Is the Stock Market Over-Valued?

The stock market swooned last week and has been bouncing around ever since. “Surely the market is over-valued” is a comment that you hear frequently.  Agreement with such a statement means that many people will be very worried because it implies that stocks have peaked and will stop rising.  Retirees never like to hear that since their future incomes are tied to future growth in stock values. But all of us are concerned – no one wants to see wealth disappear. Simply – whether you are young and beginning to save or old enough to be on a regular diet of prunes – it hurts when stock prices stop rising. It hurts even more when they fall.

So what is the truth here? Are stocks going to stop rising? Fall? Or is all of this nonsense and stocks will continue rising?

Below you will see why I am not pessimistic about stocks. But let’s begin at the beginning. What does it mean when people say stocks are over-valued? If your boss tells you that you are over-valued, you know it isn’t a compliment and it probably means no wage increase is imminent. The word “value” is a common one that most of us understand. All things have value. Even my old pair of jeans has value to someone. 

Value, however, can be a tricky thing. How about those old jeans? Some of my well-dressed friends would toss a pair of old jeans as soon as the fading begins. In contrast, my hippie friends won’t even wear a new pair of jeans until they have washed them enough times that they are not only faded but have holes in the knees. Point – the same product might have very different values to different people.

Economists recognize this dilemma but point out that markets are places where values are assigned through prices. If a house sells for 1 million dollars, that’s the value of the house. The seller may be unhappy with that price and the buyer ecstatic – but the economist records $1 million. That’s the price at which both parties agreed to the transaction.  So – implicit values can be almost anything but market price is an objective criterion widely accepted as value. If we want to know if stocks are over-valued then we use stock prices. 

What does it mean for stock prices to be under-valued? There is no single meaning. The popular way is to use something called a price/earnings ratio. P/E has two parts – a stock price and an earning figure. Think of a single firm. Suppose its stock price closed at $100.  When you buy that stock for $100 you are hoping it will be a good investment. For the moment forget the capital gain you might receive by buying low today and selling high in the future. What’s left is a dividend you might receive from that share. Let’s suppose the earnings of the company are only $1. In that case, since dividends reflect earnings, the most you would expect to receive for your $100 investment is $1. That’s a 1% return. Ugh.  That stock is over-valued at $100. If you had paid $20 for the stock, then your return would have been a much better 5%.

Some of you are waving your hands! Larry – when you pay $100 for a stock you have it for more than one year. So what matters is not just one year of dividends or earnings – but what happens to earnings over the future. And for that question/comment you get a gold star. But that’s what gets us into trouble with this price/earnings approach. The current price and earnings data are known but are not perfect. But to use future earnings brings in unknowns and expectations and lots of different opinions. Ron might think a stock is vastly under-priced because he sees large increases in future earnings. James is more pessimistic about earnings and thinks today’s stock is highly over-priced.

So while the price/earnings approach is one that is widely used – it isn’t perfect for determining when and if the stock market will fall or rise in the future. It is a valuable approach but it leaves room for other ways to think about stock prices. Since I am about as boring as a rock in a stream, I like intuitive simple approaches. Consider some facts about the market. Here I am using the S&P500 price index. I downloaded data for the time period from 1950 to September 2014 from a website (https://finance.yahoo.com/q/hp?s=%5EGSPC+Historical+Prices ).  I then graphed the data. I converted all this daily data to annual averages. My limited abilities mean I couldn’t get the graph on this page. But you can find a graph at the link above.

·        Similar to my waist size – the S&P500 has had up and down cycles many times but it has trended upward.

·        The value of the S&P index in 1950 was about 17 and now hovers at about 2000. You math jocks can figure out the rate of return of $100 invested in 1950.  It is a pretty big number. If you gave that money to Uncle Charlie (or Uncle Sam) in that year, your return might not have been so good.

·        During those years there were many times when the market surged ahead only to return to more sober (lower) values. Many analysts point out a period from the early 1970s to the early 1980s when the market was essentially flat. But that is about the only time since 1950 when the market did not pop back in a more reasonable period of time.

·        Looking at the graph from 1995 to 2000 and then from 2003 to 2007 the increases where spectacular. Both peaks were followed by declines that lasted 2-3 years. The declines were followed by more increases.

·        There were also interesting time periods when stock prices rose precipitously but did not fall for extended time periods. If you start in about 1975 the market rises through the early 2000s with several major spurts followed by shorter setbacks.

The above points are pretty well known but they do underscore one fact – market gains always have setbacks but those time periods vary greatly in their intensity from a couple of months to several years. Gains do not necessarily imply a seriously stagnant market price.

Now one more point. If you put money into the S&P500 in 1995 or 1996 and held it until it reached 2000 last month – your annualized continuously compounded yield would have been around 7%. That annual appreciation is very much in line with stock returns over a much longer period. An average market, therefore, is expected to give you about 7% per year. Now consider the recent time periods of so-called explosive growth. If you invested money in the year (first column below) and sold when the market hit 2000 recently*, your investment would have earned the average compounded rate (column 2) over those number of years (column 3):

1997      4.5%   17

1998      4.3%   16

1999      3.0%   15

2000      2.4%   14

2001      5.2%   13

2002      7.8%   12

2003      6.5%   11

2004      6.0%   10

2005      5.6%    9

2006      5.2%    8

2007      3.9%    7

2008      9.4%    6

2009    13.6%    5

2010    15.1%    4

2011    20.9%    3

2012    17.8%    2

2013    18.9%    1

*Rates of return in the table are calculated from September of each year given through September of 2014.

From the above table you can see dramatic growth of the last five years. Those are indeed spectacular returns. But if your eyes move up the table you see that even with these fantastic stock increases, the annual average returns from money invested anytime between 1997 and 2007 yielded below historical averages. Thus even with spectacular growth of the last few years – the longer term returns in the market are well below average.

What do you make of this? The answer is that there is no way to know the future. Price/earnings ratios are interesting but don’t tell the whole story. Returns of the last five years are indeed spectacular. But even with stock price increases in those five years, money that got invested 7 to 17 years ago are not impressive. Stocks could rise several more years before that money earned the average annual return.

Will the market peak soon and swoon? Will it remain at present levels for 10 years? I don’t know. But the answer is clearly not a slam dunk.