Is the Stock Market "Expensive"?: A Discussion of Valuation Measures
Many of the investment themes that we experienced in 2022 are reversing themselves so far this year. Last year, almost all major asset classes and sectors within them - with the notable exception of commodities - fell in value. (Cash and cash surrogates held their value last year, but not after factoring in inflation). By contrast, in the year to date, all major asset classes, except for commodities, have generated positive returns.
Investment styles within the stock market have also experienced an about-face. While the largest growth stocks bore the brunt of the selling last year, they have been this year's winners so far.
To a large extent, these reversals of fortune within the financial markets reflect changes in investor concerns from last year to this. In 2022, investors were primarily concerned with the inflation that had been ignited by the combination of supply disruptions and COVID-related fiscal and monetary stimulus, and with the Fed's relentless response to that inflation. This year, investors are more concerned about the possibility of a recession as a by-product of Fed tightening, bank failures, and the debt ceiling debate.
The U.S. stock market has rallied, primarily because of excitement over the growing adoption of artificial intelligence in corporate America. As with much of the bull market in recent years, this rally has focused on a handful of the largest tech-oriented growth stocks and has not been accompanied by much overall improvement in investing fundamentals.
In fact, although most inflation measures have continued to improve during the last few months, interest rates have risen as it has become increasingly clear that the Federal Reserve is not going to cut rates anytime soon. In addition, more attention is being drawn to the budget deficit and the accompanying supply of U.S. Treasury bonds in an environment in which the cost of servicing this debt is rising and in which liquidity in the form of the size of the Fed's balance sheet is declining.
The impressive year-to-date returns in the S&P 500 and in the NASDAQ index without the benefit of much growth in corporate earnings or sales has resulted in our stock market becoming expensive, and by some measures very expensive. In discussions with clients, I am often asked how I come to the conclusion that a given stock market is cheap or expensive.
Typically, practitioners aggregate the market values of all the equity in a given stock index (like the S&P 500) by multiplying the stock price of each company in the index by the number of that company's shares outstanding. This total stock market value is then compared to (i.e. divided by) some fundamental metric like the total sales or earnings generated by these same companies, or to some measure of total economic output. By tracking these ratios through time, we gain historical perspective on current stock market valuation.
Two of the best-known and most widely followed stock market valuation indicators are Shiller's CAPE 10 indicator and the so-called Buffett Indicator. A recent MarketWatch article discussed these and other valuation measures, and included my comments on why they are important tools for the purposes of portfolio management and retirement planning for clients. You can access this article by clicking on 10 Other Tools to Help You Understand Stock Market Performance.
It should be carefully noted that while these stock market valuation gauges are very good predictors of future returns over the long-term, they are lousy tools for market timing in the shorter term. Cheap stock markets can get cheaper, and expensive stock markets (and stocks) can get more expensive. And to quote famed economist John Maynard Keynes:
“Markets can remain irrational longer than you can remain solvent”
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.