As stocks continue to hit new highs instead of correcting, it’s become commonplace to read that the market is expensive and perhaps even in a bubble.
Of course, a price-to-earnings ratio of the market should determine the truth or falsehood of that assertion, right? If only markets were so easy to decipher.
As financial blogger and investor Barry Ritholtz points out in a column on the Bloomberg View site, “your take on how expensive or cheap stocks are is a Rorschach test — it reveals as much about the observer as it does about equity valuations.”
Using a chart provided by JPMorgan, Ritholtz points out U.S. equity prices closely match their long-term average price-to-earnings ratio of 15.5. “That’s precisely at fair value if you are comparing it to the Standard Poor’s 500 Index earnings-per-share average of analyst estimates for the next 12 months,” he writes.
If this ratio were the only device used to measure stocks, it would prove that stocks are reasonably priced, not overvalued and certainly not in bubble territory.
A simple P/E ratio is the most common way to value companies, but there are plenty of other approaches that show stocks either over or undervalued.
For example, an increasingly popular P/E ratio, which looks at earnings over a 10-year cycle rather than a single year, is flashing overvalued market. The so-called CAPE, an invention of Yale professor and Nobel Prize-winning economist Robert Shiller, is trading at a very rich 25.6 times cyclical earnings. Market bears are championing this number over a simple P/E ratio because it bolsters their argument that stocks are overvalued and due for a correction.
But if only things were this simple. According to Ritholtz, since 1990 the CAPE has only been below its historical average 2% of the time. “If you avoided equities while they were above their historical CAPE measurement, you just missed 24 years of equity gains,” he writes.
And don’t go looking to the so-called PEG ratio for help. According to JPMorgan numbers, writes Ritholtz, “the P/E-to-growth ratio is below its 10-year average but above its 25-year average. The price-to-book ratio is below its 25-year average but above its one-year average. Price to cash flow at 11 is a little higher than its 25-year average of 10.6.”
If you’re thoroughly confused about whether stocks are cheap or expensive, you’re in good company.
Another topic that resembles a Rorschach diagram, rather than a clear set of facts, is market sentiment. Though a low VIX suggests that investors have grown complacent and fearless, other investors and pundits take solace from the fact that fund flow data suggest that investors still haven’t fully bought into the notion that stocks are great.
A recent piece in The Wall Street Journal points out that despite positive returns for stocks, investors have lately been net sellers of mutual funds that hold these shares. In the second quarter through June 25, investors pulled a net $15.1 billion from U.S.-stock mutual funds, according to estimates from the Investment Company Institute trade group.
“That’s a reversal from net inflows in the first three months of this year; for the first half of 2014, through June 25, U.S.-stock portfolios took in an estimated net $3.8 billion,” the Journal reported.
This is statistical evidence of the so-called wall of worry that contrarians like to see since it means that there is extra money that can come back into the stock market.
In a piece for Minyanville, John Gustafson, president of Palmetto Wealth Management, writes that retail-investor behavior is not even close to bubbly.
“There are no big, flashy warning signs that we saw prior to the last big falls — probably because there are still so many things wrong economically and politically around the globe to forestall such overconfidence,” he writes.