A Canadian's random thoughts on personal finance

Feb 27, 2011

The market is over-valued

I usually don't try to make predictions about the stock market, but a rather complacent post by Potato has led me to end my 6-month blog drought to explain why I think the market is over-valued, and why I'm not selling anyway.

I want to start by drawing your attention to this chart:

This chart, stolen from Wikipedia, is based on data from Robert Shiller, and shows the relationship between the P/E ratio of stocks (using the average earnings of the previous 10 years) and their performance over the subsequent 20 years.

The relationship is striking. The higher the P/E, the lower the returns over the subsequent two decades. This makes P/E the only reliable indicator I'm aware of for predicting future stock performance.

As I write this, the P/E of the S&P500 is 24. Based on the above chart, if historical trends hold, that means from this moment forward we can expect a 20-year return of approximately 0%. (In the market, historical trends seldom hold, but it's food for thought.)

Even if we we set aside Shiller's musings, and focus only on what the P/E ratio tells us directly, P/E=24 means annual earnings are just 1/24 = 4.2% of invested capital. This, plus earnings growth, is what we can expect to earn from the market whenever P/E=24.

(How much is earnings growth? Well, the nominal earnings of the S&P500 have roughly doubled every 30 years for the past century, which comes out to something like 2.3% per year, but with enormous error bars.)

4.2% nominal return is not an exciting number. The iShares Bond Index Fund XBB is paying 4% right now. The extra risk you're taking in the market rewards you to the tune of just 0.2% (plus earnings growth).

And if that's not bad enough, multpl.com has a chart showing the current P/E in relation to the historical values. Looking at the current value of 24, you'll notice the market has never had a P/E this high without crashing shortly afterward.

So... I find this is a scary time to hold stocks. As a net purchaser of stocks over the coming decades, I'm disappointed that the prices are so high, and if I were a market forecaster, I might even venture to guess that a correction is coming soon.

The question naturally arises, then: should I sell my stocks? Well, don't think I didn't consider it. However, I'm planning to hang on to my stocks for now for just one reason:

This is exactly the roller-coaster I signed up for.

I invest money I don't need soon, so I am largely indifferent toward fluctuations. Because I'm only interested in the highest expected returns, I stay invested in stocks.

I don't have the skill to time the market, nor to outsmart it. Yes, there's a good chance my stocks will some day be worth less than they are now, but that does not necessarily mean I should sell now. For example, if the 10% drop I fear were to be preceded by a 15% increase, on the whole I would regret selling now. And if I do sell now, there's a guy on the other side of that transaction buying my stocks, and who's to say he's the one who's wrong?

So, in the end, while I'm worried that my stocks will drop in value, I'm not going to start basing my investment choices on gut feelings. I must say, though, that as a net buyer of stocks over the next couple of decades, I do wish prices would drop to a more reasonable level!

And if the P/E rises another few points, I may be back here re-evaluating my position on this.


Potato said...

A good post, makes me think :)

I do like the P/E-10 measure, and can't believe I forgot to check it before writing my post.

I'm not sure how to reconcile the two readings. I tried reasoning that maybe P/E-10 is off due to two recessions within 10 years, including a historically bad one (one of the few times earnings on the S&P500 was negative), but even replacing a few quarters of 2008 with more typical recessionary earnings still leaves the P/E-10 in the 20's.

I've been 100% equities for about two and a half years now, and have almost been reaching for reasons to get back to a little more balance lately...

Patrick said...

@Potato: I have my doubts about P/E-10 too after reading Barel Karsan's take on it. So if it comes down to trusting my own analysis of what P/E-10 tells me, or trusting that the market is smarter than I am, that's not even a close call.

Patrick said...

@Potato: Sorry, I meant to link to Barel Karsan's more recent comments on PE10.