Why value the stock market?
As an investor its often tempting to attempt to predict the future. The incurable human tendency to back decisions with emotion combined with the impossibility of fully anticipating the future makes this exercise laughable.
However, with a proper context of “value”, investors in aggregate have always determined market prices that, long-term, move in tandem with actual value. This idea is known as “market efficiency”.
While markets are either nearly entirely or mostly efficient, there are always opportunities to find value and outperform. Bust asking simply if the stock market is overvalued is a bit complicated.
What do we mean by “stock market”?
The entire universe of stocks is encompassed by a diverse source of demographics, industries, and legal systems. In 2023 the U.S. market is by far the largest equity market and certainly most investors both in the U.S. and globally would consider this market a key representative of stocks generally.
But even within the U.S. there are small-caps, large-caps, value, growth and even a breakdown between stock sectors. As far as this examination will go its entirely appropriate to look at the stock market through the most widely regarded indexes: the S&P 500.
Can we accurately measure stock market value?
Measuring the value of anything can be difficult, especially something as large and complex as the S&P 500. However, based on their correlation to future returns, 6 indicators have actually be reliable in the past.
Ways of measuring the stock market
Advisor Perspectives tracks four out of the six indicators monthly. On their site they chose to average the four and compare them to historical returns. This format is useful because it illustrates just how risky or cheap the stock market is in any given month. I check their page frequently and I encourage anyone interested in market valuation to check it out.
The four listed on their site are: Crestmont Research P/E ratio, Cyclical P/E ratio, the Q ratio and the current deviation from the market’s regression trendline. In April 2023 the average of the four sits at nearly 100% overvalued. For comparison this is somewhere close to the value the S&P500 traded at during the 90’s dotcom boom before 2000.
While these four give a useful datapoint as to the markets value, there are two others that I believe are just as, if not more indicative long-term. These two are the market to GDP ratio(also called the Buffet Indicator) along with the household equity allocation.
The market to GDP ratio, popularized by Warren Buffet, has long served as a crude assessment of stock market value. It compares how the value of U.S. equities weigh against the size of the economy. Currently the buffet indicator is somewhere north of 150% which is overvalued. In context this level is as high as it was in the early 70’s (which saw lower subsequent 10-year returns) and the mid 90’s (which led to the dot com crash of 2000).
All of this does not guarantee that the stock market will crash this year. In fact, the stock market could continue to rise as it did in the late 90’s even past the point at which the market is currently valued. Predicting the future can be difficult but it is useful to have some context into where U.S. stocks currently sit.
Lastly, a 6th indicator I have used is the household equity allocation. This indicator uses information provided by the FED to measure the average current percentage of equities held by investors in their portfolio.
The reason why this is useful is that it gives crucial insight into the supply-demand reality of how much capital is available for investors to move from other assets into stocks. Logically the higher the percent of assets invested in equities, the lower potential future influx of capital into equities.
The latest reading from the FED shows that around 45% of assets are invested in equities. This is one of the highest we’ve ever seen in recent decades. In fact there have only been two peaks with a higher percent of assets in equites for any of the last 70 years. Those two times were the stock peak of 2000 and the peak in December 2021. This number is sitting at around where investors were in 1997 or 2018.
An alternative question
As I discussed at the beginning, there is always an inherent risk of A) miscalculating stock market value and B) benefiting from this knowledge. It is both possible to inaccurately calculate the frothiness of the market and at the same time over (or under) react the forementioned information. As an example, an informed investor in 1995 might have looked at the relatively quick rise in stock prices, compared them to historical prices, and decided to step out of the market. Anyone familiar with what followed knows that stocks were poised for one of their largest bull runs in market history.
Instead of looking at stocks through the lens of “cheap” verse “expensive” a more beneficial way of viewing the market is to ask where the risk/reward tradeoff lies. More precisely, there is more to risk/reward than simply value. There are four total factors that should influence an investors decision to decide whether to stay the course. Not only does “value” in the historical sense matter, but also the investors time horizon, alternative options, and the current trend of the market.
Value can give us an understanding of the long-term return prospects of the market or a particular stock, but value won’t tell us whether the price will go up in the next week, month or even several years. However, for long-term investors who view the market in terms of decades, not years or months, value is ultimately all that matters.
Time horizon matters because for those with a shorter time frame(like those nearing retirement) cannot afford to wait out the long-term market cycle in the hopes of a rebound. Younger investors who are willing and emotionally capable of waiting out bear markets should not try to time the market.
A natural part of the market cycle is an ebb and flow of various stock market segments going from overperformance to underperformance and back again. Not only do stocks work in this way, but all other asset classes also have segments within them that vary in performance. Weighing your stock alternatives may not only be prudent within the stock universe, but among all asset classes.
Lastly, trend watching, which has a bad reputation in certain investment circles, can sometimes add a valuable layer of actionable insight. Historically when the stock market is above its 200-day trend line stocks have performed better with lower volatility. Gauging the trending risk or opportunity in an asset or whole asset classes may help improve outcomes that are not available to purely value investors.
Back to the question: What’s the best way to value the stock market?
There is no “right” way to value the stock market. And in fact, as we have discussed, value is not the only factor that should determine our current stance on equities. This is especially true for the young investor. For those of us who are not in a particular need of capital in the next 15-20 years, staying put in the market may be the most prudent decision. After all, we have no way of knowing if stocks are in for another rip higher like they did in the late 90’s.
On the other hand, for those who take a more active investment stance or those who may need their money sooner, reducing exposure to equities may serve as an appropriate risk mitigation technique.