Stocks Are Somewhere Between Tremendously And Enormously OvervaluedAdvisor Perspectives
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My business is to constantly look for new stocks by running screens, endlessly reading (blogs, research, magazines, newspapers), looking at the holdings of respected investors, talking to a large network of investment professionals, attending conferences, scouring through ideas published on value-investor networks and finally, scouring a large (and growing) watch list of companies to buy at a significant margin of safety.
With all of that, my firm is having little success finding solid companies at attractive valuations.
Don’t just take my word for it. Take a look at several charts, below, that show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.
Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued – somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, I don’t know either. But this is my point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.
Let’s go to the charts. The first chart shows price-to-earnings of the S&P 500 in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the 1999 run-up to the dotcom bubble burst.
We know how the history played in both cases – consequently stocks declined, a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean-revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.
What we don’t know is how investors will fare in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it say hello to the pre-dotcom crash level of 164% above average? Nobody knows.
One chart is not enough. Here’s another, called the “Buffett Indicator.” Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the entire U.S. economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.
This chart tells a similar story to the first one. Though I was not around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first 10 months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: First: “This time is different” (it never is). Second: “Yes, stocks are overvalued, but we are still in the bull market.” (They were right about this until they lost their shirts.)
I was investing during the 1999 bubble. I vividly remember the “This time is different” argument of 1999. It was the new economy versus the old, and the new was supposed to change or at least modify the rules of economic gravity. The economy was now supposed to grow at a much faster rate. But economic growth over the past 20 years has not been any different than in the previous 20. Actually, I take that back – it’s been lower. From 1980 to 2000 the U.S. economy’s real growth was about 3% a year, while from 2000 to now it has been about 2% a year.
Read the full article here by Vitaliy Katsenelson, Advisor Perspectives