Are Stocks Overvalued?

February 9, 2017 2:00 pm

As a follow up to our recent blog entry, “2016 Market Review”, some friends recently asked me about current stock market valuation levels. In the following chart, we see that several major stock market indices surged to new all-time highs at the end of 2016 (Some indices have moved even higher in 2017).

The Question:  Is the stock market overvalued?

Given U.S. stocks have produced one of the more robust and unexpected market rallies in recent years, the media has predictably followed with a host of articles about how the market is now “overvalued” (A term that implies stocks have gotten ahead of themselves and are due for a fall). This is a constant theme in the media whenever the market is climbing upward, and it never fails to stoke fear in investors that a downturn is looming. A quick Google search on this subject is instructive – because it shows such articles appearing every year going back to the 2008-09 bear market (There were even articles arguing that stocks were overvalued at the Dow’s low point of 6,627 in March 2009!).

As many of you know, we are not in the business of forecasting and instead use logic as well as an evidenced-based investment approach at our firm. For example, if we dive deeper into the data on the S&P 500 Index (which focuses on larger domestic companies), it doesn’t appear based on the following chart that stocks are overvalued in the U.S. as some talking heads claim (albeit expected return may be lower in the near-term for this area of the market but not necessarily negative).

S&P 500 VALUATION

Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management. See below for additional disclosures.

 

When investment managers assert that the market is overvalued, the extension of this logic is that investors should do something to diminish the risk to their portfolios by reducing stock exposure, or even exiting stocks entirely. Our advice is that investors should stick to their financial planning strategy and make decisions based on the ability to meet their specific goals and objectives.

In most client scenarios following large market movements, we apply modest rebalancing to manage risk and don’t make dramatic portfolio changes unless something has changed with our clients’ needs and circumstances.

However, for those investors already retired or planning on full retirement in the next five years or less, your situation may be different. If this applies to you, it would be wise to seek advice on what the right level of stock market exposure is for your investment portfolio so you can best manage sequence of return risk and ensure sustainable lifetime income. For others still working and accumulating savings, other factors such as taxes and costs will play a critical role when it comes to making important investment decisions.

Our Beliefs and the Media

One of the central tenets of investment success is maintaining a sense of faith in the future – holding fast to the belief that the overall state of humanity is improving. From an investment perspective, it stands to reason that businesses, being collections of people, will both be the catalyst for, and beneficiaries of, this state of perpetual improvement and future stock returns will therefore reflect these improvements.

At this point, we suspect there are many reading this blog who are either shaking their heads or rolling their eyes – or maybe both – at the notion that “things are improving.” After all, when we are bombarded daily with constant examples of how things are going terribly wrong in the world, how can anyone assert that things are getting better?

A fascinating article we ran across recently entitled Why are we determined to deny that things are getting better? highlights the disconnect between what we perceive to be reality versus what is, in fact, reality. In the article, author Johan Norberg notes that, despite dramatic reductions in violent crime, poverty and infant mortality around the globe, most people still perceive things to be getting worse instead of better. Mr. Norberg attributes much of this skewed perspective to the saturation of negative news stories in the media and the instantaneous availability of those stories via smart phones.

To bring all of this back to an investment perspective: Investors who embrace a negative world view tend to manifest that belief in their investment decisions, becoming overly cautious in their desire to hold riskier assets like stocks even when their age and financial goals dictate the need for such assets. It is therefore important not to let anecdotal examples in the media – however jarring those examples may be – drive us toward an overly cautious approach to investing that will only serve to diminish our financial wellbeing in the future.

We appreciate our relationship with you and as always we are here to help.

Best,

Marc

 

DISCLOSURES:
Source: FactSet, FRB, Robert Shiller, Standard & Poors, J.P. Morgan Asset Management. Price ot earnings is price divided by consensus analysis estimates of earning per share for the next 12 months. Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies. Dividend yield is calculated as the next 12-month consensus dividend divided by most recent price. Price to book ratio is the price divided by book value per share. Price to cash flow is price divided by NTM cash flow. EY minus Baa yield is the forward earnings yield (consensus analysis estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Std. dev. Over-/under-valued is calculated using the average and the standard deviation over 25 years of each measure. “P/CF is a 20-year average due to cash flow data availability. Guide to the Markets – U.S. Data are as of December 31, 2016.
M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. We provide investment information that we believe to be useful and accurate. However, there cannot be any guarantees. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance.
This presentation does not constitute a complete description of our investment services and is for information purposes only. Actual portfolio allocations may vary from the allocations within this post. Past performance is no guarantee of future results or returns. The returns are generated per the retroactive application of the stated index, designed with the benefit of hindsight, to historical data (i.e., back-tested). They represent hypothetical results of an investment in various asset class indexes and do not reflect actual investments of money in any CAM Investor Solutions strategy, and may not reflect the impact that material economic factors might have on CAM Investor Solutions’ management of the model portfolios if it were actually managing the model portfolios during the period described. Returns are gross of advisory fees, brokerage or other commissions, mutual fund exchange fees, and any other expenses that a client would have paid.

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This post was written by Marc Jimenez, CFA, CFP®

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