September 7, 2019
Following on from last week’s post, there’s a growing sense of worry in the US, and here in Australia, that the sharemarket is overvalued.
And after a ten year period of solid returns, with markets near record highs and growing tensions across the world, it’s not hard to see why many are worried.
The implication being, this cycle is running out of steam and it’s going to end pretty soon. Badly.
So is this true? And for those of you on the road to Financial Independence, what should you do about it? It’s an almighty topic, so let’s dive in!
First, you can pretty much ignore the term ‘record high’. Why?
For all the ups and downs, the sharemarket goes up over time. So this means shares are regularly hitting record highs! And that effectively renders the term meaningless.
Let’s say today is a record high – an imaginary value of 1000 points. Tomorrow the market is at 1001, another record high. Maybe a week later it’s at 1003 – holy shit, another record high!
As the sharemarket goes up over the next few decades, how many record highs do you think you’ll see? Exactly!
Ben Carlson outlines this perfectly in relation to the US market…
“Looking at over 100 years of data on the Dow going back to 1915, shows that stocks have had 1,252 highs. That works out to an average of about 12 new highs every year. Assuming the average investor is in the markets for 40 years, that would be almost 500 highs in a lifetime of investing in stocks.”
This table shows the number of highs by decade going back to 1915…
So why is the term ‘record high’ used all the time? Because it sounds like a big deal. And if it sounds like a big deal, it draws people’s attention. That’s why the media loves it, when crafting hysterical articles about the coming recession or impending market crash.
But the market being at a record high doesn’t actually mean anything. It doesn’t tell us whether it’s cheap or expensive. That might surprise you, but think about it this way.
If the market continues to rise to new highs, but company earnings are growing at a faster rate, then the market is not getting more expensive.
In fact, you could argue the market is getting cheaper. Because you’re buying each dollar of earnings for less than before, as measured by the price-to-earnings ratio. Let’s look at that now…
What is the price-to-earnings (PE) ratio?
Basically, the PE ratio tells us what price the market is trading at, in relation to its earnings. Put another way, how much it costs to buy one dollar of annual earnings.
Here’s a chart from the RBA earlier this year showing the history of PE ratios for Australia and the US.
For Australia, the market isn’t far from its long term average. The US looks expensive though. But take a second look at that chart. The US has been ‘overvalued’ a lot of the time since the early 90s, or most of the last 30 years. So perhaps something else is going on here? More on this later.
Back to Australia. This more recent chart shows valuations have crept higher this year. Although the second chart shows the dividend yield is right around average.
So you could probably argue that both markets are priced a little bit more richly than the long term average. And indeed, it gets a little scarier when looked at another way…
What is the CAPE ratio?
The CAPE ratio stands for the ‘cyclically-adjusted price-to-earnings’ ratio. Yep, it’s a mouthful! Created by Professor Robert Shiller, it’s often referred to as the Shiller PE.
In simple terms, it’s the price to average company earnings from the last ten years, adjusted for inflation. The goal is to smooth out the ups and downs in earnings and give a perhaps more accurate view of value.
In the US, it’s a popular way to measure valuations, as the CAPE ratio was very high right before the 2000 tech bubble crash, and also in 1929 in the great market boom before the Great Depression.
So what does this measure show right now?
Yikes! Looks a little worrying to put it mildly! The market has only been this ‘expensive’ twice before in history. And neither of those occasions were exactly a great time to buy!
But again, it’s showing the market has appeared highly priced since the mid 90s. So if this was your bellweather, you’d likely have felt nervous investing for most of the last 25 years!
And as we know, returns have been very healthy…
So how useful is the CAPE ratio? Why is it so bearish? And is there an alternative way to help forecast long term returns?
I’ll declare my hand now. I’m a big fan of Professor Jeremy Siegel, author and Professor of Finance at Wharton. From the market academics out there, he makes the most sense to me. He’s written a couple of books, including the classic “Stocks For the Long Run.”
In this excellent presentation, Professor Siegel explains some issues with the CAPE ratio. And interestingly, he’s a long-time close friend of its creator Robert Shiller. By the way, if you want to see the two of them duke it out, they debate whether stocks are too high here.
So what did Professor Siegel have to say about the CAPE ratio?
“There have been only 9 months since January 1991 when the CAPE ratio has been below its mean.
The CAPE ratio indicated the market was overvalued in May 2009, when the S&P 500 was at 919 (it’s now 2700).
Basically, over the last 30 years you’ve never been undervalued – except from a few months at the bottom of the worst bear market in 75 years. That looks strange to me.
It has called the market overvalued for the last 8-9 years and has been totally wrong.”
Why is this? What’s going on? Siegel studied market earnings to find out.
He noticed that Shiller’s paper on the CAPE ratio was released in 1996. Two years later, accounting rules were changed for company earnings, causing earnings to be understated in some cases, especially so during the GFC.
An example of this is where a company makes a cash profit of $100m. In the same year, it writes down the value of an asset it owns by $50m on paper. The company is forced to report an accounting profit of only $50m, even though underlying cash earnings were actually $100m.
Where there were huge write-downs during the GFC, this new rule distorted the appearance of company earnings, and therefore metrics like the CAPE ratio.
This would explain some of the bearishness of the CAPE ratio in recent years. And it should be noted that Warren Buffett also believes the new accounting rules are overly conservative. Buffett has even called the figures “useless” for analytical purposes.
Bottom line: the CAPE ratio has been saying the market is overvalued for quite a long time, and despite that the market has delivered pretty strong returns.
So how does Professor Siegel value the market? He uses the earnings yield.
The earnings yield is simply found by taking the PE ratio and flipping it over. A price-earnings ratio of 15 gives you an earnings yield of 6.66%. All you do is divide 100 by 15. 100/15 = 6.66%.
And Siegel points out that this is the best predictor of long term real returns. As it turns out, over the last 100+ years the long run PE ratio has been close to 15. So perhaps it’s no surprise that the long run real return from stocks for the US (and indeed Australia) has been about 6.5%.
That’s interesting. Today, the PE ratios of both markets sit higher than that. Closer to 20 in fact. What’s the reason for this? And does this mean markets are overpriced?
First, let’s look at what the current figures imply. If we take a PE ratio of 20, that implies a real return of 5%. That’s after inflation. Add inflation of 2% and we get a long term total return of 7% per annum.
That doesn’t seem too bad. Lower than history, but still pretty good. It certainly doesn’t match the hysteria that surrounds most chatter about the level of the market. But can the market maintain a higher PE ratio than the long term average? How is this sustainable?
One case put forward warranting a higher PE than the long run average is the cost of investing. More specifically, the rise of indexing and how easy and cheap it is for the average investor to buy a diversified portfolio of shares.
In the olden days, building a widely diversified portfolio was expensive, as you had to buy the stocks individually, or pay exorbitant entry fees just to access a high-fee managed fund.
So if long term real returns were 6.5% per annum, what were investors actually getting? Maybe 5%?
Now, the cost of investing is basically zero. Brokerage is incredibly cheap, and you can own every major listed company in an index fund for almost nothing.
So a higher PE could be sustained for investors to earn exactly the same return, after costs. Rather than a long term average of 15, this one factor alone could justify a new long term average PE of 20.
It’s also been posed that the sharemarket should be trading at a higher PE ratio than 100 years ago, as economies like the US and Australia have developed and become more stable over time.
The idea is that due to more data and information, economies have become a bit better managed, with the business cycle having less wild swings than it did during the early 1900s, before central banks were created.
This is obviously a contentious issue. Nobody feels like things are stable, and hanging shit on the government and central banks is a national sport in most developed countries.
Of course, we can all point to reasons why things aren’t as good as they might be. But overall, there has been no deep recessions and no mass unemployment for a very long time.
Inflation has been low and stable. Interest rates have been low and stable. Wages have still been growing quicker than inflation. And technology is slowly improving things, with new conveniences, opportunities and breakthroughs in medicine that we never imagined.
Australia and the US are part of the extremely wealthy developed world and things move a bit smoother than they used to. So the idea is, investing is a little less risky than it was 100 years ago, and slightly higher valuations are not unreasonable. I think there is some merit to this idea, but I’m not totally convinced.
One major reason why many asset prices around the world are high, is low interest rates. Low interest rates make cash investments like term deposits and bonds less attractive to own. Therefore it encourages more money to go into higher returning assets like shares and property.
Essentially, interest rates tell you the return you’re going to get for taking no risk. Currently, a term deposit at a large bank might earn you a bit under 2%.
After inflation, this return is essentially zero. And that’s before tax. So in today’s world, you take no risk, you get no return.
In comparison, other asset classes look much more attractive in a low interest rate environment. Interest rates around the world are about as low as they’ve ever been, in an attempt to boost economic growth, among other reasons. Some countries even have negative interest rates, which is another topic entirely!
Again, yields on term deposits and bonds are so low that long term returns are likely to be poor.
Why? Because the best predictor of long term returns on bonds is the starting yield. That’s why bonds have had great returns over the last few decades. Interest rates and yields were very high back then.
So the outlook for bonds and cash isn’t very good, but both will continue to provide a cushion against volatility, if you’re into that sort of thing. How do these options – taking risk vs taking no risk – compare right now?
The difference between the return of shares and safer assets like bonds is called the equity risk premium (the estimated premium you’ll earn for the risk of investing in equities).
So, with yields on bonds and cash around 1-2%, we could expect to earn a long term real return of around zero.
With a current sharemarket PE ratio of 18 in Australia – an earnings yield of 5.5% – we can probably expect a long term real return of around 5.5%. Remember, long term real returns are typically in line with the earnings yield, as Jeremy Siegel shows here.
The above numbers imply that we can expect to earn an equity risk premium of 5.5% per year. Is this good? How does it compare to history?
Well, the RBA notes that in Australia the long term equity risk premium is around 4%.
This means, compared to safer assets, stocks are actually more attractively priced than the long run averages. Based on current valuations, taking sharemarket risk should be handsomely rewarded over the long term.
And in Australia, franking credits are an extra boost, meaning the compensation for taking risk is even higher. Even if you want to be conservative and assume a drop in earnings to account for the business cycle, markets still seem reasonably priced, given there is plenty of fear and risk aversion around.
With interest rates so low, there is likely a huge opportunity cost for holding more cash than your situation demands. Of course, the next argument goes, “when interest rates return to more ‘normal’ levels, this will all be over.”
I won’t make any forecasts here for two reasons. It’s way above my pay-grade and brain capacity. And nobody can tell you exactly what interest rates will do over the next 30 years.
Interest rates around the globe have been pretty low since 2008-09. Economies have recovered since the GFC, but they’re hardly flying. As such, central banks aren’t able to increase rates much, if at all. In fact, a number of countries are now cutting interest rates as the global economy has slowed.
So it doesn’t look like rates will be heading higher in the short term. Well, what about the medium to long term?
We can look to long term bond yields to get a hint for what markets believe interest rates will do over the next few decades.
As we can see, long term bond yields today (blue line) have come way down from only a year ago (brown line). This implies that the expectation for inflation and long term interest rates is also lower than before. And that rates are likely headed lower in the next couple of years.
What does this mean for the sharemarket?
Well, as always, anything can happen in the short run. But given the current level of interest rates, and that rates are expected to remain very low for a long time, this reinforces the point above that stocks are more attractively priced than many think.
Add to that, the earlier points about the ease and near-zero cost of index funds. Under these conditions, paying 20 times earnings (5% earnings yield) for stocks certainly doesn’t seem unreasonable.
Warren Buffett has mentioned a few times that if rates stay low, then stocks are cheap. And Jeremy Siegel also said this on valuations and interest rates;
“Given how low interest rates are, stocks are really pretty cheap. The market is not overvalued on any sort of long term basis.”
Given the information we have, the notion that stocks are dangerously overvalued seems a bit far-fetched. Instead, markets seem to be somewhere between reasonable value and fairly attractive.
The advice for us to be cautious is well meaning. And the worry surrounding a possible recession is fair. But it doesn’t make sense to spend all your time worrying about it.
One day we will have a proper downturn and it won’t feel good. By the way, I have no idea when that will be or what it will look like. In any case, your regular saving and investing will ensure you’re taking advantage of the lower share prices on offer.
That means as the market recovers, like it always does, you’ll come out the other side in an even stronger financial position than before. But you have to sit through the short term pain to get the long term gains.
Luckily that involves simply sticking to your plan and continuing to buy shares in a large basket of companies, reinvesting your dividends, and getting on with building your ideal life.
I usually try and keep it pretty simple around here. So hopefully covering this endlessly-discussed topic didn’t break that principle!
My view: the sharemarket is not overvalued. I’m not saying it won’t fall – who would argue that? It definitely will at some point. What I’m saying is, shares look attractively priced compared to the alternatives. And that safer options offer very poor long term returns from here.
The best long term returns will be had by those that continue to buy diversified assets which produce growing income streams over time.
Most important of all, if you’re building a portfolio to reach Financial Independence, you should focus on exactly that… building the portfolio!
And that’s not done through watching, waiting or worrying!
So keep your head down and ignore the news (it’s not education, it’s entertainment). Focus on your personal goals. And remember, the future is bright.
The life skills you’re building – like good money management, adaptability, and living with a feeling of gratitude for our already-great place in the world, will ensure you’ll be perfectly fine whatever happens along the way.
***Nothing here is advice. These are the opinions of one random blogger. Please make your own investment decisions. I leaned heavily on the works of Jeremy Siegel and Ben Carlson in forming my views on this topic. Credit goes to both – these guys make the most sense to me.