Are Valuations Unreasonably High?
By: Mike Earl
The most common question we have heard from clients in 2017 is some variation on this one:
"Is the stock market due for a drop?"
For some clients, their concerns relate to uncertainty about policy decisions of the Trump Administration. For others, fears stem from endless media reports about the stock market making new all-time highs. For others, it's a well-placed understanding that bull markets don't go on forever (true).
Let's take a look at the historical record. Historically, here are the frequency and magnitude of losses for the S&P 500 (data from 1928-2016):
- 5% losses occur three times a year.
- 10% losses once a year.
- 15% losses once every two years.
- 20% losses once every three to four years.
The last 20% decline we saw for the S&P 500 Index was the 57% decline in the Index from October 9, 2007, to March 6, 2009. That was the second-worst peak-to-trough decline in US stock market history (next to the Great Depression, which witnessed nearly a 90% decline from top-to-bottom of the market).
In spite of not having a 20% decline since 2007-2009, we have had several meaningful declines since the Great Recession:
16% decline in fall 2010
19.4% decline in fall 2011
14% decline late 2015/early 2016
Since we know that meaningful stock market declines are bound to happen at not-so-infrequent intervals, should we be doing something about it? The short answer is no. We cannot predict when the the declines will start, nor can we predict when those declines will end. If you're trying to time the next correction, you have to guess right twice: when to sell out of stocks (or reduce stock exposure); and when to get back into stocks.
With that foundation in place, let's review where the overall stock market stands today. Are stocks "rich" (i.e. expensive) right now? Are we simply experiencing a "Trump Bump", as many commentators have called it? We don't think so. There are plenty of stocks that offer reasonable valuations right now. And while Consumer Confidence is at its highest level since 2000, we aren't seeing bubble-level optimism across the stock market.
You might think of companies like Amazon and Tesla as examples of irrational exuberance in the stock market, but we see those as exceptions today, not the rule. Alphabet stock (Google) trades at a Forward P/E ratio of 23.4, in spite of having grown earnings historically at a rate of 36.8%.
Would you believe me if I told you Coca-Cola stock is 60% more expensive than Apple stock today? Or that Procter & Gable is 80% more expensive than Intel? Those are both true statements:
Forward P/E on selected stocks from the Dow Jones Industrial Average:
I am not making any judgments about whether any of those stocks are good or bad buys. Rather, it is fascinating that a historically fast-growing company like Apple is cheaper to buy (based on stock price divided by earnings per share) than Procter & Gamble. Apple makes iPhones; P&G sells toiletries. P&G is a great company in many respects, no doubt. But this illustrates how there are still many value opportunities in the market today. That's why Warren Buffett recently pumped many billions of dollars into buying Apple stock.
Overall, the average forward P/E for the 30 stocks in the Dow Jones Industrial Avearge is 16.5. That number means stocks are not a screaming buy; nor are they significantly overpriced.
Does this guarantee that a correction will not come our way for the remainder of the year? Absolutely not. But, it does tell us there are plenty of attractively-priced stocks within the overall stock market. If we think these companies will continue to create new products, grow revenues, and expand their customer bases, then we should be investors in these companies.
Of note, we do not buy individual stocks for our clients. Rather, when our clients own stocks, they own them as part of a basket of hundreds of different stocks, so that single-stock exposure is minimal (less than 1% of any given client portfolio).