Stock Market Overvaluation and the Passive Investor

Valuations for stocks look reasonable going by the conventional price-to-earnings (P/E) ratio, but Professor Shiller’s cyclically adjusted P/E ratio says the U.S. market is about 70% overvalued and Smithers & Co.’s q-ratio (market cap/replacement cost, as defined on their website) says it’s 17% overvalued. Here is a chart showing both measures.

Both Prof. Shiller and Smithers & Co. will be the first to say that neither of their valuation yardsticks forecast where stocks are going in the short-term. Indeed, stock markets could climb upwards in 2008 and become more overvalued. However, over the long haul, they believe, stock values should revert to the historical means in their indexes.

The overvalued readings in their measures may have implications for the school of passive indexing, which focuses on the long run. Adherents correctly point out that stocks go up over the long run, so all one has to do is hang on through the volatility. But going by Shiller’s and Smithers & Co.’s indicators, the wait may take longer than it would if the passive investor was starting their indexing in a period when the two valuation indexes were showing undervaluation.

Comments

[Silver-Bullet]

Bravo, Bravo!

May I add that the age of paper asset (stocks, bonds, derivatives and fiat currencies) is stepping aside for the age of hard asset(commodities, precious & base metals, agriculture, oil).

[jerry p]

Inflation will kill fixed income securities

[Realsit]

Can anyone give me their opinion on the stocks that I hold:
AGU,CF,CNQ,CPL,DVN,ECA... After a month of studying the market I came to the conclusion that hard assets (i.e. commodities, iron ore, metals, steel, agriculture, and oil) were the places to invest. In addition, Brazil is a good market to invest in. Russia and China did not make it into my portfolio, although India looks interesting. Over half my stocks are foreign. When I did a backtest to see how my portfolio has performed since the beginning of the year, it grew nearly 40%. I just invested about 10 days ago. I hope this growth trend hold up through the rest of the year.

[Realsit]

the rest of the holdings: NUE, PBR, PBR.A, PDA, POT, RIO, SID, SYT, TTES, XEC

[kopuschen]

It makes sense at first sight and the graph is very convincing. Yet after further examination I just don't think this is a good indication of further outlook, short-term or long-term. Just look at year 1990-2000 especially the latter half. In other words, both lines are neck-to-neck. So pardon me ask, isn't dot com bubble something "over-valued"... as we know it now? How come it never show up on the graph? Instead, the model believes the value is going up indeed and go hand-in-hand like an innocent individual stock buyer (note, not investor).

The reverse reasoning should also holds, just because someone using the model to say the market is overvalued doesn't mean the model recognize any undervaluation. I'm not saying the current market is undervalued, I just want to point out that this model is flawed.

[bearfund]

Gotta buy something. Cash is losing somewhere between 1% (CPI-U minus 1-year CD rates) and 11% (SGS CPI minus 3-month T-bills) per year. Treasuries yield nothing and are going to experience huge price drops as inflation and/or higher overnight rates combine with massive oversupply and tepid demand; indeed, it's already happening. If you don't like equities there's little reason to like corporate paper, either. Commodities are all near all-time highs in any terms (except silver, for which the historical comparison in misleading) and thus look pricey themselves. And so on.

Bottom line, there's a lot of money out there looking for a home. The tax system practically forces everyone to stuff money into 401(k)s and IRAs, and most people opt for index funds and other broad-based investments, if indeed they even have a choice. That profits relative to GDP are already near all-time highs or that CAPE shows stocks to be overvalued or that there's no realistic chance that today's valuations are justified by reasonable DCF estimates are irrelevant. Tastes in investment change over time. 100 years ago a stock that paid no dividend and sold for 20x earnings would have been a joke and no one would have looked at a CLO as anything but a curiosity. Maybe someday everyone's retirement plan will offer gold and rice as the default options, but right now the demand is for stocks, especially low-yielding "growth" stocks (whose dividends don't grow even if earnings happen to), because everyone has been told they need to buy them and they only go up, so historical P/E ratios and future dividend (and inflation) expectations don't matter. There's demand, there's supply, and that's all there is to it.

If you are in a position to invest with a 100- or 1000-year horizon, by all means stick most of your money somewhere safe (whatever that means to you) while you wait for stocks to reach reasonable valuation levels. You'll surely beat nearly everyone in the long run. The rest of us have big piles of cash that have to earn us a decent return in the next few months or few years, so we can't sit around waiting for the market to become rational, nor can we afford to bet against it while we wait - you know the saying on that one. Yeah, we know the market is overvalued, but so what? We can't do anything about that. We need returns, so we have to take risks, timing the market or picking the few winners and perhaps a handful of extraordinary losers from the giant cesspool of overvalued mediocrity. Isn't that what "seeking alpha" is all about? So what's your point? There's nothing new or helpful about this article. How about correlating overvalued/undervalued indicators with historical returns on LEAPS or, well, anything actually investable?

[richjoy]

Having looked at 100s of charts over the years, I am left with the impression one can make a chart to show just about anything one would like.

I have found that Total Return Investing works fine for me (and lets me sleep better). I'm sure you know how it's done, so I won't bore you with the particulars.

[Woodycon]

Russell Napier's book: Anatomy of the Bear, a survey of the four greatest bear markets of the 20th century, uses the "q" to rate the bear markets. Thus, on the basis of q, the '82 bear market was worse than the '74 one. Russell further makes the point that the bear markets usually last 10-14 years. Thanks for the link to the "q".

[growthvalue]

SLT an indian metals company is very stong

[cheesecake]

GE is at 30, this company has billions of assets and expertise...yet dumbass google is at 500...the stock market DOES NOT price things correctly, that's a misnomer.
within the context of this article, the market is undervalued, there are a lot of good stocks out there, which should be higher. And please i hate the P/E ratio, what a crock of shit. the ratio i use most is asset / # of shares or rev/ shares...this above all will give you a fair idea of what your asset is worth.

[steve west]

ZZZZZZZZZZZZZZZZZZZZZZ...

[srqadvisor]

Notice how q is derived.. It is a function of book value. Depreciation and capital expenditures have to be adjusted to "arrive" at replacement cost. This measure, from my experience, is hardly even close to the "private" market value of a company - nor does it impute "economic advantage". It does not assign any value for future earnings, only book asset value. Agreed, you can use it to make a bear case... But, tell me why Bear Stearn's book value was close to $80, but the "price" was $10 (so far!)... Actually, don't tell me -- it will just upset me! Why is it that an investor will stake their financial claim on one indicator that has missed cylical highs and lows by extremes?

[bearfund]

cheesecake, are you serious? Assets per share, really? So given equal number of shares outstanding, you value a company with $10b in assets, no debt, and a return on equity of 20% the same as you value one with $10b in assets, $5b in debt, and a return on equity of 4%? We could even suppose they generate the same amount of revenue, so that by both your measures they are equally valuable. But the first will earn $2b per year, the second only $200m. If each has the same payout ratio, the first company is worth exactly 10x as much. In reality it's worth more, because the second company's large debt load makes it riskier, for which you should demand a premium. Your approach makes no sense; any sane value investor will look at all fundamental aspects of a company's capital structure, operations, and prospects, not just the one or two you mention (which are in any case among the least meaningful).

Yes, GE is much more valuable than GOOG, but the reason is more complex than just assets or revenue divided by shares outstanding. And it's not exactly cut and dried, either - GE has 4.72x as much debt as shareholder equity; GOOG has no debt. You have to look deeper to understand why GE is better than GOOG - a good place to start is the fact that GE makes things that people need in order to live or operate their businesses and pays a dividend; GOOG does neither (and no one seems to expect that GOOG will *ever* pay a dividend).

But frankly I don't really want to own either of these companies at current valuations. Let's look at fair value. For GE, I put it around $24. That's based on continued 10% dividend growth and 15% discounting, with a 10% risk penalty for the hefty debt and rising payout ratio. That's fairly generous, but it's definitely achievable and GE has a solid history, quality assets, and plenty of competence. The recent earnings miss may well just be a short-term bump in the road. Still, I'm not going to pay $33 on the assumption that everything is rosy. It's clearly not.

For GOOG, I put fair value at $275. Because the company pays no dividend and is not expected to, we have to use book value. I do not value companies that pay no dividend above book value because from where I stand as a shareholder they are not going concerns; the only value I can expect to receive is at liquidation. This company actually looks a lot like Microsoft - a cash-generating machine that cannot efficiently invest that cash to grow its business much further but refuses to pay it out to shareholders. For GOOG, book value is $77 (of which over half is cash and short-term investments). I assume retained earnings of $20, $24, $28, $31, $33 for the next 5 years based on near-term analyst estimates and a marked decline in pointless consumption (and thus in advertising value) in the US and Europe and some continued growth in Asia, a terminal growth rate of 5% thereafter, and 15% discounting. I impose a 20% penalty for the risks associated with a poorly-managed company transitioning from a growth phase to mature operation and the possibility that I understate the macro shift away from pointless consumption back to essentials.

My discount rate of 15% is also on the low side; with prices rising around 11% that's historically a low return for the risks inherent in equity investing. It wouldn't strike me as unreasonable to use a rate as high as 18-20%. In any event, if Mr. Market won't sell to me at those prices, that's fine; I'll just buy other stocks that are fairly valued. Finding them is the trick, because the bulls have the entire system on their side and virtually all valuations far exceed the returns investors can ever realistically hope to obtain. One does not bet against an irrational market, but neither does one bet on its irrationality continuing indefinitely. Buying either of these stocks today is exactly that, and the same could be said for most of the market - which I believe was the point of this article in the first place. The reason the market is so overvalued is precisely the fact that far too few investors undertake an analysis even as superficial and simplistic as the one I just demonstrated. Yours, however, really takes the prize for sheer irrelevance.

[sopocistudio]

bearfund,

You said it much better than I ever could. I like your comparison of MSFT to GOOG.

jan

[galewhitaker]

cheesecake
Your words are strange. Common stocks do not have "worh", they only have price. Obviously when a company goes broke you have nothing. Real estate has "worth", not stocks.

[muki]

Have you noticed the behavior of 'q' over past 5 years? As the stock market climbed a little, this measure went down, i.e. became more favorable. This is too short a time period for any reasonable statistics, but it leaves me unconvinced about its usefulness. If you actually waited for this q to come down, you've already lost a good part of the gains, and if you wait longer, you are likely to lose even more. As someone here has already suggested, there is no point in waiting for these valuations to go down. They can stay above your entry point almost indefinitely.

[Vikram]

How does one value the replacement cost of intellectual capital and brand names? I would like to hire Einstein please; can you tell me the replacement cost?

This measure might make sense for Canada since their biggest exports and products are raw materails (think Potash, oil from sands etc.)

[User 183569]

The map is not the territory. Models, like maps, have flaws. This chart depicts two indexes over a century. These indexes represent perceived value in a market at a given time.

P/E ratios are sometimes used together with growth in dividend yield to establish expected total return.

A significant variation in stock price is associated with expansion and contraction of the P/E ratio. Historically, a low P/E for the S&P 500 would be around 6 to 7; and an average of about 14.5 to 15.

This chart, a stand-in for the P/E ratio for the S&P 500, indicates the P/E is contracting; and suggests that the P/E won't start expanding again until the q and cape indexes get to about -0.6.

These indexes could also turn on a dime. Direction and magnitude are in the eyes of the beholder, and , the trend is your friend, until it breaks.

[WarrenBuffett]

Only Clueless idiots compare absolute P/E ratios.

P/E ratios should always be normalized to a Risk-Free Rate (10 Year Treasury for Eg)

An investor can
i) Buy a $100 Bond and earn $3.5 perpetually (Current 10 Year Yield) or
ii) Buy $100 S&P 500 and earn $5 (If forward P/E is 20) plus a growth of historic 7%

Any smart investor will find stocks cheaper than bonds.

OTOH, if Interest Rates go up to say 10%, then the same P/E of 20 becomes expensive

Bottomline, P/E should be normalized to underlying Risk Free Rate.
(Of course just like future earnings, you have to take future expectations of Interest rates)

If you are conservative, you can even compare dividend yield to check the valuation

And to the second set of idiots who insist on buying Gold,

Asset = Stuff that produces Cash Flow
Real Estate is an asset (Produces Rent Dividends)
Stocks are assets (Produces Earnings which stockholders have claim to)
Bonds are assets (Gives out coupons)
Gold, Commodities produces no revenues let alone Cash Flows. Gold/Commodities are like Tulip Bulbs and Internet Companies. Its only worth is what the next idiot is going to pay for it.

Anything that produces cash flow can be fairly valued (It is a different issue that it may trade at a different price). But stuff that produces no cash flow can never be valued and invariably clueless investors pay a higher price and when the price comes crashing down blame George Bush and the Fed