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Retirement Report: Are Stocks Expensive?

April 27, 2020
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Last year was a banner year for U.S. stocks. All sectors within the S&P 500 generated double-digit returns. Now that the stock market continues to reach new highs, is it time to ring the register?

Nothing Lasts Forever

Last year was a banner year for stocks. The S&P 500 index, on a total return basis, notched a 31.5% gain in 2019. It was the best year since 2013, and all eleven sectors generated double-digit returns. The Russell 2000 Total Return index, which is a proxy for small cap stocks, gained 25.5%.

Returns like these justifiably make investors question the future. It’s unrealistic to assume that stocks can rise indefinitely. But before we attempt to think about what the future may hold, let’s first discuss the concept of valuation and recognize its limitations.

Price vs. Value

Warren Buffett once said, “Price is what you pay, value is what you get.” I can think of no better way to begin a discussion on valuation.

On its own, price offers no insight into the value of an asset. A $1,000 stock could be a bargain compared to a $10 stock, just as a $1 million home could be a steal when compared to a $100,000 home.

Valuation analysis requires metrics that compare assets on a level playing field. In real estate, price-per-square-foot is commonly used since most shoppers value square footage.

The price-to-earnings ratio (P/E ratio) is a common valuation metric for stocks because investors typically value earnings. The intuition is analogous to real estate. How much someone is willing to pay for $1 of company earnings is no different than what a home buyer is willing to pay for a single square foot of a house.

Nearly any characteristic can be used to assess value. If a home buyer cares more about the number of bedrooms instead of overall size, he can just as easily use price- per-bedroom.

Similarly, some stocks are owned to generate income, so these tend to be valued on the cash they generate. Younger companies tend to be valued on a price-per-sales basis because revenue usually matters more than profits earlier on.

It’s All Relative

On their own, valuation measures are practically useless. In fact, Vanguard published a report in 2012 that concluded the P/E ratio and other valuation metrics have been unable to predict the future of stock prices since 19261 .

Therefore, any pundit who claims that the stock market is going to crash solely due to a high P/E ratio should be ignored for the same reason a bull should be for recommending the stock market because of a low P/E ratio.

Valuation analysis is often more art than science, but there are three factors that should be considered to provide structure to any evaluation. The first is likeness.

If a home buyer were to determine that a house is selling for $500 per square foot, this would not be enough to tell her if she is getting a good or bad deal. Paying $500/sqft in rural Wyoming would be a rip-off, but that same price in lower Manhattan is a bargain.

Comparing a utility stock to a technology stock would also make little sense. The former tends to be used for income and the latter for growth. It’s apples and oranges.

The second is quality. If new construction is selling for $500/sqft, it would be unfair to compare a fixer-upper to a move-in ready house with top of the line appliances.

Stocks work the same way. Since we are valuing the earnings (by use of the P/E ratio), we must compare both the quality and expected growth. A high P/E ratio is often justified if future earnings appear attractive. A low P/E ratio should be expected when future earnings look shaky.

The third is the current and projected path for interest rates. This is gravity for all financial assets and cannot be ignored. For example, when interest rates are low, people typically buy more houses, which makes housing more expensive.

The same applies to stocks. Relatively low interest rates pull down investment returns in cash and bonds to the point where investors are forced to buy stocks. This causes P/E ratios to rise.

If this phenomenon sounds eerily familiar, it is because this is precisely what happened following the financial crisis. Shortly after the Fed’s decision to drop interest rates to zero, investors who needed income fled from cash investments to find better returns.

The next stop up the “risk curve” was bonds. As investors bought more bonds, prices rose. This brought down the income generated by these bonds to the point where even they could no longer pay the bills. It didn’t take long until investors moved into stocks because there were few options left that had attractive yields.

Therefore, a stock market with a relatively high P/E ratio may not necessarily be overvalued if today’s interest rates are relatively low. Where investors can get in trouble (and where bubbles can form) is when valuation metrics and interest rates are both high. That usually ends badly.

Now We’re Ready

As of December 31st, 2019, the P/E ratio for the S&P 500 was 18.2 times forward earnings, and the average ratio over the last 25 years was 16.3,2 . Since the current P/E ratio is higher than the average, it may appear that stocks are overvalued.

However, as explained above, this is not enough. The next step is to assess the quality of earnings relative to the past, and today looks quite different from prior economic cycles.

Companies that survived the financial crisis have spent years improving their operations through cost controls, inventory management, and better technology. These efficiencies have driven record-high margins and more consistent profitability.

Balance sheets also look better. Debts are far more manageable, and the 2018 corporate tax cuts should continue to fuel reinvestment and reward shareholders via dividends and share buybacks. These improvements should lower the risk of owning stocks because if a recession were to surprise investors, companies are better equipped to handle a downturn.

On the flip side, because companies are operating so well, it’s hard to see how they can become more efficient from here. Rising paychecks, while great for employees, will only add more pressure to company margins. Meaning, future earnings growth will likely need to come from selling more stuff than cutting costs.

The Federal Reserve has provided ample commentary suggesting little desire to raise interest rates anytime soon. Current inflation measures should support the Fed’s position, so this should continue to act as a floor for stocks.

To summarize, while future earnings growth looks good (but not great), the quality of earnings is strong. Interest rates remain at historic lows, which should provide added support. Hence, stocks appear to remain attractive.

The Bottom Line

Valuation analysis is subjective, and there is no shortage of equity bears out there. Some are famous investors with multiple commas in their bank accounts. But how an investor reacts can impact performance more than the analysis itself. A good rule of thumb is the bigger the move, the bigger the risk to meeting long-term goals.

For example, if an investor believes a recession is imminent, fear may drive her to sell all stocks and go to cash. Once the market tanks, she could then buy at the bottom and wait for the market to recover. If it were only this easy.

The first issue is that any gains in a taxable account are going to get hit by Uncle Sam. Then, if by chance she got lucky and missed the carnage, she would need to have both the courage and timing to buy into the drawdown. Few get lucky twice let alone have the stomach for that ride.

If she does not get lucky and stocks continue to rise, she will want to kick herself. She paid taxes on gains and is now sitting in cash (losing money safely to inflation). Down the road, she will eventually be forced to decide whether to buy back or risk watching the market rise higher in her face.

The point here is that rather than make dramatic moves one way or the other, adjust allocations slowly. The economy does not move fast, so directional moves should be migratory.

Small adjustments to a portfolio can also help mitigate the effects of being wrong (even the most successful investors tend to be wrong more times than right). That way, you remain focused on managing risk rather than taking too much risk.

The bottom line is that although stocks appear to be attractive, what matters is how an investor incorporates analysis into strategy. Here, slow and steady tends to win the race versus bold moves in one direction or the other.

 


Three Key Points

  1. Last year was a banner year for stocks.
  2. Equity returns in 2019 justifiably make investors question the future.
  3. The bigger the move, the bigger the risk.

Sources

  1. https://personal.vanguard.com/pdf/s338.pdf
  2. J.P. Morgan, Guide to The Markets 1Q 2020

Disclosures

This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.

Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Consult your financial professional before making any investment decision. This material is for informational purposes only and sets forth the views and opinions of our investment team as of this date. The comments, opinions and estimates are based or derived from publicly available information from sources that we believe to be reliable. All indexes are unmanaged, and an individual cannot invest directly in an index. Index returns do not include fees or expenses. Investing may involve risk and may result in the loss of principal.

Advisory services offered through Richard W. Paul & Associates, LLC, a Registered Investment Advisory Firm. Insurance services offered through Midwest Financial Consultants, Inc. The aforementioned are affiliated companies.