I randomly dish out investment lessons to my 7 year old. Yesterday I was explaining the concept of revenue and costs. I started off with a simple one. I asked him, if you made $1,000 in revenue and you spent $400 in costs, how much profit do you have left? $600 he responded. I went on, if you made $1,000 in revenue and you spent $5,000 costs, how much profit do you have left? He looked at me. Puzzled. His eyebrows pinched inward. And he burst out laughing. You have no money he responded. Clearly he has not heard of Uber, Tesla (until recently), Snap, AirBnB, Slack, and so on. His response was totally logical. And it is the same response many investors today give.
With the exceptions of Q4 of 2018 and March of 2020, the stock market has been on an uninterrupted bull run since the recovery from the GFC. As the stock market continues to make new and a record number of All Time Highs (ATH), investors are wondering whether the stock market is overvalued.
To offer some perspective, I have put together three measures that illustrate current valuations.
1. Price to Earnings (PE) Ratio
The PE ratio measures the price investors are willing to pay for every dollar of earnings. For example, the current PE ratio of 22 means investors are willing to pay $22 for every $1 of earnings from the market as whole.
Historically, the market has been willing to pay 16.11 on average. The drop back in March of 2020 saw a massive sell off on the basis that earnings would fall. Today, we're seeing companies' earnings strengthen, and as long as price growth slows down or remains flat, the ratio is expected to fall.
2. Cyclically Adjusted Price Earnings (CAPE) Ratio
Similar to the above PE ratio, the CAPE ratio averages out the last 10 years of inflation adjusted earnings. The higher the ratio, the lower the expected future returns. Whereas the lower the ration the higher the expected future returns.
3. Dividend Yield (%)
All else being equal, a falling dividend yield means prices are rising. The current dividend yield on the US stock market is the lowest we've seen since 2001. It's a stark contrast from March of 2020, where we saw dividend yield at the highest level since 2012 and it appears to be declining from here. The only way dividend yield rises, is if companies increase dividends, or for prices to correct.
As markets continue to embarrass market forecasters, pundits are finding even more reason to manufacture a narrative supporting their point of view. Are markets cheap? No. Are they expensive? I have no idea. If you simply look at these three charts, you could come to that conclusion.
There are so many other factors that come into play - the factors that go through my mind are: We've never seen interest rates this low. Investors have no other option but to take on risk. Trying to identify patterns based on historical data is a fools errand. I spoke about this exact topic in Episode 25 of Masters in Investing with Bhanu Singh. Trying to compare what happened the last time we saw this 50 years ago, with how markets and companies operate today, just seems incomparable. Just because something hasn't happened before, it doesn't mean it can't happen - just think about what investors were saying/thinking before the new (valuation) peak in 1987, then a higher peak in 1992, and again in the late 90's/early 2000s.
Just as my 7 year old laughs out loud at losing money, which I'm sure you do too, I just think the way businesses operate today is different to the way businesses operated 50 years ago. I think companies are taking a much longer time horizon on building businesses. In fact, the way some businesses are being built these days is different to the way they used to be. Granted, they're taking on much more risk in doing so, and usually using other peoples' money. Think Uber, Tesla (until recently), Snap, AirBnB, Slack and so on.
I think investing is more about time horizon and risk profile. Investing is more personal than it gets credit for.