Stocks Aren't Overvalued
There is no shortage of pundits, advisers, analysts, strategists or alarmists who warn that stocks are overvalued and that a sizable setback could occur at any time.
Sure, something could occur at any time, or no particular time, simply because stocks are volatile and subject to the discontinuous ebb and flow of investors’ risk appetites that can change on a dime. Nonetheless, stocks aren't badly overvalued. Rather, they seem reasonably close to fair value. As for the future, many factors may emerge that can increase or decrease the attractiveness of stocks, albeit with more potential positives than negatives. So on balance, there's reason to be cautiously positive on the equity-market outlook.
It has been widely noted that stock indexes such as the S&P 500 have risen almost 250 percent from the lows of March 2009, that they have set record highs, and that they have increased for eight consecutive years. If these facts don’t suggest stocks are expensive, what could? Yet none of these facts speak to whether stocks are expensive or cheap; they only show that stocks are more expensive than they were in 2009. The facts cited above provide no suitable benchmark to judge the market. Since March 2009, corporate profits have also increased quite sharply. So although stock indexes are at record levels, valuations are not. And that’s the only sensible criteria by which to judge whether the stock market is expensive.
The price-earnings multiple is one key metric to judge valuations, though it suffers from some weaknesses. Since 1954, the S&P 500 P/E trailing multiple has averaged about 16.6. But this encompasses very high P/E periods, such as the 1950s and the 1990s and exceptionally low P/E periods, such as the 1970s. Using a simple average treats radically different periods equally, which is simplistic, naïve and wrong.
While the current market P/E is somewhat above average, that average is a meaningless mix of high and low interest rates and P/E multiples over very different economic environments. As anyone who has ever worked with a dividend discount model understands, high interest rates imply low P/E multiples and low interest rates imply high equilibrium P/Es. If we focus on those periods when inflation and interest rates were low, as they are today, the implied equilibrium P/E multiple is well above the historical average, but also above the prevailing multiple in today’s market. Indeed, with interest rates still close to record lows, the appropriate equilibrium for the market’s P/E multiple should be high.
That is decidedly not the case. Investors remain implicitly nervous about stocks, as indicated by surveys of investor sentiment after the collapse in 2008 and early 2009. Investors simply will not accord the stock market the P/E multiple implied by prevailing interest rates. And this nervousness is also evident in the relatively high P/E multiples assigned sectors widely regarded as less cyclical and safer, including consumer staples, utilities, health care and telecom. Sectors that are regarded as riskier are priced at much lower price-earnings multiples, reflecting that cautious investor attitude.
Investor caution is also evident in the bond market. Yields on Treasury bonds, the safest asset class of all, do not compensate investors for the inherent risk of those instruments. The 10-year Treasury yields about 2.4 percent. For an investor with a tax rate of 33.3 percent, the after-tax return of 1.6 percent is well below the rate of inflation of the core and total consumer price indexes, and about equal to the Fed’s preferred personal consumption deflator of 1.7 percent, yet below the Fed’s 2 percent policy objective. If the Fed gets its wish -- and one of the cardinal lessons of investing is that you should never fight the Fed -- investors who own 10-year Treasures will earn a negative real return after taxes for the next 10 years relative to the lowest available inflation measure.
And, they are already losing money relative to all the other inflation measures. The willingness of some investors to own Treasuries instead of corporate bonds or stocks can only reflect the ongoing fear of these investors to invest anywhere else other than the absolutely safest investment that exists. If the Fed normalizes interest rates significantly over the next several quarters, these investors will suffer sizable capital losses far greater than the modest yields they earn while holding these bonds. In our judgment, such bonds offer quite a bit of market risk with little yield as compensation.
Some might argue it is better for investors to focus on the return of their capital than to seek a return on their capital. But, this cannot be the prevailing objective of the collective of all investors for many years at a time. This condition can only reflect an ongoing high level of fear that has prevailed ever since 2008. Indeed, investor fears were also elevated for years after the Great Depression during the 1930s. The risk of such a catastrophic collapse has long since faded, however, though some pundits actively employ a business model of forecasting an impending depression in the hope they will be proven correct once in their lifetime.
Oddly, being wrong has not inhibited them from earning a very good living by selling books and subscriptions that prey on the fears of individuals, not by managing portfolios. So, prevailing interest rates and equity pricing reflects the ongoing caution on the part of many investors and the distortions created by the Fed’s quantitatively expansionary monetary policy. As the Fed normalizes interest rates, pricing should revert to more appropriate levels. In this context, stocks are fairly valued and bonds are quite expensive.
All of this is subject to change, of course, depending on the policies of the Trump administration. Increased spending on defense and infrastructure should bolster economic growth and corporate profits, and any reduction in corporate tax rates would make stocks cheaper overnight. Barriers to trade and deficit spending could slow growth and increase inflation and interest rates, hurting stock valuations. At the moment, you should favor stocks over bonds, especially those with longer maturities.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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