What Does “The Market is Overvalued” Mean?

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Cautious investment experts have been warning about the market being overvalued for the past few years. What does this mean and why does it matter (or does it matter)?

The market typically refers to all stocks in the U.S. economy or a group of stocks that represent the U.S. economy, such as the S&P 500. The market being overvalued means that stock prices may be too high compared to the true values of their underlying businesses.

Generally, investors buy stocks to grow wealth and eventually generate income streams from accumulated assets. The problem with too-high prices is that if I pay too much now, I'm less likely to enjoy investment gains and grow my wealth in the future. In addition, when I sell stocks to produce cash, I'll might get less money than I counted on.   

But there are ways to deal with the problem of an overvalued market.

Basic Ways to Measure Whether Prices Are High

First, let's consider why some believe the market is overvalued. There are many ways that stock market observers and experts gauge whether prices are too high, attractively low, or about right. Here are a few of these measures:

P/E Ratio

A common measure of value is Price to Earnings or P/E ratio. Generally, the P/E ratio can be calculated by looking at a company's stock price and dividing the price by earnings per share. Earnings in this formula could be the current year's earnings, the past year's earnings, or the past 12 months' earnings (also called trailing twelve months' earnings or TTM).  The resulting P/E ratio is then compared to a historical norm for this particular stock, stocks in this industry, or all stocks.

In the past, a P/E of 15 seemed to indicate a reasonable value. A lower P/E ratio suggested a lower price than typical and potentially a better bargain than a stock with a higher ratio. Conversely, a higher P/E indicated the possibility that the stock was priced too high.

As of this writing, Amazon (AMZN) has a P/E ratio of more than 280. Using traditional methods of valuation, this number seems absurdly high. At the same time, The Disney Company (DIS) has a P/E ratio of 17. Through the lens of P/E ratios, Disney's number indicates that this company's stock may be a better buy and more likely to generate investment gains for its shareholders in the future.

You can calculate P/E ratios yourself or look up these numbers on your broker's website. 

PEG Ratio

Another measure of valuation is the Price to Earnings Growth or PEG ratio. In the current economy (fall 2017), in which many companies are exploding in sales and profits, this number may be viewed as more useful than the P/E ratio. That is, the PEG ratio incorporates growth rates into its valuation measure whereas the P/E ratio looks simply at earnings at a certain point in time.

Generally, when investors buy stocks, they anticipate a dividend payout or an increase in the stock's price. This increase may result from the investor's ability to snag a stock at a bargain before other investors recognize its value and drive up the price. This movement could also result in the persistent growth of a company's earnings and a steady increase in its underlying value. The use of PEG ratios stems from the idea that business growth drives stock prices. 

The PEG ratio is calculated by taking the P/E ratio and dividing this number by the company's projected growth rate for the upcoming year (or another time frame). According to a broker's website, Amazon's PEG is 8.91 as of this writing, based on an anticipated growth of 30%. Disney's PEG is 2.52 with expected growth of about 7%.

A PEG ratio of 1.00 or less indicates an attractive price. Considering these PEG ratios, both AMZN and DIS may be overvalued or priced too high to produce growth in a portfolio. PEG ratios are often listed on a broker's website or you can do your own calculations.

CAPE

The Cyclically Adjusted P/E Ratio (aka CAPE, P/E 10, or Shiller P/E) looks at average earnings over the most recent 10 years, adjusted for inflation. CAPE typically references valuations of entire markets or representative indexes such as the S&P 500, not individual holdings like Amazon or Disney.

This measure was developed by Robert Shiller, a Yale University professor and Nobel Prize winner for his work in financial economics. His research findings suggest that markets are inefficient, meaning that stock prices can fluctuate in a way that's unrelated to company earnings, dividends, or underlying value.

In the past, a CAPE ratio in the 20s or more has indicated an overvalued market, followed by poor investment performance over the next decade or two. A ratio in the 10s or below suggests an undervalued market with lower prices and better deals for investors, leading to relatively strong performance in subsequent years. 

Gurufocus.com calculates the Shiller P/E on a daily basis and the number as of this writing is 31.

Ways to Think about High Valuations

The message that I've often heard about such high numbers is that a market correction is imminent. However, this warning has been going on for several years and stocks have steadily increased in price during this time.

Benjamin Graham, billionaire investor Warren Buffett's mentor, also experienced market seasons in which investment growth persisted despite what seemed to be unreasonably high valuations. In his book, The Intelligent Investor, Graham expressed a key learning in these times: “Old standards (of valuation) appear inapplicable; new standards have not yet been tested by time.” What's tricky about valuations is that it's not always clear which ones are the most useful.

In addition, I like to remember that the market is made up of individual stocks. Generally, a statement that the market is overvalued is interpreted as meaning that nearly all stocks are priced too high. Collectively, the entire market may be overpriced. However, in some cases certain stocks or specific segments of the market (technology or health care, for example) are too high; at the same time, other stocks or other segments may be undervalued, slightly high priced, or rightly valued.

Steps to Consider When Stock Prices Are Too High

Whether predictive of market movement or not, high P/E, PEG, and CAPE ratios aren't always terrible news. Still, it's possible they can portend financial challenges in the near future. Difficulties for investors might arise from:

  • a market correction in which prices fall to become more aligned with underlying values
  • a reversal of fortunes in which prices fall well below the underlying values
  • stagnant prices while underlying values slowly increase to a level in which stock prices and value are more closely aligned (that is, periods of low growth)

One or all of these events could be favorable for someone who is buying index funds or shares of a certain company's stock over time. In this scenario, a decline today could allow investors to buy at lower prices and enjoy gains later. (Here's an article on how investing over time during market fluctuations can be beneficial.)

On the other hand, if I need to generate cash from the sale of stocks to pay living expenses, declines could mean I'll need to sell more assets and deplete my account balances at a faster-than-desired rate in order to maintain my standard of living. Ditto if I'm selling stock to pay college expenses, fund a bucket-list trip, or buy a vacation home. (Here's an article on how down markets can affect account balances and the use of accumulated wealth to pay for expenses. Here's another one on why I hold more cash than I used to.)

In The Intelligent Investor, Graham says it's impossible to know what the market might do. Particularly for conservative investors, he urges caution when prices get too high. Specific actions he suggests include: 

  • don't borrow to buy stocks
  • don't increase the stock portion of your portfolio
  • bring stocks and bonds to a 50/50 ratio by selling stocks and investing the proceeds in high-quality bonds and savings (note: bond returns were higher in Graham's era)
  • for those who buy stocks using a dollar-cost-averaging method, continue or suspend buying activities but don't start buying a new stock

What I've learned, then, is that concerns about high valuations are not (or should not be) designed to predict market movement with precision. Instead, this information is meant to benefit planning decisions and prompt portfolio rebalancing. More specifically, instead of plugging in growth rates of 10-20% when projecting the value of my investments over the next few years, I should consider using much lower rates and even plan for declines. As a result, I may be more likely to reach my goals.

Disclosure: I am long on AMZN and DIS.

What do you do when the market seems overvalued?

 

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