The S&P 500 is overvalued by about 25%, but you wouldn't necessarily know it if you listened to the mass financial media. Fair value for the S&P 500 is around 900, based on how the market has been valued historically using 10-year trailing earnings as a measure. Again, you might be lulled into thinking the market is undervalued if you spend too much time listening to CNBC (Heehaw), or reading the likes of Barron's or the Wall Street Journal. Likewise, many of the brokerage firms are busy talking to clients and telling them now is the time to buy, buy, buy!
The only problem with that self-serving assessment is that it probably isn't true. Again, the S&P 500 is about 25% overvalued if history means anything at all. One of the best long-term measures of stock market valuation is the Price-to-Earnings (P/E) ratio, based on trailing 10-year average earnings (commonly known as Shiller's P/E). The current Shiller's P/E is about 20, well above the long run average of 15x - 16x, putting the current market in the top quartile in terms of EXPENSIVE. But why should you care if you are a long-term investor? Isn't it conventional wisdom to buy and hold your investments rather than "time" the market? And doesn't the Efficient Market Hypothesis tell us that no one can outperform the market by timing the market anyway? (since the market is always "correctly" priced given the known information), and therefore everyone should always be invested all of the time if they have a long-term time horizon?
In fact, you should care, because likely three year investing returns change drastically when buying into an expensive market - and your typical friendly neighborhood stockbroker (a.k.a. fee-based advisor) won't necessarily tell you that since they operate under the convenient assumption that stock market returns are unpredictable and, "oh what the heck, let's just always stay invested". Reality is somewhat different from that party line, however, and can lead to LOOONNGGG periods of time needed to recoup market losses for those investors who stay aggressively invested during high risk markets.
First the return assumptions typically used by advisors...
The standard return assumptions based on 125 years of data are: a normally distributed set of returns for a 3-year holding period averaging 9.5%, including dividends; a 15% probability of investors losing money over the 3-year period, a slight possibility of tripling their money and a slight possibility of losing around 80% over three years. The standard return assumptions in fact are merely past history projected into the future. But what if those return assumptions are wrong? What if the actual returns for a 3-year holding period where only 7% annually on average with a 28% probability of losing money during the 3-year holding period? Would you be quite so eager to own stocks then?
Probably not. And, as it turns out, the current Shiller P/E of 20 does create a return distribution in line with the second scenario. Shiller P/Es of 19.2 or higher produce return results averaging a mere 7% per annualized 3-year holding period with a likelihood of losses 28% of the time, according to Keith C. Goddard, CFA (Goddard used Professor Shiller's work on stock market price-to-earnings as his base data). Would individual investors make the same allocation decisions if they knew they had a 28% probability of losing money over a 3-year period rather than only a 15% probability of losing money? Again, probably not, if our experience with investors is representative.
Now, throw in the fact that the broad money supply is still in contraction (real M3 contracting is a 100% accurate indicator of recession 6 months down the road) and the already expensive market becomes an exceedingly dangerous one. Investors should plan accordingly....
(Biechele Royce Advisors will continue to buy good companies at great prices when we can find them, but continues to currently see very little of interest, which also indicates an expensive market.)
