, but I can’t see how investing in equities today will generate returns tomorrow. About 1 year ago, I sold a lot of equities and bought bonds instead. It has performed very well (and the trend won’t stop if rates are going to 0%).

    There is a theory, based on Warren Buffett’s famous yardstick, that future returns depend on the current Market Valuation / GDP. His yardstick happens to have 90%+ correlation with 10 y future returns and the current level suggests 10 year returns of around 0% (I recently wrote a post on the subject: “Timing the Market like Warren Buffett”.)

    Earnings have been down for 5 quarters and companies are increasingly reporting non-GAAP earnings that turn losses into profits. The unemployment rate is starting to trend flat, which usually doesn’t last long before it goes up. It could stay like this for a few more quarters, until something triggers panic in the markets (what that will be is anyone’s guess).

    In the meantime, I’m also building up my cash position. If there’s a market downturn, I’ll invest. Otherwise I’ll use it as a downpayment to buy another rental property and benefit from these super low rates.

    Sorry if that was a long comment, but I really enjoyed your analysis and like you I’m a bit confused on the current market status. Feels good to see it’s not just me 🙂

  • July 12, 2016 at 6:57 PM

    Markets are definitely hot. Personally, I’m taking a small break and selling calls and puts. I’m still moving a set amount of money to my brokerage account each month, but I’m holding it there for a while to see how the markets behave. This is not to say I won’t buy any stocks, but I only will if I can find some value.

  • July 13, 2016 at 4:20 AM

    It has been a good couple weeks since Brexit (who woulda thunk), and it has been a good 5 months since the February trough, but for me it is all noise. I’m still a long term investor (no plans to retire and pull money out in the next 5 years) so I am all for throwing more money into the market and letting it build over time as it always has in the past.

  • July 13, 2016 at 4:39 AM

    The PE has been significantly affected by the energy component of the S&P. This would improve as oil prices continue to improve.

    I am going to make a wild guess that your Well Known Energy Company is among the largest US midstream companies:)

      • July 13, 2016 at 5:25 PM

        Midstream MLPs or midstream C corporations. These got sold off big time even when their cash flows were, for many, stable.

        • July 13, 2016 at 9:33 PM

          I’ve been thinking the similar thing, and have been pushing my way into that sector, now that I’m done investing in upstream.

  • July 13, 2016 at 5:10 AM

    I don’t try to time the market, so in reality I don’t really care one way or the other. If I have cash available, I invest it. What I do know that there is a very good chance that in 10 years, equities will be higher than they are today and that is what matters to me. Equity analysts and news pundits have been warning about a pending recession for some time now (years) and I don’t pay any attention to it. If and when it does happen, I’ll still be deploying capital 🙂

    • July 14, 2016 at 7:33 AM

      Why do you believe equities will be higher in the future? I know what’s happened in the past, but the data suggest the future won’t be as bright. Productivity is flat (or declining), birth rates in the states are now below replacement levels.

      What information causes you to believe they will go higher?

      • July 14, 2016 at 11:19 AM

        Optimism. The fact that we can trust mankind to evolve positively, and that this will improve in line with capital (or, if it doesn’t, capital won’t matter as much as it does today). In 15 years SpaceX will have an IPO, businesses will emerge on Mars and other planets. Renewable energy will become big. “Something” will launch and be the equivalent of the iPhone launch in the 2000’s.

        Past results are no guarantee, but I trust that mankind is trying to create more value with time, that part won’t change.

  • July 13, 2016 at 10:12 AM

    I’ve been reducing beta for several months. Just as Brexit was the self-imposed financial crisis that cost the Brits 10-20% of their wealth overnight, we in the US have a chance to shoot ourselves in the foot coming up in November. A similar scenario to Brexit will play out if Trump beats the polls with higher net voter turnout. I’ll hide out this binary lose-big or gain-nothing event.

    The question is, how to hide out? Cash positions did poorly for the Brits as their currency crashed overnight due to their shockingly poor decision which will impair their economy for a generation or more. Maybe foreign exchange ETFs?

  • July 14, 2016 at 2:26 AM

    Charlie Munger was once asked why investors didn’t want to replicate what Betkshire Hathaway did.
    His answer? – because it is too simple.

    Too often we try to overthink the markets when simply dollar cost averaging into the market is the tool to stop us looking at the markets. Let’s be simple and avoid complexity.

    Nobody knows what the markets are going to do.

    I just buy through the ups and downs and sideways movements.

    • July 14, 2016 at 7:29 AM

      So, are you suggesting I’m over thinking it, and your strategy is the right one?

      • July 14, 2016 at 3:38 PM

        There is no right or wrong path. Black and white works in chess and a few other things.

        Being a simple indivdual ( at least as it applies to investing), the discipline to keep investing through the good, bad and ugly is a philosophy that works for me.

        At the end of he day, any investing approach should be consistent and methodical. If it works over the long haul for you, don’t change it.

  • July 14, 2016 at 8:52 AM

    Remember my comment in your previous article? I am following Assiduity – ‘sit on your ass’ investing, that’s what’s needed now. Charlie Munger had it right for ages. If you invested in good companies, there’s nothing else to do.

    • July 14, 2016 at 1:00 PM

      Yes indeed! I’m definitely not selling, that’s for sure.

  • July 24, 2016 at 6:25 PM

    I didn’t even need to read the article, one I saw the title I was screaming yes! However, of course I continued to read the article. I am using this time to stockpile cash and wait for things to cool off. Like many readers, I don’t try to time the market. However, one of our screeners is using the PE ratio compared to the broader market and there are vary few stocks that would pass that metric. So for now, I’ll let things cool down and wait. I’m also considering paying down debt in the meantime.

    Thanks for the great article!



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