The stock market is never shy of clashing views. After all, if we all agreed with each other, there would be no trading and no markets. But the current clash seems to be especially severe nowadays, as we ride a nine-year winning streak since the 2008 financial crisis.
When asked if concerned about stock prices being too high earlier this year, Warren Buffett answered that stocks are actually cheap. In August, after the Standard & Poor’s 500 index made further gains, Buffett said stocks are less cheap, but still better than bonds. At the same time, we see increasing worries that stock market is overpriced, and investors should brace themselves for a possible crash.
Which view makes better sense?
[See: 10 Ways You Can Invest Like Warren Buffett.]
First, why does Buffett think stocks are not too expensive? His exact words are the following: “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.”
What is measured against interest rates?
Interest rates represent investors’ opportunity costs of buying stocks — the rate of return you forfeit if you invest in stocks. The lower interest rates are the more attractive the stock market is compared to the safer investments such as T-bonds — and more investors pour money into the stock market will drive up the overall stock price. The flip side is, the higher the interest rate, the less attractive stocks are, and stock prices have to be low enough to lure investors into buying. In other words, a public company’s stock price will be different even if the fundamentals — profitability, growth prospects and risk — are the same when moved from a high interest rate period to a low rate period.
Those who disagree with Buffett argue that the stock price is too high relative to earnings compared to historic levels. The S&P 500 is trading 18 times over its forward 12 month earnings, higher than the 10 year average of 14 times. A particularly alarming piece of evidence is from Shiller’s S&P 500 CAPE ratio, dividing the S&P 500 index by the 10-year average inflation adjusted realized earnings. The Shiller CAPE is about 30, higher than 1987 market crash (17) and 2008 financial crisis (25), only dwarfed by internet bubble in 2000 (42) and pre-Depression crash of 1929 (33). Many commentators use this comparison to highlight their belief that investor sentiment has driven stock prices into irrational territory, not supported by the earnings.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
There is no question that PE ratio analysis is useful, but any attempt to predict returns just by comparing PE with historic level is naïve. The price-earnings ratio measures stock price relative to a firm’s earnings. And market-wide PE ratio measures how the market index is traded relative to aggregated earnings of firms covered by the index. A few factors jointly determine PE — profit, growth, firm risk, and prime interest rate. One has to look at all these dimensions before drawing conclusion about price, because the high PE may as well be justified by higher than historical average profit, growth, and lower than historic average risk. Any publicly traded company, when moving from a high-rate market to a low-rate market, will be traded at higher PE because price will be pushed higher while earnings remain constant. But this high-low comparison says nothing about investor sentiment.
Now let’s compare the current interest rate to historic market peaks. In 1987 before market crash, the 10 year Treasury bond rate was about 9 percent. In 2000, before the burst of the dotcom bubble, the rate was 6 percent. In 2007, right before the outbreak of financial crisis, the 10 year T-bond rate was about 5 percent, whereas the T-bond rate is 2.3 percent right now. Holding everything else equal, a decrease in T-bond rate from 5 percent to 2 percent could double the PE ratio (based on back of the envelope math with some assumptions on other determinants of PE). This is to say, a forward 12 month PE of 14 in 2007 is far more alarming than a PE of 18 in 2017.
Seen from a different perspective, the current 2.3 percent T-bond rate translates into a PE ratio of 43 — taking you 43 years to recoup initial investment. Back in 2007, a 5 percent T-bond rate corresponded to a PE of 20. So in 2007, stock was traded at 14 times forward earnings while T-bonds were priced 20 times earnings, whereas now stocks are traded at PE of 18 versus T-bonds at 43. That is why Buffett says stocks are still cheap compared to bonds, thanks to the low interest rates.
These low interest rates, combined with high expectation of profitability and growth, lead me to agree with Buffett that stocks are not overly expensive.
[See: 7 Ways to Buy Precious Metals With ETFs.]
Of course, this doesn’t mean that some individual stocks are not overpriced. If you want to stay in the stock market but feel somewhat anxious about this long bull market, I would suggest moving out of individual stocks and into index funds, especially out of high volatility and high beta stocks. For your 401(k) or individual retirement account, diversify into bond funds and international market funds.
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Are Stocks Cheap or Expensive? originally appeared on usnews.com
