This blog post is adapted from my French column with the newspaper Les Affaires.
Equity Markets
I often read texts by commentators who are worried about stock markets breaking one record after another over the past few years. They think that share prices have become too high and are therefore vulnerable to an eventual correction. But is that really true? And if so, is it a good idea to sell your equities and fall back on cash?
How to decide whether the market is too expensive
The most common way to determine whether equities are overvalued is to look at the price/earnings ratio, i.e., how much an investor has to pay to “buy” a dollar of profit. For example, if you pay ten dollars for a share with one dollar of earnings per share, the price/earnings ratio is ten.
The price/earnings ratio is made up of two components. The first one is share price. It is easily observable and isn’t subject to interpretation. If the Royal Bank closes out the trading day at, say, 100 dollars, this share price is accepted by everyone and isn’t up for debate. However, measuring the other component, earnings per share (EPS), is open to considerable interpretation. Are we talking about fully diluted EPS or not? Do we have to exclude certain non-recurring items, such as extraordinary gains further to the sale of a division? And why not use analysts’ average estimates for the coming year instead of historical figures?
Thankfully, measuring EPS has become less controversial over the past few years. Many experts (including yours truly…) have adopted the method proposed by Professor Robert Shiller of Yale University (and a Nobel Prize-winner to boot!). Professor Shiller measures EPS for the overall market by calculating the average for the past ten years, adjusted for inflation. This measurement is far from perfect, but it is good enough to enjoy a consensus, which isn’t a bad thing.
Why and how do people find that stock markets are overvalued?
Professor Shiller measured the U.S. stock market’s price/earnings ratio from 1880 to the present day. When experts say that the American market is overheated, they are often referring to the historical, 138-year average, which stands at 17 times EPS. Currently, the U.S. stock market’s price/earnings ratio is (wait for it) over 30 times EPS. That means it’s 76% above the historical average. Are we headed for a meltdown?
Some reservations
I too find the U.S. stock market expensive. But it’s not that simple.
First, in 1880, horses were the main mode of transportation. Homes didn’t have electricity or telephones. On top of that, the majority of the population lived on farms, and the American economy was first and foremost agrarian. In short, it was a different era. And there are other reasons to believe that today’s market justifies a price/earnings ratio higher than the historical average. Up until the 1950s, large pension funds didn’t invest in equities, which were seen as too speculative. That’s no longer the case. Another important factor is the growing popularity of index-based, exchange traded funds, which now allow all investors to build a highly diversified portfolio at very low cost. And on top of all this, interest rates are very low worldwide, and may stay significantly below the levels observed from the 1960s to 2000. All of these factors contribute to higher share prices, and that’s why I’m convinced that the historical ratio of 17 times EPS underestimates the real value of the U.S. stock market.
What I think about the market being overvalued
In my opinion, given the economic conditions that have developed since 2000, major stock exchanges in developed countries can reasonably support a price/earnings ratio of 20 to 25. The U.S. stock market has hit 30 times EPS, which is undeniably high, perhaps 20% above the market’s normal value. As for the world’s other major developed regions, I don’t see any overvaluation. Canada is at 24 times EPS, Europe is at 22 and Asia-Pacific is at 20 — all reasonable levels. As for emerging markets, which remain affordable despite major gains over the past year, the figure is 14 times EPS.
What not to do with your portfolio
The worst decision people could make is to get rid of all of their equities to invest in cash. No one can predict stock market ups and downs. Not even Warren Buffet. Some readers may recall Alan Greenspan’s famous speech in 1996. Worried about the go-go stock market, the maestro announced that the market was showing “irrational exuberance.” Result: Markets continued to chalk up one record after another for three years! Still thinking of selling your U.S. equities because they’re overpriced? Bad news: The predictive power of Shiller’s price/earnings ratio is a meagre 40%! That means you have a 60% chance of being wrong.
What to do with your portfolio
Set target percentages for your portfolio’s weighting in equities and bonds. Diversify your equities worldwide and make sure your bonds are well-diversified and safe. If stock markets “bite the dust,” the percentage of equities in your portfolio will fall, and this will be the signal for you to sell some of your bonds and buy more shares at reduced prices in order to rebalance your portfolio. Inversely, if equities soar, the rebalancing process means that it’s time to pare back your shares a bit and safely invest this money in bonds.
Sources: Yale University, PWL Capital