After a big bull market, with volatility creeping back up, it is worth looking at some of the biggest risks to further gains in stocks. One that frequently gets discussed is how expensive stocks are, so let’s look at what that means.
When people say stocks are expensive, it is reference to their valuation. The valuation of stocks is simply their price compared to some fundamental metric, most often earnings. It essentially says that investors are willing to pay “x” for every dollar of stock earnings. The “x” that investors are willing to pay changes over time for all sorts of reasons.
When determining whether the current valuation is expensive or not, investors generally compare the current level with historical levels. Many, if not most, valuation metrics suggest that, currently, stocks are quite expensive compared to their history.
Take for instance one of the most popular measures out there, the Shiller CAPE ratio, popularized by Nobel laureate Robert Shiller. CAPE stands for cyclically adjusted price-to-earnings. Rather than look at just a single year of earnings, which can be distorted by extreme events (see last year), it takes an average of the last 10 years’ worth of earnings and compares stock prices to that.
By this measure, stocks look extremely expensive. The only time they have appeared more expensive was in the late 1990s dot com boom. The good news is that this metric doesn’t tell us much about returns over the next year, so it isn’t necessarily suggesting an imminent crisis. However, it has a good track record of calling longer-term returns and suggests that the next 10 years might not be as kind to investors as the last 10 years have been.
However, valuation analysis shouldn’t end there. There are other lenses that we can use to view the landscape. While comparing valuations to their historical levels can be useful, there are things that can distort that assessment. If we compare things now vs. say the 1950s, we see that trading costs are much lower now, the market itself is much more liquid and trading is much more efficient, information is much more readily available, along with many other improvements. Given these factors, investors should expect higher levels of valuations. Many risks that used to exist no longer do so investors do not need to require as high of return on investment.
One of the other lenses we can use in our assessment is called relative valuation. This type of analysis looks at valuations but adjusts for other factors. The other factor can be about anything such as money supply or economic growth, but the most common relative comparison is to interest rates.
For example, one of the things we look at is comparing stocks earnings yields to intermediate-term bond yields. Higher yields tend to attract investment so when stock yields are higher than bond yields, it would suggest favoring stocks. When we look at current levels of stock valuations adjusted for bond yields, stocks still look quite reasonably priced due to extremely low interest rates.
Certainly, nobody would suggest that stocks are cheap in absolute terms, but a look at relative valuations hints that there might be explanations for those high levels. However, no measure of valuation is a great timing tool, these metrics simply speak to general risk conditions. Investors should weigh all the data available to them when making asset allocation decisions and update their views frequently.
David M. Nelson is president and CEO of NelsonCorp Wealth Management.
Disclosure: Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including loss of principal. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed.
Securities through Cambridge Investment Research, Inc., Member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc. Cambridge and NelsonCorp not affiliated.