Great Investors Know Value

In last month’s article, we focused on “Understanding Progress” as one of the great qualities to adopt for anyone who wants to become a great investor. This month we focus on a similar, but slightly different quality…Great Investors Know Value.

Big Round Numbers

The stock market has continued on a bullish trend so far during 2017, and has made several “new highs” during the course of this year. In fact, on September 15th the S&P 500 closed at yet another all-time high value of 2,500 for the first time in history, to the delight of financial journalists everywhere. New market highs always make for great headlines, but the best headlines come from “Big Round Numbers”. When markets accomplish these watershed levels such as “Dow 20,000”, or “Nasdaq 5,000”, the media always has a field day reporting these lofty levels.

There is an old saying that “bull markets climb a wall of worry”, and new market highs are always accompanied by angst among investors, who fear that the market is “too high”. However, we cannot remember a new high in the past which was accompanied by more skepticism, doubt, fear, and even hatred among investors and the financial media. The headline above from the Wall Street Journal gave us a good chuckle, and is all the contrarian proof we need that the bull market in equities is alive and well.

Inevitably, the media publicity that accompanies a “Big Round Number” like this almost always inspires a chorus of calls from market pundits and analysts that the stock market is overvalued, and that investors must beware these inflated market levels and prepare for an imminent correction or bear market. If you turn on CNBC this afternoon to catch up on the financial news, you will no doubt see dozens of highly intelligent talking heads using various complicated valuation metrics to prove that the stock market is way too expensive, and is on the verge of a major crash.

CAPE Fear

We have always been very skeptical of the idea that anyone can determine what the true valuation of the stock market “should be”, and then use that information to make a judgement about whether stocks are overvalued or undervalued, or to time our investment in or out of equities. Our skepticism stems from the fact that these “valuation” techniques almost always claim that stocks are overvalued, and are also almost always wrong.
As an example, one of the most sophisticated valuation methods out there is called the CAPE ratio. Even the name sounds academic and intimidating: the “Cyclically Adjusted Price to Earnings Ratio” is a complicated formula developed by some very smart academics to determine the proper valuation of the stock market. The problem is, that it is almost useless as a tool for making investing decisions. As noted investor Barry Ritholz recently wrote in his blog:

Let’s start with CAPE – the Cyclically Adjusted Price to Earnings ratio. Think of it as the 10-year P/E. It is high for US equities by historical averages, elevated for Japan, moderate for Europe, and low for emerging markets. If we wanted to scare people, we would selectively pull data out showing at present we have the highest reading outside of 2000 (43.2), 1929 (32.5) and 2007 (27.6).

Since 1990, the S&P 500 has been trading above the average CAPE ratio during 307 out of 324 months – that’s a total of 95% of the time. If you exited US equities when the CAPE ratio was overvalued, you would have missed gains of more than a 1000% over that time. In fact, had you only invested when the CAPE was 25% overvalued – i.e. when stocks were “very expensive” – your total returns since 1990 would have been 650%. This is one of the many reasons why it is ill advised to use valuation as a timing mechanism.

We always tune out whenever the media starts talking about sophisticated measurements of how overvalued the stock market is, because these measures have proven to be almost useless as a tool for making intelligent investing decisions.

Just the Facts, Please

As we analyze today’s stock market, and set aside the hyperbole of the headlines screaming that the market is too high, we find the following facts:

The “Price to Earnings Ratio” is a number which compares the future earnings of a stock, to the price which you have to pay to purchase a share of that stock, and is the most popular tool for valuation. The S&P 500 currently trades at a price of 2,544, and has forward 12 month earnings of roughly $140. At this level, the “Price to Earnings” ratio of the S&P 500 based on forward earnings is just about 18. The 25 year average for this valuation metric is 16, so markets are certainly slightly elevated above average, but nothing like in the late 90’s, when PE ratios hit the low 50’s. However, we concede that valuations are slightly elevated.

However, most investors don’t grasp the fact that the “PE Ratio” is a meaningless number when it is considered by itself – it is only relevant when it is considered in context of the level of interest rates in the economy. The price of a stock is nothing more than a tool for placing a current value on the future stream of earnings that a company will earn, in today’s dollars. That value must be influenced by the “discount rate”, or the overall level of interest rates in the economy. When the “discount rate” is very low, then the value of future earnings should be much higher, and when interest rates are high, the value of future earnings is much lower. As a result, the stock market’s current valuation of future company earnings today should be more elevated than usual, given the historic low level of interest rates.

If all of this gives you a headache, here is a much simpler way to think about it:

With the S&P 500 trading at 2,500, and S&P 500 earnings of $140, we can calculate that the “Earnings Yield” of the stock market is 5.6%. Today the 10 Year treasury bond yields approximately 2.2%. So, the stock market currently yields more than two and a half times the yield of the bond market.

Interest rates are at extreme lows, so economics dictates that equity earnings should be valued much higher than usual. In fact, this calculation implies that company earnings are still relatively “cheap” in relation to interest rates.

Don’t believe the hype about “overvalued equity prices”.

Having a Plan

The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing. They are optimistic and focused on the long term growth of capital that can arise from investing in an innovative and productive economy. They don’t let their emotional reactions to news headlines throw them off track, and they understand that a well-designed written investment and financial plan will result in long-term success.

No predictions. No witch doctor investment sorcery or magic investing formulas. No “Black Boxes”. Just intelligent planning, patience and discipline.