Are stocks too expensive?

Are stocks too expensive? You’d certainly think so if you wasted even just a little of your precious time reading the financial media.

Everybody’s talking about the end of the longest bull market in history. When they aren’t speculating about that, they are warning valuations now indicate one of the most expensive periods in stock market history.

Goldbugs have crawled out of the woodwork as a reminder of where to put your money in times of fear.

If people are moving into gold, the stock market is in its longest bull market in history and all the valuations are high, is it any surprise investors are asking questioning prices?

Maybe it’s time to pull our money out of the financial markets all together.

But the thing is, just because the news says something is so, doesn’t necessarily make it so.

In reality, if you could use the news (financial or otherwise) to make investment decisions, there’d probably be a lot more billionaires out there than there actually are.

Without doubt, there are plenty fund managers in the City and Wall Street that have made a lot of money. But that wealth usually comes from the fees people pay them rather than the investment decisions they make. And the odd one that has made money through their investing, probably wasn’t that concerned with news.

By the time things hit the news, it’s probably too late to take action anyway. If you are reading it, then so is everybody else. Any action that needed to be taken should have been taken before the news came out. By that point everybody knows and any implications about investing in the company will be baked into the price.

Bad news

Not to mention the fact that news tends to focus on the negative stuff. They say bad news sells. I’ve lost count of how many times I’ve heard the one about people pass on good information to a couple of people, but pass the bad onto at least ten.

For a long time I thought journalists concentrated on the bad stuff on purpose. However, recently I saw it explained another way.

The fact is, bad stuff like earthquakes happen quickly and regularly whereas good stuff like increases in life expectancy take years to come to fruition. Likewise, stock markets takes years to go up, but just days to go down by the same amount.

There’s also the theory that people are simply more interested in bad news than good news. According to research by Marc Trussler and Stuart Soroka at McGill University in Canada, people tend to be drawn to negative stories.

One theory is based on the fact that our evolution has led to us having quicker reaction times when potential threats are involved. In other words, our eyes are drawn to bad news in an effort to safeguard our livelihoods.

So no matter whether it’s the journalists pushing the bad news our way or our subconscious leading us to it, we tend to get more bad info into our brains than good.

I don’t know about you but I’d probably find myself reading a story about an up and coming stock market crash over one that said nothing much will be happening in the stock market over the next decade.

This leads to the conclusion that things probably aren’t as bad as we think. Perhaps the situation in the financial markets isn’t as bad as people are making out.

US bias

And there’s another problem related specifically to financial media and that’s a bias towards US markets. Even non US news sources find themselves concentrating more on US companies than those of other regions.

The saying, ‘when America sneezes, the world catches a cold,’ comes to mind. The financial crisis is proof of this. And more recently the way the markets have been responding to Donald Trump’s trade war rhetoric toward China suggests it is still true today.

At the end of the day, the US is the biggest financial market after all. Lots of the best data and research out there is US centric. More often than not investors in stocks have a good portion in US companies. This tends to be the case no matter where they are from. Some invest in global funds that tend to be heavily waited towards the US and others just like US companies.

Let’s face it companies like Amazon, Apple, Google and Microsoft dominate the world we live in right now. Who’d not want to own these companies.

But of course here lies an obvious problem. Everybody does wants to own them, and whenever everybody wants something the price tends to go up.

Have a look at the chart below which compares small and large US companies against other major markets.

High prices

Since mid 2013 US stocks have been pulling away. Other developed markets and emerging markets have more or less flat lined since the financial crisis.

Valuing stocks with the CAPE ratio?

So instead of focusing on stocks generally? Perhaps, a more appropriate question is are US stocks too pricey? Lots of people think they are. In fact, not a day goes by without somebody talking about reducing their exposure to US stocks and replacing them with exposure to other markets.

But, just because they’ve gone up a lot doesn’t necessarily mean they are expensive.

To get to the bottom of it we need to take a look at valuations.

There are many valuation measures to choose from, but perhaps the most popular is the CAPE ratio (Cyclically adjusted price to earnings ratio).

Sometimes called the Shiller PE, since it was devised by Nobel Laureate economist, Robert Shiller, the CAPE ratio divides a stock price by a ten year average of corporate earnings adjusted for inflation.

The chart below compares the current CAPE ratio, with the historic median average using data from Research Affiliates.

Stocks valued according to CAPE

So whereas other markets are looking cheap, the CAPE ratio certainly suggests the US is expensive. And that could have an impact on future returns.

You see Shiller thinks a CAPE ratio level significantly higher than the median is a problem. It indicates an increased likelihood of poor performance in the years ahead. Basically there is a reversion to the mean. Markets that out perform over one period will under perform during the next. Everything averages out over time.

Is it any wonder that all those CAPE ratio fans are selling all their US stocks and buying those from other markets?

And doesn’t that mean you should too? The way I see it, there are some reasons why you shouldn’t.

You get what you pay for

First, the prices of things are determined by what people are willing to pay for them. Last I looked stock market buying and selling is dominated by large institutions. These guys utilize the best brains, experience and technology to make their decisions. Yes, they don’t always get things right, but more often than not they do.

At any point in time the stock prices are determined by everything they know up to that point. Think about all that brain and computer power behind the stock market’s pricing mechanism. Do you really want to bet against it?

If those in the know have decided US stocks should be more expensive than those of other markets, there are probably excellent reasons why.

The old adage ‘you get what you pay for’ comes to mind. Take our UK companies for example. Are HSBC, Shell and BP really in the same ballpark as Microsoft, Apple and Amazon?

Then there’s the fact that those CAPE ratio followers have been saying US stocks are overpriced for the last 5 years or so. At the same time they’e been missing out on the big gains. After 5 years perhaps we can be forgiven for thinking those guys don’t seem to know what they are talking about.

I’ve lost track of the number of articles I’ve read about people being underweight US stocks because they are expensive. Every single one of them has missed out on big gains. They might be right somewhere down the line, but that won’t help them recoup their past underperformance.

The CAPE ratio has more than its fair share of fans, but there are still plenty of people who aren’t believers.

Jeremy Siegel

Most noticeably fellow economist, Professor of Finance at the Wharton School, and long time friend to Shiller himself, Jeremy Siegel.

Siegel uses the more common price earnings (P/E) ratio to make valuations, rather than Shiller’s CAPE ratio. The P/E ratio values a company by measuring its share price as compared to its per-share earnings.

And Siegel questions the CAPE ratio idea that there must be a reversion to the mean. He says:

Should we go back to 15 as the long-run normal (P/E ratio), or CAPE at 16.5 [median return] or so? My feeling is, ‘no, we shouldn’t.’ I say that the warranted P/E ratio is higher than history. And one of the reasons for that is indexing at zero cost, which was totally unavailable during the greatest part of this [market] sample.

Jeremy Siegel

Siegel’s argument is that people will be willing to pay a bit more for stocks than in the past because they don’t have to pay high fees anymore. In other words, they’ll get the same returns anyway.

Let me explain. The P/E ratio gives you an indication of what return you are going to get. You divide 1 by the P/E number. So if we go back to our average P/E ratio for US stocks of 15, we can see that this indicates a real return of 6.7% (1/15 = 6.7). And this has more or less been the historic real return for US stocks.

But during that time investors have had to pay high fees. Estimates in the region of 1.7% a year aren’t beyond reason. So if you think about it, they were really only getting around a 5% return. In other words, investors bought stocks to achieve a 5% real return.

Low cost index funds means we don’t have these costs to pay anymore. Consequently, we can get the same 5% via a P/E of 20 (1/20 = 5). Incidentally, at the time of writing the P/E ratio for US stocks (S&P 500) is 20. Maybe US stocks aren’t all that expensive after all.

Siegel also mentions some other reasons why valuations could be justifiably higher right now. He points out that US companies are reducing the amount of dividends they pay. This should increase earnings growth and distort the CAPE ratio. And finally he says that you’d expect a higher valuations in a low interest rate environment.

Warren Buffett & interest rates

Warren Buffett echoed this sentiment in an interview with CNBC on the 25th Feb 2019. He said:

If 30 year bonds remain at 3% for the next 30 years then stocks are incredibly cheap. Interest rates govern everything. It doesn’t look like interest rates are going to be jacked up anytime soon. We maybe in a new world. A world Japan entered back in 1990.

Warren Buffett

He went on to say if he had a choice between buying 10 year bonds that were paying about 2.7% at the time or buying and holding the S&P500 (US stocks) for 10 years, he’d ‘buy the S&P in a heartbeat.’ And that’s at a time when the CAPE and P/E ratios were pretty much the same as they are today.

The bottom line

Are stocks too expensive? In general, maybe not, but perhaps there is an argument that US companies could be cheaper. The jury’s out on this, but even if they are, there seems to be some compelling reasons why.

In any case, it’s certainly not the case that you should shy away from investing in stocks, US or otherwise.

Choosing when to invest or selecting certain parts of the market to invest are pretty bold investment decisions. In fact, for an individual investor, that would equate to taking an active bet, that in all likelihood we wouldn’t be qualified to make.

And think of it this way, those guys who are qualified don’t seem to be put off by supposedly high stock prices. The UK’s most successful fund manager, Terry Smith is still buying plenty stocks, mostly US, and Warren Buffett the most famous investor of them all hardly buys anything but US stocks.

Most of us are probably better off sticking with a globally diversified portfolio of low cost index funds. One that contains all the stocks.

That way if US stocks continue on their merry run we’ll be in the money, but if they start to take a back seat to other markets we will have them anyway.

You can read more about investing in stocks here.