Lately we’ve received many questions on market valuations. There are all kinds of variations on the theme, but they all essentially come down to whether the markets are overvalued, and how to react to that (assuming they are). Market valuations are interesting because while there is some value there, the value is completely different than what most of the people talking about them believe the value is. So, I want to break this down systematically and look at how you should be thinking about market valuations, and the role they play in your investment portfolio.
To start, let’s look at what market valuations actually are, and why they can be valuable (if you use them correctly and sparingly). In the second section, we’ll do a deep dive into the problems with relying on market valuations in your portfolio. Again, market valuations can be great tools if you use them correctly, but most people just don’t know how to do that.
Market valuations are a representation of people trying to get a handle on the relative “value” of the market – how the market, or a security, is priced relative to one or more fundamental measures of economic activity. We don’t want to simply look at the price of a security, or the market as a whole, because the amount of economic activity changes through time. We want to measure the price relative to some objective (1) measure of economic value.
The economy is a lot bigger than it was in the 1950’s. There’s more economic activity, and more value being created now than there was back then. It makes sense that the value of the market is higher now than in the past, but we need to identify a way to figure out if we’re paying too much for that increased economic activity. What we want to do is essentially compare scaled prices so that we can compare how “expensive” securities have been through time. So we want to look at prices relative to the underlying fundamentals – a company’s earnings, or their accounting value, or their profit – and how those things have moved through time. There are always going to be judgement calls on how to measure these fundamentals (2), but these metrics are trying to expose how far your dollar is going in the market.
There are all sorts of different market valuation metrics, but probably the most common, and certainly most influential, measure is the Price to Earnings ratio, and specifically the Cyclically Adjusted Price to Earnings (CAPE) ratio from Robert Shiller.
The basic Price to Earnings ratio is simply the price of a security divided by the company’s earnings from last year. Shiller’s CAPE ratio tries to take a longer-term view by smoothing out a company’s historical earnings. The typical length is 10 years (which is why you might see someone talking about the CAPE10 ratio), but there’s really no magic to this number. You could just as easily use the previous five years, or the previous fifteen years. The reason for this smoothing is to try and capture a full business cycle, or at least minimize the impact of whatever happens to be going on with the company right now, good or bad.
It’s important to remember that these measures are comparative measures. It doesn’t do me any good if you just tell me that the market’s CAPE ratio was 32.25. You need to give me the historical context around that number for this to mean anything; I need to understand how that number compares to what occurred in the past.
But in addition to accounting for where the current ratio is relative to what it’s looked like historically, I also need to think about how the market has changed from what has come before. Robert Shiller has calculated the CAPE ratio for the market all the way back to the 1881. As you might imagine, the market today is a little bit different from the market back then. Not only are accounting practices wildly different today than they were back then, but how companies act has also drastically changed.
For example, historically, companies haven’t retained their earnings at nearly the rate that they do today. Presumably, these companies aren’t keeping their earnings because they feel like it; they are choosing to invest them in internal projects. This means that we should expect a higher growth rate than we have seen in the past because companies are putting those earnings to work, rather than sending them to investors as dividends.
Here’s the thing. There actually is some real value in market valuations. They convey important things about what the market is likely to do going forward, but they aren’t the things that you want them to be.
Market valuations really do give you some sense of what future expected returns will look like. This makes a lot of sense. If we focus on price to earnings, well, both of these things tell you a lot about the business. As we said earlier, what you’re really doing is looking at how much you are paying for a dollar of the company’s earnings. If the P/E ratio is high, the market is saying that it’s willing to pay a lot for this company’s earnings, and it doesn’t really need a very high expected return to justify holding this company, because it’s relatively less risky (for whatever reason). If the P/E ratio is low, the market is saying that it’s not willing to pay a lot for this company’s earnings, and it really does require a high return to justify holding the company, because it’s relatively more risky (for whatever reason).
There are a lot of folks out there (including folks that I really respect) who will go out and calculate out the exact expected returns that are implied by different CAPE ratios, and you can do it, too. You can absolutely translate a market valuation into an assumed forward looking expected return. The question is, what do you do with it? How meaningful is that number? Is it meaningful over the next three years, or the next thirty years? And should this impact how you invest?
The simple answer is that CAPE ratios (and other market valuation metrics) do have some predictive power – over the long term. The market is simply too noisy in the short term for these numbers to provide actionable information. The way I read a high CAPE ratio (like we have now) is that the market is expecting that the future expected returns of stocks will be lower than it has been in the past. No more, and no less. As you are determining your long-term asset allocation, this is absolutely something that you should keep in mind.
However, we can’t take that next, really attractive step. Changes in the CAPE ratio don’t help us time the market, or adjust our portfolios in the short-term. We’ll look at why that is in Part 2 next week – The Problems with Market Valuations.
