Valuations: Are They Too High?
By Frank Mastrapasqua Ph.D. on The Capital
Principal, Chairman, and Chief Investment Officer
With the market flirting with new highs, questions about valuation always rise and often become the dominant concern of market participants, particularly the prognosticators and media talking heads. The basic metric that is used most readily is the P/E ratio of the S&P 500. A comparison to a historical average is very common and tends to dominate thinking. Currently, the price earnings ratio is projected at 18.8x for 2020. The historical average has been 16x’s over the last 50 years, and on that basis, the market appears expensive.
Although this approach is easy to understand, it is essentially one dimensional. The market is made up of millions of entities making millions of decisions daily. Given the view that the market discounts events in advance (not always accurately, but uncertainty plays a role), market participants do know the historical and expected P/E ratio. If so, why do they choose to ignore what appears to be excess valuation? Are there other factors (variables that suggest that the market may not be overvalued)? Most certainly, the equity market is a complex multifaceted entity. Any attempt at modeling the market involves many factors, not the least of which are interest rates (domestic and international). The economy, public policy (monetary and fiscal), financial flows, investor psychology, momentum, geopolitical considerations, international growth, and currencies are some of the variables that interact to generate asset values.
Clearly, the market does not offer the value that existed a year ago. However, then, uncertainty was elevated. Trade conflicts, Brexit, growth prospects, the financial market climate, and policy directions (the ninth-rate increase occurred in December 2018) were vivid in investors’ minds and may well have warranted lower valuations. Focusing upon market valuation is often a prelude to “market timing”. When markets are down, the fear that it will go lower keeps many investors from participating in the values that were created by market uncertainties. When the market is making new highs, fear of buying just before a correction creates a paralysis, and thus no action.
The short-term focus of Wall Street with the many experts and prognosticators giving instant analysis does little to promote the discipline of investing to meet a person’s long-term goals for retirement, education, etc. Smart beta funds, algorithms, special ETFs, hedge funds, program trading, Robo-investing, and factor models are a number of vehicles that have been created to achieve superior performance. Yet little performance success has been attained while asset gathering has been a huge success. Few approaches work better than the long–only, disciplined investment strategy. Given the performance of many hedge funds and other specialty funds, some firms are now considering creating long-only strategies (funds). When assessing the various major investment options (stocks, bonds, real estate) they should be looked at in relation to each other as well as their respective market characteristics. With the 10-year U.S. Treasury at 1.60% along with the German 10-year yield at -0.44% and Japan a -0.05%, the fixed-income landscape pales in contrast to the other alternatives.
In isolation, stocks may appear overvalued, but in the context of domestic and international financial assets, they may be quite cheap. The S&P 500 dividend yield alone is at 1.8% and growing. The earning yield on projected earnings is near 5.3%. Real estate, on the other hand, is a local consideration and varies from region to region and the product is not homogeneous. For example, the higher tax states that have been affected by SALT (state and local taxes) have experienced declines in value and the phenomenon continues. Furthermore, too many investment decisions, particularly in real estate, are based upon tax considerations as opposed to potential investment returns, with little regard for liquidity and marketability.
What is the appropriate P/E multiple for the market in a world with a 1.6% 10-year Treasury yield, a growing economy, the supply of equities of non-financial corporations declining, and expanding money flows? Higher than it is today!
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This article originally appeared in Frank Mastrapasqua’s newsletter, Capital Market Comment, on February 13, 2020. To receive these newsletters in your inbox, sign up at www.mcapitaladv.com.
