How Can You Tell if a Market is Overvalued?

Do valuation metrics work in this new new world of abnormal interest rates and an ageing population? Dan Kemp investigates how to tell if a stock is good value

Dan Kemp 25 July, 2017 | 10:17AM
Facebook Twitter LinkedIn

What constitutes value investing in this new world of abnormal interest rates and an ageing population? Some investors justify the higher asset prices in the short term on the basis that the paradigm has shifted – including prominent investors such as Jeremy Grantham – while others remain steadfastly wedded to traditional valuation metrics which look increasingly stretched.

While the debate is healthy, it is important to remain focused on how excessive valuations may be.

There are literally hundreds of ways to approach this, yet regardless of the chosen approach one should remain firmly grounded in the fundamental drivers of returns and reminded by the cyclicality of markets.

This involves a focus on the metrics that form the cornerstone of long-term investing and helps reduce an investors’ susceptibility to the ‘recency bias’; leading to an expectation that the current trend will continue.

In this regard, we can demonstrate changes in valuations over time by comparing some of the more popular fundamental inputs relative to their available history. One of the more digestible methods has been to show an average of three key valuation metrics as a percentile of its history – namely the price/book-value ratio, the price/sales ratio and the CAPE10 – 10-year cyclically-adjusted earnings ratio.

This is depicted below, with a score of 50% meaning that valuations are ‘normal’ relative to the available history, 0% indicating that they are at their cheapest and 100% suggesting they are at their most expensive.

Using traditional methods of valuation markets look overvalued

The central idea is to objectively and repeatedly identify periods of euphoria and fear. Excessive optimism – a score near 100% – is said to be a clear sign that risks are increasing, while unwarranted fear – a score near 0% – can theoretically present a great buying opportunity.

We can see from the chart that this relatively simple approach was successful in identifying 2009 and 2012 as periods where most markets were ‘cheap’ based on the valuation-driven fundamentals. It also shows that 2007 was a period where all major markets were ‘expensive’.

Are Valuation Metrics Still Relevant?

A question being flaunted more and more is whether valuation metrics such as the above are still effective in today’s world. This has been something that some of the world’s most reputable investors and academics have been pondering – including Jeremy Grantham of GMO and Robert Shiller as a Professor at Yale University.

Take Shiller’s cyclically-adjusted price-earnings ratio as an example. This is his favourite metric, showing the relationship between long-term 10-year real earnings against today’s prices. With major technology shifts impacting the way we do business, some are pondering whether this may combine with today’s low interest rate paradigm and imply higher fair values.

A similar theme applies to many of the other valuation metrics including profit margins and the price-to-book-value ratio. After decades of proving their validity, the question is now whether investors should reconsider their appropriateness.

To our straightforward way of thinking, fundamentals and valuation metrics are the gravity by which prices are held to sanity. Therefore, while record low interest rates and technological advancements may influence the fundamentals, it is ultimately the long-term revenue, profitability and dividend generating capabilities that remain vitally important.

What Does that Mean in Today’s World?

If we are so brave to apply the ‘old school’ methodology to today’s market, exhibit 3 shows that we are almost entering the first occurrence since the 2008 financial crisis where all six major markets are deemed ‘expensive’. Should this make us so rash to start predicting a major crash? Or should we rethink the methodology that has worked so well over history?

Perspective helps here, as history shows countless periods where euphoric conditions take hold and people begin to second-guess their process. Things like political reform and a strong wave of economic prosperity are regular features of such euphoric periods and it is a well-known behavioural trait that investors develop a ‘fear of missing out’, derived from the herd mentality.

Therefore, as tempting as it may be to chase the latest fad in the later stages of an economic cycle, we have every reason to believe that people will still respect fundamental inputs such as revenue, profitability and dividends as a way of working out how much to pay for an investment.

Said simply, a long-term valuation-driven approach should be equally applicable in 1917, 2017 and 2117.

Using this logic, we can present a comprehensive way of assessing long-term valuations over time. It shows the prospective returns relative to what we consider to be ‘fair’ or ‘normal’. This is a valuation-driven approach that includes fundamental factors such as return-on-equity, margins, pay-out ratios and the cost-of-equity.

Current valuations of asset classes across the globe

We also include other assets such as fixed income in the comparison as a means of showing relative value, and by doing so, demonstrate the challenges we face in today’s environment.

This is a clear depiction of a modern investment landscape that defies our view of rationality. While some pockets of opportunity are apparent, the landscape can be generally viewed as unattractive for investment on a risk-adjusted basis.

The challenge of turning this analysis into a well-represented portfolio is exacerbated in its complexity, requiring us to be acquainted with the ‘overconfidence bias’ and deal with it by setting a clear investment time horizon, risk parameters, a strong culture of challenge and a clear way of sizing positions to reflect the extremity of valuations. It is another case of investing being simple but not easy.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures