September 12, 2017    7 minute read

Is the US Stock Market Overvalued?

Calculating Worth    September 12, 2017    7 minute read

Is the US Stock Market Overvalued?

“The stock market has hit an all-time high. Another record-breaking day for Dow. Dow, S&P and Nasdaq post record close.”

Stock Valuations

Nowadays, it has become increasingly common to find the aforementioned titles in all the main financial newspapers. Market sentiment, expectations and the economic environment are radically different with respect to 10 years ago when the financial crisis erupted from Wall Street. This has been one of the longest stock market rallies in history. Stock valuations are very high, comparable to situations in pre-crisis periods. This has disturbed many market participants who have been warning that the stock market is overvalued and that a selloff is imminent. Many go as far as to warn that the next crisis is nearly upon us. Yet, there are also plenty who argue that valuations are fair and there are no alarming signs. Thus, the market participants are on opposing sides with regards to this issue.

A stock is considered overvalued when its current price is not justified by its earnings outlook. Thus, the market expects the stock to go down. These stocks may be trading at a premium due to brand, goodwill, better management or other factors. One of the most popular earnings valuation metric is the Price to Earning (PE) ratio. It is calculated using the current stock price and historical earnings per share.  It is called trailing PE when using the EPS of the last 12 months, or forward PE when earnings estimates are being used. Both cases will be considered in this analysis.

The PE ratio indicates the dollar amount an investor can expect to invest, in order to receive $1 of earnings from that company. A stock with a high PE ratio suggests that investors are expecting the company to grow at a higher pace or have higher earnings. Stocks with PE ratios that are extremely high without justification are considered overpriced. The debate arises due to the fact that the whole stock market is considered by many to be overvalued.

Rapid Growth

During the summer, many well-respected investment banks warned that the stock market has highly elevated valuations in almost every metric. The forward PE ratio of the S&P 500 is 18x, up 80% since 2011. The trailing 12-months PE of the index is 22.1x, while the 10-year average is 16.7x. The Financial Times, in an analysis, looked at how much the stock market is worth compared to the average corporate profits over 10 years. Their conclusion is that the market has been this expensive only twice before, before the 1929 market crash and before the dot-com bubble.

GMO, a Boston-based asset management firm with more than $118bn of assets under management, predicts negative annualized returns for stocks over the next 7 years. Their model breaks down the total stock returns into dividends, earnings, margins and earnings multiple. In the long term, almost all of the return on a stock comes from dividends.

During the past seven years, returns have been 13.6%, whereas since 1970 the total average return on the S&P has been 6.7%. The question that arises is: why should an investor buy now? Is it due to expectations that dividends will grow at an even faster pace, or that multiples and profit margins will continue to expand? If that is not the case, then the stocks are clearly overpriced.

PE ratio is an average including high and low points. Therefore, many argue that it leads to a wrong conclusion. However, GMO calculates the price to sales and Shiller PE multiples using the median stock rather than the average. Still, their result is the same as before. For them, the S&P is more expensive than it should be.

Moreover, many investors are increasing their bets against the highest performing stocks in the market, the so-called FAANGs (Facebook, Apple, Amazon, Netflix and Google). They continue to short-sell these stocks, despite experiencing losses of around $8bn, convinced that their predictions of a selloff are true.

Reasons for High Valuations

It is an indisputable fact that valuations are high. This has happened for several reasons related to the economic situation in the US, but also worldwide. The global economy has operated in a low-interest rate environment for quite some time now. This has driven investors away from bonds and has made stocks the asset of choice. The returns on bonds are too low and their price is too high due to the central banks purchasing them to drive rates down. Thus, naturally, investors have preferred stocks which have given them a higher return. Furthermore, the low-interest rates have resulted in higher stock valuations.

On the other hand, the global economy has been improving in recent years (although at a slow pace), resulting in a global bull market. Yet, it needs to be mentioned that this has been an 8-year-old bull market and only a few have lasted longer.Another aspect that has driven the stock market towards new highs has been the 2016 US election. The new President has promised fiscal stimulus, deregulation and tax reform. And the market has priced this in.

Sustainable?

So, judging from this perspective, these high valuations seem justified. The issue is whether this is sustainable. What happens if the new US government does not satisfy the market? What is the extent that the market will be impacted by geopolitical events? Furthermore, rates are likely to increase.

Even if there are no further hikes in 2017, economists expect around 4 additional increases in 2018. High-interest rates will lead to lower PE multiples. Thus, as the normalization of rates continues, pricing will go down to more appropriate levels. At least that is what the investors that disagree with the overvaluation of the market argue. This group sees it more as a natural correction that is bound to happen due to the changing of the macroeconomic factors, rather than a crisis that is waiting around the corner.

Nevertheless, the fact that many investors are undertaking a lot of risks is worrisome. They have to do so in order to attain a decent return. However, history has shown that huge investments in, and high attraction towards, new and obscure financial assets or products has been the vanguard of crises.

In 1987 it was the portfolio insurance strategies. In 1994 many were attracted to interest rate swaps, while in 2007 it was the emergence of CDOs. Currently, as the Financial Times points out, there is a trend of investing in ETFs- marketable securities that track the performance of an index, commodity, stock or other assets. They are highly liquid and are traded like stocks. Recently, the ETF sector has “exploded in size”, with more than $4trn in assets under management, $3trn of which only in the US.

The ETF’s have maintained a low profile, quietly attracting investors. Passive investors make up 60% of US equity AUM. A decade ago, this figure was only 30%. These investors are flocking toward new, but highly risky, ETFs such as the Inverse VIX, which bets against market volatility and has had a return of 100% this year. Of course, such a high return is associated with very high risks. What happens if market sentiment suddenly changes? It is highly improbable that it would cause a crisis of the same scale as in 2007. Nevertheless, this excessive risk taking should be more closely monitored. As Howard Marks – the CEO of Oaktree – suggests, now is the time for caution.

Conclusion

To conclude, it is possible that a correction is likely coming. Whether it will be a 5% or 10% pullback is difficult to say. But the current situation is no bubble. Thus, there is no danger of a financial crash hitting the world economy. Stocks are currently more attractive than bonds and valuations will remain high as long as the rates will be this low. A lot of good news is already priced in, and the probable correction will come either due to a disappointment from the fiscal policy in the US or a geopolitical crisis. While it may be time for caution, there is no reason for panic as doomsday scenarios for the stock market are not only premature, but also groundless.

 

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