The Market Is 'Overvalued' And Other Dangerous Thoughts

| About: SPDR S&P (SPY)
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Summary

A recent TV guest suggested that the market was slightly overvalued.

In turn, advocating that securities did not look enticing as a result.

This article demonstrates why that can be a dangerous notion to carry around.

In the investing world it's important to have an opinion - a baseline or logical framework from which you can make decisions. Yet, in my view, it's equally important to understand the limitations about what you're doing. When you're coming up with earnings assumptions or growth rate projections, you're simply making guesses about the future. These guesses have a very good chance of being wrong.

People get so caught up in the calculation that often the "hey remember this is simply a guess" part is forgotten. They meticulously work through a series of calculations, get to answer and then treat it as "the answer" - as if once it has been calculated it's the only possibility remaining. The beginning calculations are important, but I find an unwavering dedication to the results to be a common investment blunder.

This thought resurfaced when I was watching Nightly Business Report recently. They had a guest on and were asking him some questions about investment recommendations. One particular exchange stirred up this "margin of error" notion. The host asked him how he felt about the current state of the market. Here was that guest's response:

"We've had a big move on the upside and you know that. On your common sense alone as well as my number crunching says that we've moved to a level that's pricey or overvalued. We're about 3.5% overvalued as I do the numbers. That means that it's not particularly attractive. The upside is not particularly attractive. It's not that enticing."

This is what I'm talking about in my introduction. When you do a calculation you're going to get an output. Just remember, it's not "the output." Three and a half percent sure sounds precise, and certainly some sort of logical framework was behind it, but it's a guess about the future. Why not 3% or 4%? For that matter why not 0% or 10%? How about -10% or 20%? Suspecting you happened upon a crystal ball is a sure-fire way to lose your way in the investing world.

Yet, let's forget for the moment the need to recognize margin for error (which is vital in my view). Let's suppose that this guest is precisely correct and a given group of securities, or we'll say the S&P 500 index (NYSEARCA:SPY) is "pricey or overvalued by 3.5%." Just for illustration sake. Does it also follow that investing would not be particularly attractive if this were the case?

We'll create a hypothetical demonstration. Suppose you have an aggregate group of securities earning $10 per share. A "fair" price for those companies, considering the underlying quality of earnings and their respective growth rates, is 15 times earnings. (You can pick whatever number you'd like, the point rests on the small claim of "overvalued" and not a particular earnings multiple.)

So a fair price to begin would be $150 (per whatever unit you would like). Now let's think about some growth rate assumptions. Suppose the dividend payout ratio sits at 45% (equating to a starting yield of 3%). Earnings are to grow at 5% per annum (and dividends will follow suit).

Under these circumstances, after 10 years you would anticipate collecting $59 or so in dividends (prior to thinking about reinvesting). Those firms would also be generating $16.30 or so in earnings. So if we went from "fair value" to "fair value" (15 times earnings to 15 times), the share price would go from $150 up to ~$244.

Your total expected value would be just under $304. Expressed differently, you would anticipate your original investment to double, equating to total gains of about 7.3% per annum.

Now let's look at the "tragedy" of seeing 3.5% overvaluation. Instead of a $150 starting price, you'd be looking at $155.25. The amount of dividends that you would collect and the underlying earnings claim would be the same - resulting in the same ~$304 total value expectation. In this circumstance your total gain would "only" be 6.9% annum.

Perhaps you see the flaw in the logic the NBR guest mentioned above. Even if they are precisely correct in their "3.5% overvalued" claim, this alone does not simultaneously indicate that a particular security or group of securities is now unattractive.

If you say "3.5% overvalued is not enticing" then you're also suggesting that paying a fair price would not be attractive either. You're not suggesting that valuation is the problem, but instead that you don't want to own a collection of very profitable businesses for years. Because the difference between the two simply isn't that large.

Now some might point to the idea that in the long term this may not make a big difference, but in the short term it could. That's basically my point. If you're trying to predict what happens next year, a 3.5% possible difference may (and I think may should be stressed here) influence your line of thought. Yet over the long term, that argument just doesn't make a lot of sense.

And remember, there's no crystal ball here.

I'm reminded of the analyst covering Wells Fargo (NYSE:WFC) who said you ought to sell the security because the share price was slightly lower than his estimate. It has some logical bearing, but it misses a whole lot of realities. The same problems show up here.

For one, and this is the big one, your estimates may be off. Perhaps you used 10% instead of 9%. Or perhaps you wanted to use 9% but decided against it. Perchance the growth rate turns out to be a bit better than you thought. Or it is conceivable that things don't go exactly as you predict. There are way too many unknowns to be confident, especially if you're talking about the difference between a few percent.

Beyond that, comparisons can be dangerous. Suppose that equities "only" generate 5% annual returns moving forward. If you elected to hold cash or lower paying bonds for years - recognizing this lowered return possibility - there is no great triumph here. You could get the sentiment right, but the wealth building process wrong.

And then you have frictional expenses that could mitigate any benefit from jumping in and out. For that matter, suppose you buy today and the collective bids do decrease in the future - an outcome many people fear. This could actually be fine news, as you continue to be a long-term net buyer through "fresh" capital, reinvested dividends and on your behalf via share repurchases.

Finally, even if you're "right" you could be wrong. Even if the market is "overvalued" by precisely 3.5%, there's nothing preventing shares from going to 10% or 20%. You could elect to make a decision based on a large unknown, only to see that the market doesn't pay particular attention to your calculations.

A large group of securities or "the market" could very well be "overvalued" today. I'm not discounting that possibility. However, I would like to make a few points.

For one thing, suggesting that it is "pricey by 3.5%" is a sure way to get frustrated in the investing world. There are way too many complexities and unknowns to get a figure that precise. I like to work in ranges - say 0% to 20% - and even then you have the same problems involved. When in doubt (which is always in the investing world) be humble, not specific.

And second, even if you're right in the short term you could be hindering your long-term performance. I like to do these studies to see what a "worst case" scenario looks like for the consistent long-term investor. They are eye opening.

For instance, the difference between buying at the best possible moment and worst possible moment each year, isn't as large as you might imagine. Or even if you waited to invest at the peak of each market, you still could have amassed tremendous wealth. As Warren Buffett would have it, "since the basic game is so favorable, it's a terrible mistake to try to dance in and out of it… the risks of being out of the game are huge compared to the risks of being in it."

The market or an aggregation of securities may very well be overvalued. Yet, there are some important caveats. For one, you may be wrong. Two, this could be a dangerous thought if it prevents you from regularly investing. And three, even if this turns out to be the case, your potential returns are still apt to be quite positive over the long term.

Disclosure: I am/we are long WFC.

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.