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Recent financial commentary on the high valuations of developed-market stocks has tended to argue the following.
First, equities are expensive compared with their historical multiple against earnings, both on a forward basis and using the Nobel laureate Robert Shiller’s “cyclically adjusted price to earnings”, or Cape, version.
Second, earnings growth for the S&P 500 index as a whole has declined for consecutive quarters, meaning the lofty expectations reflected in share prices will inevitably be dashed on the hard rocks of economic reality.
Investors are being advised, implicitly or explicitly, to trim exposure to stocks as a whole or to dump everything and cower in the foetal position, depending on the degree of pessimism of the commentator. Anyone relying on such advice to increase their wealth should think twice.
The problem with this approach is it is neither practical nor precise. Warnings about irrational stock valuations fail the test of practical advice because they inherently require an unspoken reliance on market timing.
Cape has been indicating that US stocks have been overvalued for large stretches of their post-financial crisis bull run, and anyone using it to enter or exit the market would have missed many years of valuable performance. Market timing is usually folly, and most investors who engage in it do so to the detriment of long-term returns.
Such warnings invariably fail to suggest an alternative home for the jittery market timer’s money. Should they buy zero-yielding government bonds instead? Should they sell their entire stock holdings and switch to cash, hoping to buy up shares when they crash in the future?
Perhaps the valuation of stocks in the aggregate will stay the same, grow or fall. Anyone who claims to know when this will happen is deluded or lying.
Stocks have historically provided savers and investors with attractive rates of return on a compound basis that requires multi-decade, or at least multi-year, time horizons. People who invest in equities for the short term are typically either speculating or mandated to do so professionally, such as fund managers who are paid according to annual performance.
This approach fails the test of being precise because it is reliant on broad, top-down analyses of synthetic stock indices such as the S&P 500 to make narrow, short-term valuation calls. A form of cognitive dissonance ensues when the vague and general informs decisions that are intended to be accurate and specific.
Stocks represent fractional ownership of companies, which own real assets and generate cash flows. The index-timer school tends to rely on the average p/e multiples of a large collection of unrelated companies and industries as a reflection of the underlying economic reality of these assets. But the aggregate earnings of an index such as the S&P 500 tells you very little about the durability or quality of the cash flows of its constituents.
Many on Wall Street and in the City of London claim to be “value investors”, seeking out mispriced investments, when in fact they are actually “valuation investors”.
They look at metrics such as stock prices versus forward earnings or book values, but care little for efforts to sort through the underlying assets of real-world businesses, let alone picking through financial statements to understand the companies they are buying.
Fund managers who consistently beat the index — and they are vanishingly rare — do not look at the overall price of the market in deciding when to buy and sell. They do the hard work of waiting until the market offers an opportunity to buy something for less than they believe it is worth.
Passive investors should not seek to time the market. However, if investors, either professional or amateur, are going to engage in active management they should look to market forces to open up specific opportunities, rather than prevailing prices.
Using crude metrics such as the p/e ratio of the S&P 500 to dip in and out of the market is likely to result in long-term disappointment.
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