The Economy

Caution: Stocks Are Historically Overvalued

Investor relations professionals should prepare for what's eventually inevitable: a reversion to the mean for stock prices.
Vitaliy KatsenelsonOctober 24, 2018
Caution: Stocks Are Historically Overvalued

In my business as an investment manager, I constantly look for new stocks. How? By running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at the holdings of respected investors, and talking to a large network of investment professionals.

Also, I attend conferences, scour through ideas published on value investor networks, and compiling a large (and growing) watch-list of companies to potentially buy at a significant margin of safety.

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Yet, with all of that, my firm is having little success finding solid companies at attractive valuations.

Don’t take my word for it. Take a look at the charts below. You will then understand the magnitude of the stock market’s overvaluation and, more importantly, be able to put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued — somewhere between tremendously and enormously.

If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry. I don’t either. But this is my point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s go to the charts. The first one shows price-to-earnings of the S&P 500 in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. At only two other times in history were stocks more expensive than they are today: just before the Great Depression hit, and in the 1999 run-up to the dotcom bubble burst.

We know how the history played in both cases: subsequently stocks declined, and by a lot. Based on over a century of history, we are fairly sure that this time, too, stock valuations will at some point mean-revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

In the interim, before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it say hello to the pre-dotcom crash level of 164% above average? The answer is that nobody knows.

Here’s another chart, called the “Buffett Indicator.”Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of it as a price-to-sales ratio for the entire U.S. economy — that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a story similar to the first one. Although I was not around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first 10 months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: “This time is different” (it never is), and “Yes, stocks are overvalued, but we are still in the bull market.” (They were right about that until they lost their shirts.)

I was investing during the 1999 bubble. I vividly remember the “This time is different” argument of 1999. It was the New Economy vs. the old, and the New was supposed to change or at least modify the rules of economic gravity. The economy was now supposed to grow at a much faster rate.

But economic growth over the past 20 years has not been any different than in the previous 20. Actually, I take that back — it’s been lower. From 1980 to 2000 the U.S. economy’s real growth was about 3% a year, while from 2000 to now it has been about 2% a year.

Finally, let’s look at a Tobin’s Q Ratio chart. This simply shows the market value of equities in relation to their replacement cost.

If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then the Tobin’s Q Ratio is 2.0. The higher the ratio the more expensive stocks are.

This chart tells the same story as the other two: U.S. stocks are extremely expensive — and were more expensive only twice in the past hundred-plus years.

One might ask, did the stock market decline cause the recession, or did the recession cause the stock market decline? But the answer is not that important, because no one can predict either a recession or a stock market decline.

In December 2007 I was a speaker at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was, “When are we going into a recession?” I gave my usual, unimpressive “I don’t know” answer.

The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from 6 to 18 months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the U.S. economy was already in a recession.

Back to the present: An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. The argument sounds true and logical, but there is a crucial embedded assumption that interest rates will stay at these levels for the next decade or two.

In truth, no one knows when interest rates will go up or by how much. But as that happens, stocks’ appearance of cheapness will dissipate.

Here’s another twist: If interest rates remain where they are today, or even decline, it will be a sign that the economy has big, deflationary (Japan-like) problems. A 0% interest rate did not protect the valuations of Japanese stocks from the horrors of deflation; Japanese P/Es contracted despite the decline in rates.

The U.S. is maybe an exceptional nation, but the laws of economic gravity work here as they do elsewhere.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. Here’s some advice for investors: How about being patient and not taking poison at all? Buying expensive stocks hoping they’ll go even higher is not investing. It’s gambling.

One thing is certain: Timing the market is impossible. I don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random — as random as you guessing the next card on the blackjack table.

In contrast, valuing companies is not random. The market falls in love and out of love with specific sectors and stocks all the time, but in the long run stocks revert to their fair value.

Vitaliy Katsenelson is the CEO of Investment Management Associates, which is anything but your average investment firm. (Seriously, take a look.)

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