Despite all the digital ink that has been spilled promulgating the idea that stocks are overvalued and in a bubble, especially over the last several years, the reality is that “valuation” is more opinion than it is fact and too slippery to nail down in absolute terms. It depends on how you want to measure it. In this piece, we outline why we think stocks are not overvalued and why we think there will be new highs in the stock market before it all ends in tears (as it surely will).
If you only consider an “instant in time”, then the market is always priced-to-perfection; moment-to-moment, the value is simply whatever investors are willing to pay. But that is not very useful. All you get is one data point, which is zero-dimensional information. With that thinking, tulips and Beanie Babies where never undervalued, nor overvalued, they were always properly valued. However, you would never try to make a profit with this approach. You would only buy a tulip or a Beanie Baby for its utility value, not for investment purposes.
To profit from a transaction, you need to add the dimension of time. You would invest in Beanie Babies only if you believed that they were undervalued, not at the instant you bought them, but relative to sometime in the future. Or you would short them if you believed they were overvalued at a particular instant in time relative to the future.
During a bull market, the “undervaluation” crowd is always right, and during a bear market, the “overvaluation” crowd is always right. Over the last ten years, the “undervaluation” investors have been making all the profits, and we think that, despite being in the later stages of this bull market, stocks are not overvalued at this particular instant in time.
There are two key points in the discussion above, 1) value is determined according to what investors are willing to pay and, 2) undervaluation and overvaluation are only determined over time.
In the first instance, value is directly proportional to investor sentiment (emotion) which, in turn, is usually impossible to explain from a fundamental perspective. Sentiment is so often disconnected from classic fundamental analysis, that using fundamentals in isolation to predict how the market will price something, seems to be a waste of time.
In the second instance, value is relative to the future which, of course, is totally inaccessible. That means we only have the past (history) to work with. Fortunately, even though no two markets are ever identical, the fact that human emotions do not change over time means that repetitive patterns are established which can be used to determine probabilities for the future.
Price-to-Earnings as a Measure of Value
The price-to-earnings ratio (PE) is the most common metric used to back-up the idea that stocks are overvalued. The chart below shows the PE of the S&P 500 (SPX) for the years 1995–2018.
At the moment, the PE is 25, and as the green horizontal line shows, 25 would be considered high relative to the 2003–2008 bull market, but low when compared to the 1995–2000 bull market. Using PE in isolation does not tell us very much.
In the past (here), we have argued that the present bull market is more similar to the tech rally of 1995–2000 than it is to the housing rally of 2003–2008. In particular, the part of the present bull market which starts with the double bottom of 2015 and the final third of the tech rally that started at the double bottom of 1998 are most similar. The two charts below show these two time periods with the various corresponding rallies labeled “R” and the corrections labeled “C”.
The pink rectangular areas on the charts highlight the corresponding correction patterns (C3) in the two time periods. Notice that in both markets, the PE dropped significantly during the C2 corrections, increased during the R3 rallies, then dropped again during the C3 corrections. We are not looking simply at the nominal value of the PE. Instead, we are looking at the pattern of change in the PE and conclude that the two markets are expressing similar “sentiment” with regard to valuation. If these repetitive patterns continue to replicate, then we would expect the market to make new highs during the R4 rally, just like it did in 2000.
Yield on the S&P 500 as a Measure of Value
By yield on the S&P 500, we mean the dividend yield paid by the 500 companies that comprise the index. The chart below shows that, today, for every dollar invested in the S&P 500, there is a return on capital of 1.89% in the form of dividends. This is higher than at any time during the housing bull market and higher than the last half of the tech bull market (1997–2000).
But to get a proper comparison, we need to take interest rates into account. The chart below shows the net-yield that results from subtracting the yield on risk-free 6-month Treasury Bills from the dividend yield of the S&P 500.
The net-yield is currently -0.20%, and although that is the lowest it has been since the start of this bull market, it is much higher (18x and 28x higher) than in the previous two bull markets; -3.5% at the top of the housing bull market and -5.5% at the top of the tech bull market.
In addition, the net-yield profiles of the tech bull market and the present bull market are, again, very similar. Especially the 1998–2000 and the 2015–2018 sections that we highlighted above. The next two charts show close-ups of these similar patterns.
A declining net-yield is a normal late-stage bull market pattern, but before the tech rally ended, the net-yield curve flattened. Today’s net-yield curve is declining, but the nominal value is historically high and the curve has yet to start flattening. That implies we have not reached “peak valuation” just yet and that stock prices can still go higher.
In closing, by comparing how PE ratios and net yields were changing during the tech rally of 1995–2000 to the current bull market, we can conclude that there is still plenty of room to accommodate the future euphoric investor sentiment that will drive this bull market to new all-time highs. It is our opinion that this market, while close, is still not overvalued.
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