There are strong opinions about the overvaluation of the US stock market. The human behavior is a fascinating field to study. People show over-reaction and under-reaction in every field. Forget what history has to teach you and it's probable that you will be enslaved by over-reaction. Be bounded by the past and it's probable that you will be enslaved by under-reaction.
In the last months, several articles appeared about a possible overvaluation and bubble about the market. Is the market overvalued because the weighted average SPY P/E ratio is about 19 while the historical average is 15? Before trying to answer such question, I have to say that, to stock pickers, it really does not matter where the market is as long as you pick undervalued stock with a time horizon of 3-5 years. It matters to noise investors for instance day traders and momentum investors. For long-term investors, the cost of getting out of the market at the wrong moment is way too high. We have already discussed this point here in December 2015. In the fist months of 2016, there has been a big correction and we have been very happy to increase our exposure on the stock market in February. Currently many are scared by the 2100 of the SPY.
Let's deep into the matter of an overvalued market. Is it a P/E ratio of 19 too high? Is it a P/E ratio a good proxy to spot a bubble at all? In 2000, the peak was driven by extraordinary P/E ratios, and the bubble was not a market bubble but a sector bubble. The P/E ratio was driven by the technology sector and some large caps stocks. During the bear market that followed between 2000 and 2004, the technology stocks lost most of their value, on average more than half of their market capitalization, but still roughly 40% of the S&P 500 stocks increased their value. But what about the 2007 peak? The subprime bubble was not a bubble on the market capitalization side of the story, but on the earning side of the story. What grew unusually high was the aggregate profit of the financial sector along with the energy sector earnings. The P/E was in line with a fair value given the level of the interest rate, inflation, return on capital, profit margins and earnings growth. Simply the earnings of the financial and energy sectors were not sustainable because they were inflated by the subprime bubble and the oil price.
What about now? What is happening? Is there a bubble anywhere? The current SPY P/E ratio is higher than the historical average and the reason why it is so needs to be investigated starting from the drivers of the P/E ratio: return on capital, earnings growth and cost of capital. If the return on capital, the earnings growth and the cost of capital are historically stable the P/E needs to be stable as well and any significant variation from the historical fair value in the short-term will be corrected in the long-term.
The market average P/E ratio for the last 30 years has not been stable and is following an upward trend, no matter how many outliers you have because of bubble inflations and deflations still a clear upward trend is in place. So the real question is: is this upward trend based on the real economy of the country? This trend is due partly to the huge excess cash US company have built up and partly to a shift of the real economy from sectors with low return on capital and margins to sectors with high return on capital and margins, namely IT, Pharma and Financials. You can find the data about this shift in a McKinsey article of 2014 here. As you can see from the picture below the weight of the high margin sectors on the aggregate profits for the SPY is more than doubled since 1990. The real economy is shifting from traditional manufacturing to intellectual property-based companies with higher margins and return on capitals.
Source: McKinsey on Finance article, "What's behind This Year's Buoyant Market".
As Bruce Greenwald notices here, US probably is in a secular shift from manufacturing to service exactly as it was in a secular shift from agriculture to manufacturing during the Great Depression. If this shift continues, a higher P/E ratio for the US market when compared with the historical average is more than justified and will probably continue to trend upward in the medium and long-term even if not necessarily in the short-term. If the current margins and return on capital are sustainable, then the current valuation of the market is within a fair value estimate.
In the financial sector, US banks, in spite of heavy regulation, are benefiting from ultra-low interest rates. This benefit will not last, but given the shock of the Great Recession, low interest rates will not disappears probably for years to come. All the attention on the Fed micro hikes is a show for noise traders rather than fundamental investors.
In the IT sector, software companies have very high return on capital and usually strong moat: writing software brings high fixed cost with it and most of the times customers purchasing software have high switching costs. Additionally, the IT sector is still very far from being mature, there is still a huge room for the IT to reduce the transaction costs we incur in many aspect of our lives where the IT is still not widespread.
In the Pharma sector, the next generations of drugs may have lower margins. However, it is a difficult guess to make; most of the non-transmissible disease are incurable today and innovative solutions for improving the efficiency of the R&D costs may help margins.
The stock market P/E ratio and the market capitalization in general can certainly drop in the short-term and we may as well experience a long period of high volatility until the world economy continue to be unstable. Nonetheless, in our opinion, the market is not evidently overpriced and there are long-term trends that justify the current valuation. If you are a fundamental investor with a long-term horizon and if your timing is wrong, the price you pay to be out of the market is too high. We do not know of anyone who built a 30-year career on consistently timing the market.
We still see undervalued stocks in this market and we are not willing to get out of a market that allow us to pick undervalued stocks. If any additional correction will come in the short-term, we will add to our positions as we did in February 2016.
Always be skeptical of whoever try to call an imminent bear market or bubble popping merely on statistical price data or price-to-earnings data. If they are not able to picture how those data relate to the real economy drivers, then they are not making any calculated guess that is worth your time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.