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:
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:
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%.
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?