Measures of stock market overvaluation

Investment Analysis Clubs Macro Economic Trends and Risks
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https://www.wsj.com/finance/investing/markets-are-way-out-of-line-with-reality-according-to-these-measures-1209f9fb?mod=hp_lead_pos3

Markets Are Way Out of Line With Reality, According to These Measures

Three popular stock market valuation tools are saying the rebound of the past couple of weeks is a fools’ rally. Unfortunately, long-term investing isn’t so easy.

By James Mackintosh, The Wall Street Journal, Aug. 16, 2024

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I’ll consider three gauges here, the CAPE, the forward PE and the Fed Model. All show that the offers being presented by Mr. Market—as legendary investor Benjamin Graham personified it—are unattractive for large U.S. stocks at present. They are expensive not only compared with the past but compared with smaller stocks, foreign stocks, corporate bonds and Treasurys, too.

If these measures are right, the rebound of the past couple of weeks is a fools’ rally, and it’s time to switch away from the biggest stocks…

[CAPE chart link Shiller PE Ratio - Multpl ]

The Fed Model, named by strategist Ed Yardeni in the late 1990s, attempts to compare stocks with bonds by comparing the earnings yield, or earnings per share divided by price, with bond yields.

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Like CAPE, the forward price-to-earnings ratio suggests stocks are extremely expensive—cheaper than in 2000 or late 2020, but not by much.

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When the gauges say stocks are expensive, returns over the next decade tend to be weak. When they say stocks are screamingly cheap, future returns are higher. The pattern holds most of the time from 1985 for all three, with CAPE and forward PE tightly linked to S&P 500 returns over the next 10 years, and the Fed Model a bit less so. Statistically, CAPE and forward PE explain about 85% of the change in returns, while the Fed Model explains 74% of performance of the S&P versus Treasurys since 1991… [end quote]

According to YCharts, the forward P/E ratio is currently 21. Since the forward P/E ratio relies on analysts it’s not rock solid data. As Yogi Berra said, it’s hard to make predictions, especially about the future. Still, these are useful if taken cautiously. According to the chart, the annualized total return over the following 10 years of SPX would be under 5%, about the same as 10 year Treasuries.

The Current S&P 500 Earnings Yield is also low on a historical basis.

Investors in every past bubble have been emotionally invested in believing that this time is different – the market will always rise. Will it be true this time? Only time will tell. But the signals are warning.

Wendy

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The thing is, it is trivially easy. During your accumulation years, each pay period you invest a percentage of your earnings into any of your favorite index funds. You keep doing that for decades. When you receive a windfall, you similarly invest [most of] it the same way. Then, sometime in the future, when you need the money (to make a wedding, to fund retirement, etc), you begin selling amounts of it a few years in advance of that need and temporarily store the money somewhere relatively safe like T-bills. That’s it. Really quite simple.

The main issue is that most people (including me) don’t keep it this simple.

In fact, I’d argue that long-term investing is FAR EASIER than short-term investing.

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Agree mostly. Long term investing should be much simpler than near term for sure. Emotionally though it is difficult to ride the roller coaster, and that is where the ‘difficult’ comes in for most people. Including me too many times in my life. It basically comes down to the pain of loss being greater than the joy of reward for most people.

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Both the CAPE and the Fed model have been shown to have no correlation with future market returns.

Lack of predictive power

Wikipedia: " The analysis shows that the Fed model has no power to forecast long term stock returns… In 2018, Ned Davis Research ran a test of the Fed model’s ability to predict subsequent 10-year returns using data from the previous 75 years. Davis found that “it was basically worthless”

Why should long term investors care about a 2-week rally or a 2-week downturn? I hate the term fool’s rally. it suggests that people who keep dollar cost averaging into an index fund are fools. That kind of language is really insulting. Young people especially should continue to have 401K investments made automatically into index funds from their bi-weekly paychecks. They would have automatically bought the dip a couple weeks ago. Long term investors care about 3 years, 5 years, 10+ years down the road.

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Over the last 30 years (1994 to 2024), a buy & hold investment in the S&P 500 has delivered a nearly 2,000% return with dividends reinvested – a twenty-fold return.

Note that’s a 2,000% return while maintaining your asset allocation through 50% market drops in 2000 and 2008 and a number of smaller minus 20% blips. Being able to “stay the course” as Buffett and Bogle have long advised has happily relieved me of the need for employment over the past three decades. My working life involves spending a couple of hours at year end doing a little tax planning and deciding how to make next year’s withdrawal for living expenses in the most tax efficient manner possible.

Have the market timers seen a 20-fold return with the same lack of time and effort? I doubt it.

intercst

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I love your stuff and I have no doubt that there are warning signs, but sometimes when I read stuff like this I instantly get the following image in my head:

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Hawkwin
Who is still waiting a bit to take his foot off the gas (I’m greedy), but it is probably coming soon.

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