I’ve expressed my displeasure with valuation metrics frequently in the past (see here for instance). And I think this environment is a pretty good case study in why valuation metrics are pretty unreliable.
For the better part of the last 5 years, a good deal of value investors have cited various metrics showing the market to be overvalued or undervalued. The weird thing about “value” is that it’s truly in the eye of the beholder. And some people use metrics that conclude the market is cheap. While others use metrics that conclude the market is expensive. I liken this approach to relying on your crystal ball or your rear view mirror. Relying entirely on one or the other is likely to steer you into a brick wall at some point, so pick your poison!
After all, if you’re using trailing earnings in your metric, then you’re just trying to gauge the future from the past. You’re basically just engaging in a fancier sounding version of technical analysis or charting. And if you rely on future earnings, then you’re relying on Wall Street’s analyst teams whose estimates are just about the biggest joke in the world of “research” (see here). Sorry analyst friends!
In my opinion (which I am sure will annoy lots of value investors), you have to think bigger than this. You can’t look at past environments and extrapolate out into the future using “value” as your foundation for understanding future prices. This is why I think macro matters so much. You have to look at the big picture in the present and apply it as though today is its own unique environment. Relying entirely on CAPE, P/E ratios, Tobin’s Q, Market Cap to GNP or really any other metric to drive your approach has been an extremely narrow minded view of the world. They might provide some perspective, but they don’t tell nearly the whole story.
Additionally, market prices are largely behavioral. Valuations matter, but I question how market participants actually perceive value. After all, so many different valuation metrics are conflicting today that it actually seems like value cancels itself out depending on your bias. So what’s left? If prices are largely behavioral, then what’s driving the animal spirits? In my opinion, it’s mostly QE and the modest corporate profits expansion which can only be totally understood if you understand the big picture.
Macro matters more than ever. And if Ben Bernanke hasn’t reminded us all of that, then I am sure Janet Yellen will.