I keep hearing and reading that the market is too expensive. This is concerning because people wonder whether they should get out of the market or whether or not now is even a good time to invest. If you think about it, the thought process makes sense. Why would you want to get into the market when prices are around all-time highs. After all, you’ve heard the saying “buy low, sell high”.
But even with this notion, is it good advice to get out of the market?
Let me first share with you a few of the articles I came across that speak to the market being too expensive.
The Reformed Broker recently said that hedge fund manager David Einhorn is “ringing the alarm bells over the worship of growth stocks without earnings.” And that Warren Buffet is sitting on $90 billion in cash, “struggling to find reasonably valued assets to invest in.” The Reformed Broker also stated that the CAPE (Cyclically Adjusted Price Earnings) ratio for US stocks is at an extremely high level and that it does not bode well for stocks going forward. However, I loved his next statement where he said that this same situation was also present in 1995 and that the stock market had an unprecedented run from 1995 to 1998 averaging 26.27% per year. Bottom line is that there is no magic formula or ratio. Click here for a counter argument on the CAPE ratio written by Dimensional Fund Advisors’ Vice President, Weston Wellington.
John Mauldin of Mauldin Economics pointed out that the S&P 500 (US Large Company Stocks) has a historical 53 year median P/E ratio of 17, but the S&P is currently trading at a P/E of 24.1, which is obviously in the “overvalued” category. He said, “that tells us to expect low returns over the coming 10 years”. Be careful with relying solely on the P/E ratio as your investment strategy. Investopedia has a great article on the limitations of relying on the P/E ratio.
Jeremy Grantham of GMO predicts that US large company stocks and US small company stocks will be down 3.8% per year and 3.1% per year respectively over the next 7 years.
John Hussman of Hussman Funds recently stated that “given present valuation extremes, we expect S&P 500 annual nominal total returns to average just 0.6% over the coming 12-year period.”
If you look hard enough, you can find enough “experts” making so-called predictions about how the market will underperform in the future due to it being over-valued.
Despite the sky is falling news, we take a straight-forward approach to money management. Back in 1975, Eugene Fama won the Nobel Prize for his work on the efficient market hypothesis. It basically says that all of the information that we know or have available today is immediately factored into the price of a stock. Think of the stock market as a big information processing machine. With technology, we instantly know anything and everything about every publicly traded company. And this information is what forms the current price of a stock.
Let me try to explain this by way of example. Assume that you own a private business that you want to sell. How would you value your business? How would the buyer value your business? You can rest assured that many of the important factors will be current sales, sales trends, profit history, staffing turnover, number of clients, margins, expenses, projected sales, projected profits, etc… It’s these factors (plus others) that will ultimately determine the price of your business.
So how does this relate to stocks? When you own a stock, you are a legal owner of that company, albeit usually a very small owner. The fact that the business is public instead of private is inconsequential. The price is still determined the exact same way as in the private business example (sales, profits, etc…). If you get behind Eugene Fama’s work like we do, then you will come to the conclusion that “if” the stock market is truly over-valued, then this information is already priced into the current value of stocks. And as a result, it would be futile to assume that stocks are over-priced. This is also evidenced by a recent study that Dimensional Fund Advisors did. It reflects that historically, a market being at an all-time high generally does not provide actionable information for investors. The results specifically show that 80.5% of the months after a new market high had a positive return over the next 12 month period.
During my research for this article, I found one segment of the previously mentioned article by John Mauldin to be quite comical.
He said, “So yes, my call for the beginning of a secular bear market in 1999 was early. It was the correct long-term position, but it was painful to sit on the sidelines. Ditto the experience I had in 2007, when I said we would be having a recession and the markets would go down, which they did – but only after they went up 20% from the date of that call. I didn’t have to be spanked more than a few times before I learned that trying to talk logic regarding the market – or at least logic as I understand it – is not a useful investment or trading style. Having a rigorous, systematic approach is far better.”
Really? Logic is not a useful investment or trading style? But having a rigorous, systematic approach is far better? This is absurd. If you have a rigorous approach, one would think that it’s based on a good deal of logic.
But the bottom line is this. Trying to time the next recession can be a very dangerous game. “Experts” try year in and year out with the vast majority being wrong. Even if the market is over-priced, it is very possible that it could still provide great returns for the next several years before a correction. And you would be kicking yourself if you didn’t partake.
We know the economy will experience another correction or recession; we just don’t know when. There will always be predictions. My advice – steer clear!