By David Peartree
The Daily Record Newswire
Consider the claim that “stocks are cheap.” Is the stock market truly a bargain or is it expensive?
For young accumulators it hardly matters, as time is on their side. But for the more seasoned for whom retirement is an approaching or present reality, it can matter greatly.
First, understand whether you are buying into a short term or a long term outlook. Put differently, are you buying a market that acts as a voting machine or as a scale? Daily, the stock market casts a vote — of approval, disapproval or indifference — on policies and events of the day.
War, acts of terrorism, oil spills, sovereign debt crisis, economic data, elections and Fed policy (most recently, Quantitative Easing II) have all, in recent experience, provoked discernable market reactions. Sometimes these are irritants to the market, and sometimes stimulants.
Their lasting impact on market performance, however, is doubtful. Over time, they are mostly noise. In the long term, the stock market is better understood as a scale. It weighs the value of future corporate earnings and the resulting cash flows to investors.
Valuation matters. That is an important but often overlooked lesson for today’s investors. To see why, let’s review some basic finance theory and then address reality.
Take a single stock. The value of a stock reflects the present value of expected net cash flows. These cash flows include expected dividends, capital gains, and a final “liquidating dividend” when the investor sells. An investor expects a return on investment that justifies the purchase price. Why else would a rational investor pay what he does for a stock?
(One answer, of course is that investors are not always rational.)
The same principle applies when valuing the market. The market value is the aggregate of the present value cash flow calculations for many individual stocks. A standard measure for looking at market valuation is the price-to-earnings ratio, the P/E ratio. OK, that’s the theory, but things get more complicated when using real money.
In the real world, there are several ways to arrive at a P/E ratio. The conventional approach is based on 12 months of earnings. Sometimes this is reported as “projected operating earnings” and sometimes as “trailing (actual) net earnings.” Both approaches have significant shortcomings.
First, forward or projected earnings tend to overshoot the mark. Second, forward operating earnings have only been tracked and compiled since the 1980s, not a long time in terms of market history. This makes it harder to say what is a “normal” or fairly priced P/E ratio based on forward operating earnings.
But the most significant shortcoming is this: Is it reasonable to extrapolate 12 months of data, especially projected earnings, into a reliable long term stream of returns?
Think of it this way. If you were buying a business, which information would be more valuable — what the owner says the business is projected to earn over the next 12 months, what the business actually did last year, or what the actual net profits were for the last 10 years? Is there any question that you would want to know actual net profits, not projections, and returns for a period of years, not a single year?
A better, more reliable approach may be that advocated by Robert Shiller, a professor of finance at Yale University, and the author of “Irrational Exuberance,” a prescient critique of the housing bubble before it burst.
Building on the work of Benjamin Graham, a legendary investor and Warren Buffet’s mentor, Shiller arrives at a long term average P/E ratio built on actual net earnings over 10 years. His conclusion: The current market is somewhat overvalued. The long term average P/E is around 15 but currently is in excess of 21. By contrast, using 12 months of projected earnings, the market shows a P/E ratio below 15, making the market appear cheap.
If you don’t believe that market values will revert to the historical norm, then carry on. If, however, you accept that reversion to the norm is deeply imbedded in market behavior, then one of two things has to happen. Either corporate earnings, already at historical highs, need to advance further, or market prices need to come down. Those are the possibilities with very different outcomes, and you need to be open to both.
Any claim that “stocks are cheap” should be viewed critically. Everyone is prone to wishful thinking when it comes to investments, but the fact that the market is off from its peak in 2007 does not, by itself, mean that the market is a bargain.
On the other hand, even if the market as a whole is not a compelling bargain, individual companies or sectors may still be fairly valued and present valid investment opportunities.
Here are three key take away points:
1. Valuation matters. Fair valuations and earnings growth are key ingredients of market returns. An investor can receive greater returns by taking on more risk, but only if the investor buys at a reasonable price. You can’t overpay and expect to make money.
2. Beware of sales pitches. A market valuation based solely on the consensus forecast for earnings is a sales pitch by Wall Street. You must consider long term valuation and earnings growth trends as well. “Buyer beware” is always in order, but when conventional market valuations are questionable, proceed with extra caution.
3. Market valuation is not a short term indicator. Valuations are useful for shaping a long term investment outlook, not short term trading. Market valuation has little to say about short term outcomes over the next several years, but has plenty to say about likely outcomes over five years or more. A robust market valuation, such as Shiller’s, which measures market prices against long term, historical earnings, may be one of the best indicators of long term returns. And aren’t most of us, even retirees, long term investors?
The market recovery since the 2008 collapse has been remarkable, even if it is not yet complete. This makes it an opportune time to revisit your asset allocation and consider re-balancing. But the next time you hear that “stocks are cheap,” and before overloading on equities, a little skepticism would be a healthy precaution.
David Peartree, JD, CFP is an investment advisor with Ciccarelli Advisory Services, a registered investment advisor, offering fee based investment management and financial advice to individuals and families. He can be reached at dpeartree@fscadvisors.com.
