US Stocks Are Too Expensive…

November 25, 2014 0 Comments

Of course, you’ve already learned that from a previous post I’ve done showing how the US stock market is the most expensive in the entire global economy. However, what exactly does this mean for me and people like me? For the most part, it doesn’t exactly mean much of anything for me. Most of my exposure is in foreign equities and I mostly dabble in currencies. If anything, this information only affects people who are looking to invest in US markets, who are not exactly part of the Top 1% – 20%. For the most part, people seem to believe they are reasonably priced.

In Terms Of Price, Stocks Are Expensive

In hindsight, not all investments are bad. However, when you overpay for an investment, then thats when an investment can be considered bad. As investors, we want great companies as a cheap price (unless thats not what you want, then okay…). Commonly, we use PE ratios to determine whether or not stocks are cheap, reasonably priced or expensive. Using an historically valid metric of the PE Ratio (Cyclically-adjusted PE) we can see that stocks are more expensive than any period within the last 130 years, with the exception of 1929 and 2000.
Currently, stocks at trading at a PE of 27.16, which is currently above the long-term average of 15x or 16x. If anything, many have suggested that the market is anywhere from 20% to 35% overvalued. The risk in holding US equities is fairly high, and could be driven even further from interest rates that are still at record lows, the Federal Reserve deciding to restart a brand new round of QE and capital inflows from foreign nations. While the PE ratio isn’t exactly a good timing measure (time as a strategy is stupid), it is a very good risk measure, and the risk shows that prospect of future gains are much lower with current PE multiples.

Profit Margins Are At Very High Levels

Profit margins tend to be ‘mean-reverting.’ This means that profit margins have periods where they are either above or below average, however, they eventually return to their average margins. Investors may think stocks are reasonably priced while comparing today’s stock prices for current earnings and next years earnings. However, if you are looking at this years earnings and expect high earnings to go on for a long period of time (or forever, as some confident investors believe), you may end up losing money. Considering this, looking at valuation metrics is very useful.
The chart shows Corporate Profits as a percentage of GDP. Every time corporate profits have reached new highs (or fallen to new lows), they have reverted to the average, which is 6.4% of GDP. It is also interesting to note that in years with depressed earnings stocks can appear to be overvalued or expensive. Investors missed plenty of buying opportunities during the financial crisis. Stocks might have looked expensive, but they were actually undervalued. Often times, companies can present itself with higher P/Es because investors are expecting big things (or higher earnings growth) in the future for those companies. Considering this, investors are willing to pay higher multiples for these stocks.

You may have investors who will point to P/E and conclude that stocks are fairly priced based on Wall Street analysts’ forward earning estimate. Unfortunately, the street has a habit of being overly optimistic. For the most part, investors should find their favorite P/E evaluation process, compare it with historical data and just stick with it.

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