Stocks Are Overvalued - So What?

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Includes: CFO, DDM, DIA, DOG, DXD, EDV, EPS, HDGE, HSPX, IVV, IWM, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, TLT, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VEU, VFINX, VOO, VTWO
by: David Cretcher

Summary

As the market moves higher, so do valuations.

Valuations on most levels remain high.

So what? Do valuation matter?

Recently, the efficient market valued Tesla (NASDAQ:TSLA) higher than GM (NYSE:GM) and Ford (NYSE:F). I'll let the experts decide if a niche electric car company is worth more than a giant full-line vehicle company. Time will tell how efficient this valuation is, but I suspect it raised the eyebrows of the fundamental value camp.

Automakers aside, it reminds us valuations in the market are rising and now is the time to ask if the market is overvalued and if it is - so what?

Like most things, there's more than one way to skin the cat. Most valuation measures are some ratio of stock price, earnings, net worth, bond yields, and the economic growth.

The Value Compared To History

The most common is the price/earnings ratio (P/E), or how many dollars an investor is willing to pay for a dollar of earnings. Currently, the P/E ratio is 26.14. For every dollar of generated earnings, you will pay on average $26.14. As shown in figure 1, that's on the high side. The mean average is 15.65, and the median is 14.65. The range is wide from 5.31 to 123.73.

Fig 1: Price/Earnings ratio is 67 percent above mean average

A problem with this ratio is, it can be noisy and gives odd results during market drawdowns, like the spike shown above in 2009. To mitigate this, the P/E ratio is smoothed over the business cycle. There are many ways to do this, but the most popular is the Shiller P/E, which smoothes the data over ten years. The Shiller P/E is slightly higher than the trailing P/E. It is 28.60. The mean is 16.74, and the median is 16.12. The range is narrower - from 4.78 to 44.79.

Fig 2: Shiller P/E is 59 percent above mean average

(Courtesy of Multpl.com)

Value Compared To The Future

All valuation methods have pros and cons. The complaint with this measure is it is backward looking. Maybe earnings will grow faster in the future and the P/E ratio will go down. The ratio doesn't tell you what will happen in the future.

The P/E ratio compared to forward earnings estimates is at a post-crash high of 17.6 times estimates, and these estimates tend to be overvalued, because Wall Street analysts are optimists that want to keep their jobs.

Fig 3: Forward price earnings are the highest since before the crash

These P/E values are high, but price/earnings ratios over the last 30 years have been above average. Common reasons are low inflation and lower dividend payouts. Whatever the reason, investors have been willing to pay more for earnings in the most recent decades than they have in the earlier ones.

If the reason is inflation, maybe the higher valuations have to do with bond prices, which are strongly correlated with inflation levels.

Valuation Compared To Bonds

Another way to value stocks is to see them as a bond equivalent. When you buy a bond, you buy an interest or coupon stream. When you buy a stock, you get an earnings stream. The earnings yield from stocks is just the inverse of the P/E ratio 1/26.14 or 3.83 percent (figure 4). When you buy an average stock, you are buying an investment that generates 3.83 percent in earnings.

This method gives the investor a way to compare bonds to stocks as competing investments.

Fig 4: Earnings yield is 3.83 percent

(Courtesy of Multpl.com)

As shown in figure 3, the earnings yield is historically low. An explanation for this is that inflation and bond yields are low.

To remove the effect of bond yields, the bond yield can be removed or subtracted from the earnings yield to give an adjusted earnings yield (figure 5). A common benchmark bond is the 10-year Treasury.

By this measure, stocks are not overvalued if you compare them to the last 60 years. Experts that say stocks are not overvalued are usually thinking along this line.

Fig 5: Earnings yield adjusted against 10-Year Treasury is above recent average

Detractors of this method simply point out that maybe stocks and bonds are overpriced. To get a good value, the stock market has to be valued against something tangible, not another financial instrument.

Valuation Against Tangible Value

There are several ways to calculate this valuation. One method is the stock price versus book value, or how many times book value does and investor need to pay. Currently, investors must pay 2.99 for every dollar of book value (figure 6).

The problem with this method is book value is often distorted. Because of accounting and tax rules, book value is often depreciated and understated. Companies have a tax incentive to understate their value.

Fig 6: S&P 500 book value per share is at 13 year high

(Courtesy of Multpl.com)

Valuation Compared To Replacement Cost

Attempting to remedy this distortion, valuation is often stated as a ratio of replacement cost. How much would it cost to replace all of the assets represented in the stock market? This measurement is commonly known as Tobin's q - named after economist Jeffery Tobin who popularized the method. It is commonly measured as a percentage above either the arithmetic mean or the geometric mean.

Tobin's q is high, at 64 percent over average.

Fig 7: Tobin's q is 64 percent over its geometric mean

(Courtesy of DShort.com)

Valuation Compared to the Economy

There is another valuation method that doesn't use value or earnings. The capitalization of stocks to the country's GDP, or how much do stocks cost in relation to the overall economy. The economy grows and so do companies, and as the economy grows, the value of companies should also grow. But, if stocks are growing faster than GDP, it could be a warning flag.

As shown in figure 8, stocks as a percent of GDP are at a high level.

Fig 8: Stock market capitalization as a percent of GDP at all-time high

(Courtesy of St. Louis Fed)

So What?

So what if the stock market is highly valued? Why does it matter? After all, the market is still on both a medium and long-term uptrend (figure 9), and the trend is our friend. Or so we are told.

Fig 9: S&P 500 10-week moving average

(Courtesy of StockCharts.com)

And, the short-term correlation between stock market valuation and stock growth, as shown in figure 10, is weak to non-existent (figure 10). If you had jumped out of the market the last time the Shiller P/E ratio was 28, you would have missed a nice run up to 44. That was a 57 percent increase. Do we need to worry?

Fig 10: Nine percent of one-year market returns can be explained by the forward P/E ratio.

(Courtesy of JP Morgan)

The Risk Is Lower Rewards

The predictive value of the P/E ratio increases over time. Stock market valuation may be of limited value to short-term traders, but valuations matter to long-term buy and hold. Investors buying at high valuations have historically suffered poor future results (figure 11).

Seventeen years after its 2000 peak, the current market is just 2.5 percent above its 2000 peak - adjusted for inflation. A 20-year Treasury paid 6.86 percent back then. About 4.8 percent above average inflation. The bond would have given you an inflation-adjusted return over 80 percent.

Fig 11: Forty-three percent of 5-year returns can be explained by the forward P/E ratios.

(Courtesy of JPMorgan)

And Higher Downside Risk

The other problem is the risk of more violent drawdowns. Historically, lower-valued stock markets have smaller losses and higher-priced markets have larger losses (figure 12).

Fig 12: There is a positive correlation between high P/E ratios and higher drawdowns

Investment Implications

The stock market is highly valued on all measures except adjusted earnings yields. These higher valuations correlate with lower future performance and higher drawdown for long-term buy-and-hold investors.

The market is still in a long-term uptrend. High valuations can always go higher and produce significant gains for short-term traders. With luck, momentum trades can work in the near term. Be selective about sectors, and understand the risks behind high-value markets.

Long-term investors should make sure their portfolio is diversified and risk balanced. Consider reducing exposure to the US stock market and move allocations to lower-valued international markets (NYSEARCA:VEU). They should sell into rallies. Consider implementing stop losses or using structures with some hedging like covered call indexes (NYSEARCA:HSPX) or downside risk mechanisms (NASDAQ:CFO). Avoid shorting (NYSEARCA:HDGE) an upward trending market. And remember, it's not just the medicine, it's the dosage.

Consider adding some exposure to investments that are counter to the market like long-term bonds (NYSEARCA:TLT) and zero-coupon treasuries (NYSEARCA:EDV).

These are strategies for consideration, not recommendations. Do your own research or consult an investment advisor.

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.

Additional disclosure: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk. I am not your investment advisor, please consult your financial and tax advisers before investing.

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