I’ve written several articles over the past few years where I argued the market was not extremely overvalued when many used the historical average Shiller PE to highlight the market as being, well, extremely overvalued. The problem with using the historical average, as I see it, is including data from say the early 1900’s to forecast the valuation of today’s market is plain wrong; two different worlds. I’ll discuss the methodology to give a basic understanding on how a conclusion (market valuation) is arrived at.
This method measures market risk over a set time based on Shiller. The Shiller PE (known for Yale University economist and professor Robert Shiller) is the current price of the S&P 500 divided by the past decade's average inflation adjusted earnings of the index.
The valuation data is derived from a rolling time frame to the present or the year under examination. Five median values are calculated for each period at the specified intervals. The interval that best fits the historical record is eight years. We’ll look at a few examples to get a feel for how it works, specifically 1929, 2000 and 2007 followed by a current analysis.
The following color code definitions are:
Green – Market cheap to reasonably priced. Good time to find bargains
Yellow – Caution, more of a hold pattern. Bargains not as abundant
Red – Expensive. The period before a correction.
1929:
2000:
Finally, the great recession. Although the needle moved into the red it was different than the previous examples, i.e., overvalued but not as extreme as the previous examples.
2007:
What history tells us is there will be a correction once metrics move into overvalued territory. The unknowns are the timing and extent of the downdraft.
For example, the previous examples are summarized as follows indicating how long it took for the market to bottom:
The downdraft lasted five years from 1929 before the S&P moved up however buying in 1932 would have worked out well. The gauge went red again in 1936 and 1937. The market was up an astounding 112%.
2000; the downdraft lasted four years turning green in 2003. Four years later it entered the red zone before correcting again due to the housing mortgage market fiasco.
The downdraft lasted three years from 2007 turning green in 2009 and we've been in a bull market ever since.
Now that everyone is an expert on the methodology what about the here and now (at the time of this writing)? What might the future hold? The here and now is based on December 8, 2016. We have entered expensive territory.
We are barely in the red zone vs. the disasters of 1929 and 2000. If we end the year in the red, it would be the first time since 2007. There is no way to know how far it will push into the red zone or the timing. Will the needle push the limits or end more along the lines of 2007? What we do know is once in the red zone the shoe could drop at any time. Any spark could ignite a correction and if history is any guide it will be a surprise event.
When Alan Greenspan, Federal Reserve Board chairman used the now famous words “irrational exuberance” in a televised speech in December, 1996 the market was like an unstoppable freight train pushing higher and higher. It was another three years before what is now referred to as the internet bubble started to pop due to extreme over-valuation as visually depicted earlier.
A big unknown pushing the market to new highs are the policies of presidential elect Trump. Perception that taxes will be lowered and regulations rolled back for small and large businesses. Speculation this will unleash growth after years of low growth. Is this Trump euphoria or are the expectations real? Either way it is driving the markets up.
The other side of the equation is the Fed. The market expects rates to rise. The only question is how far and how fast. High rates too fast could put a crimp on business growth and consumer spending; not a good formula for the markets. President Elect Trump (in a past debate) attributed the market highs to the Fed holding rates down, creating a stock market bubble. The market soared ever higher once he won the election and continues its upward march at the time of this writing.
History tells us that in the end it makes no difference who is in charge, yes it could push the needle deeper in the red if investors see his policies as fuel for economic growth but in the end the pattern will mimic those of the past.
So, what should one do? It may be prudent to start building cash to prepare for periods like 2009 when bargains became plentiful. No one can predict with any certainty when a correction will occur but history tells us we are approaching one. The overvaluation could last year’s so accumulating cash does not equal getting out of the market but reducing positions that are looking overvalued and perhaps taking a more defensive position.
Are your investments at risk? I take the simplistic approach. I don’t start selling securities unless they become overvalued. I’m quicker to sell covered calls as they approach their exit value. One large position (as it relates to percent of portfolio value) I’ve cut back on is Microsoft (MSFT) being called out of half and have covered calls on the other half at a strike of $62.50. I’ve sold calls for Macy’s (M). More detail on fair values along with exit values for stocks I hold and track can be found here. The one correlation between the market valuation and stocks is as the needle pushes further right most stocks are close or exceed fair value. The other side of the coin is bargains are far more difficult to find.
Finally, instead of fearing a correction I view these as rare opportunities to get fire sale bargains which is why I will add to cash as (or if) we push deeper into the red zone and more stocks become overpriced.
A simple interactive market model where you can input a specific year can be found here.
What do you think? Is a correction coming soon or years away? I don’t have a crystal ball so I will be very conservative going forward.
