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Stocks Prices are Dangerously High: Valuations are at Extreme Levels

April 6, 2018 by Vijay Marolia

Vijay’s View: Stocks Prices are Dangerously High: Valuations are at Extreme Levels

Stock markets tell the story of prices…But “price” is not the same as “value.” Price is absolute; it’s the same for you and me…But value is relative; our personal tastes and circumstances make some things more valuable to us, than they might be to someone else. This difference allows markets to function and people to flourish. It’s also what allows investors to make money over the long term.  Most importantly, it can help us protect our capital on the downside, by alerting us to dangerous signals (like losing money). Studying and profiting from the discrepancy between price & value is known as the art of Value Investing.  In a nutshell, the strategy requires buying cheaply, being patient, and eventually, selling at a profit. Easy to say, but difficult to do.

If owning a stock means owning a piece of a business, which it does; and if businesses are meant to earn profits, which they are; then it makes sense to compare the price of a stock with the profits it earns. Hence Wall Street’s favorite metric; the P/E Ratio.

P/E ratio = price per share ÷ earnings per share (EPS)1

This makes sense, but Wall Street, is said to be “forward looking” (read: greedy and lacking any ability for self-reflection) and so they use a bastardized version of this ratio, which essentially requires usually-well-paid, but often-inexperienced analysts to essentially guess how much the company should earn in the year to come. Armed with spreadsheets and computing power, the analysts plugs and chugs his or her way to a precise figure. But although the figure is precise in its formulation, it’s often inaccurate. Not because the analysts are dumb, or have ill intentions–but because life happens…Hurricanes happen…Accidents happen…Booms happen, and busts happen…But they don’t usually happen on the same day…

For that reason, many investors (usually much older & with better track records) prefer to use a “smoothed out”2 version of the traditional P/E Ratio. It basically removes the “outliers” or one-time events that may have temporarily influenced profits in any one year. This, is known as the Shiller P/E. When it is low, stocks are cheap; and patient investors can expect fantastic returns over the coming several years.  On the other hand, when the Shiller P/E Ratio is high, meaning stocks are too expensive; returns are much lower. Recently, the Wall Street Journal cited research done by Crestmont Research, showing just how impactful this can be over longer periods of time.  Here’s a section that’s very relevant to our discussion.

“…the importance of valuation by looking at stock market total returns between 1919 and 2017 and slicing them into deciles from worst to best over 20-year periods. The worst ones had annualized returns averaging 5.2% and the best 15.4%. That is a huge difference, turning a $10,000 investment into either $28,000 or $175,000. The main difference between the two was starting and ending valuation–specifically the cyclically adjusted price-to-earnings ratio that measures the past 10 years of inflation-adjusted earnings popularized by economist Robert Shiller. The lowest-return periods had an average starting cyclically adjusted P/E of 18.2 but ended at 9.2. The best periods started at 10.1 times on average but ended at 28.2 times. Even after the recent tumble in prices, the Shiller P/E, currently at 31, sits firmly in the most expensive decile historically.”3

Do me a favor and just re-read the highlighted section one more time please…It says the best returns came when the ratio started around 10…But more interesting to me, is that it says those “best periods” ended (on average) at slightly over 28… Today my friend, we’re at 32…

For some context, the long term average ( since late 1800’s) has been around 16.8%.4. Again, we’re at 32 today. But, to be sure, this is not the first time stock prices have been elevated. On Black Tuesday,5 October 29, 1929, the Shiller P/E would have been about 30, before crashing and triggering the Great Depression…Stock prices took decades to recover–but eventually they did, albeit decades later…And speaking of decades later, on Black Monday, 6. October 19, 1987, the stock market experienced another huge crash. This one was even more dramatic, as the Dow Jones went crashing, dropping over 22% in one day. Before trading began that morning the Shiller P/E was under 20! Again, today, we’re at 32!

To be sure, we can definitely go higher from here, but I can’t help but wonder how much higher? And more importantly, at what risk? We haven’t even talked about Trump’s brewing trade-war with China. And what about rising inflation? Signs of an inverting yield curve are growing as well.

Most asset prices have doubled, or tripled (if not more) since the depths of the Great Financial Crisis (GFC) of 2008. Isn’t it time to lock in some gains and take some chips off the table?

VJM / April 6th, 2018

Respectfully,
Vijay J. Marolia
Managing Partner/CIO

1 – Source: https://www.investopedia.com/ask/answers/070314/how-do-i-calculate-pe-ratio-company.asp

2 – Nerds call it adjusting for cyclicality.

3 – Even After a Tumble, the Stock Market’s Price Isn’t Right

4 – Source: http://www.multpl.com/shiller-pe/

5 – Source: https://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929

6 – Source: https://en.wikipedia.org/wiki/Black_Monday_(1987)

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