Fed Chair Janet Yellen’s early May pronouncement that “…equity market valuations at this point are generally quite high” caused quite a stir with investors concerned that another market “correction” was just around the corner.
Many who believe that stocks are overvalued today point to recent readings of the Cyclically-Adjusted Price to Earnings (CAPE) ratio. This valuation metric, the result of research by Yale economist Robert Schiller, compares current stock prices to average inflation adjusted earnings over the past 10 years. Today, the CAPE ratio stands at almost 27, well above the 16.6 average since 1881. The problem with higher valuations? The more you pay for stocks today, the lower your chance of making a profit in the future.
But there is another side of this debate as well. Market strategists who believe that stocks have more room to run suggest that such long-term averages can not be relied on to assess “fair value.” Consider that the S&P 500 when first constructed in 1957, was largely a composite of industrial and utility companies with a few railroads thrown in. In 1989, consumer shares ruled while today technology and financial firms dominate (see chart below).
And a great many other things have changed as well. Corporations today are more inclined to use their excess cash to repurchase shares (thus boosting per share earnings growth) and perhaps most importantly, the very nature of the nation’s investor base has evolved. Prior to 1980, stock market activity was dominated by large institutional investors. Today, individual investors through retirement plans and high frequency trading dominate. The point here? If the very nature of the economy and the market has changed, doesn’t it make sense that the way shares are valued should as well? Whether these and other fundamental changes warrant higher valuations is unclear. But the fact that the CAPE ratio has been greater than its long-term average in all but 15 months over the last 25 years suggests some fundamental changes are afoot.
While the stock market valuation debate is interesting, I think it misses the point. Over long periods of time, stock prices are indeed based on fairly constant things like corporate profits but over short periods of time, unpredictable investor emotions hold sway. Time and time again, research has shown that trying to accurately predict when to get in and out of stocks has been a losing proposition. So what to do? First, recognize that volatility is a part of owning stocks and that the higher long-term returns they offer are compensation for this risk. Second, be sure to keep funds that you need within the next five years in a mix of cash and bonds. This way if stocks do decline, you can simply wait for prices to recover. Finally, take advantage of the upward long-term bias in stock prices for funds that have a longer time horizon.