Wednesday, July 22, 2015

So Stocks are Overvalued – Then What?

Much virtual ink is going into articles on whether stock markets are currently overvalued. Let’s suppose you know for certain that they are 25% overvalued. What should you do?

The natural answer is to sell all stocks. If we knew the markets were going to have a sudden correction soon to erase the 25% overvaluation, the correct next move would be to sell all stocks and short the markets. Of course, we can’t know this.

What if stock markets correct slowly over the next two decades? Suppose that the companies making up the world’s stock markets have business performance that outperforms inflation by 5% per year for the next 20 years. Suppose further that stock prices beat inflation by around 4% per year over that time so that the 25% overvaluation is erased after two decades. Is selling still the right call?

The answer to that question is no. If I knew for certain my stocks would beat inflation by about 4% per year for the next 20 years, I’d be thrilled to hold them.

It’s not enough to have insight into whether stocks are too pricey. To be able to take useful action, you need insight into how prices will come back to “normal.” I have no useful insight into these questions. So, I’ll continue to snooze. I’ll even snooze through the next market crash that is certain to come at some point.

19 comments:

  1. If you snooze like Rip Van Winkle you just might end up a multi millionaire - as long as you had the foresight to drip your dividends.

    RICARDO

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    1. @Ricardo: Fortunately, I have a spreadsheet that sends me an email if I have to wake up and do something. If there was a secure way for the spreadsheet to see my cash balances, it could tell me when to reinvest dividends as well.

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  2. Robert Shiller's cyclically adjusted price / earnings (CAPE) ratio for the S&P 500 index, for example, currently stands at 27.3. Its long run average is 16.6. On a CAPE basis, the US stock market realistically has only been more expensive twice in history– once in 1929, and once in early 2000, both years of spectacular busts.

    Good luck to you Michael. I'll take another path thank you.

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    1. @Anonymous: CAPE has been above 16.6 for about 6 years now. There could be a huge crash in stock prices now and I'd still be better off than if I had sold out of stocks 6 years ago. If I knew when the crash was coming, I'd get out, but I don't know. Who knows how much higher stocks will go before the next correction?

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    2. What's the plan then? Just curious...

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    3. @Le Barbu: I'd be curious to know the anonymous commenter's plan as well. Some people manage to time their exits and re-entries profitably, but the math says that most end up losing money with market timing.

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    4. @TheBeardedOne: Michael takes a very mechanical approach - index investing with full reinvestment. It's working for him so far and fits his temperament.

      On the other hand, we've outperformed the market (SP500 and TSX60) and held significant amounts of cash at various points over the last 20 years. We hold lots of cash now as well as securities that are undervalued or fairly valued. When we can't buy below fair value, we prefer to hold cash.

      http://www.businessinsider.com/cash-as-a-call-option-2012-9
      An investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?”

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    5. @Anonymous: Of course Buffett has succeeded by taking money from those who failed at the same game. Beating the market is a zero-sum game before costs. I'm not interested in trying to win at this game because I'm more likely to end up one of the majority who lose (after costs).

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    6. @Michael: "the math says that most end up losing money with market timing."

      If that was our approach -- market timing -- we would indeed lose money. However, we choose to use other frameworks based on valuation of individual securities. When they're cheap we buy; when they're expensive we sell; when there's nothing to buy, we hold cash. Companies well bought can be held for very long periods of time. The CAPE is just another perspective that we notice, but don't act upon.

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    7. @Anonymous: By "market timing" I intended to include all active investment strategies. Your success has to come at the expense of other active market participants. Given that the majority of active investment dollars are controlled by professionals, I have little interest in playing the game.

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    8. @TheAnonymousOne, your plan may be good for you. You probably think the same about our plans than what I think about people buying F-150 every 4 years, overvalued houses and debts breaking all time records. This is a lot more dangerous than being 100% stocks with P/E around 18...

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    9. @TheBeardedOne @Michael: Thanks for the comments. It takes all types of investors to make a market. I always encourage Michael and others to think more widely and poke in with different views than Michael's. Michael has some good thought-provoking columns. We all frame the problems differently and sometimes other frameworks give different answers.

      @Michael - It can't be zero sum. There is wealth creation overall as evidenced by return in excess over inflation. Individual investors may not benefit -- negative sum, but the investors as a whole gain a positive sum. But yes, people do get their hats handed to them. As the saying goes, "if you don't know who the patsy is, you're the patsy".

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    10. @Anonymous: Trying to beat the market is zero sum (before costs). Wealth creation is built into the market's tendency to go up over time. The effort to make even more than the market offers is the zero sum part. Any excess returns over the market indexes must be taken away from some other active investors (who then get below-market returns).

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  3. P/E ratio contain 2 variables. As you demonstrate in you example, valuation can go back to "normal" or even "low" with no sudden drop in market price.

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    1. @Le Barbu: It's true that both variables in P/E matter. However, I'd guess that the path to the next time P/E gets to an average level will involve both increase in earnings and price drops.

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    2. @Michael, probably, we'll see!

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  4. I'll hold something that's overvalued if everything else is even more overvalued. Bonds and cash don't have much appeal to me right now, and I don't have the time or knowledge for picking stocks or stock pickers. However I have taken advantage of some other opportunities to invest in myself this year rather than maximizing the amount I put into my portfolio.

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    1. @Richard: Investing in yourself sounds like a good idea. Since my university days I've preferred learning on my own, so "investing in myself" has involved the investment of time rather than money.

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    2. I did too, then I ran out of time :)

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